This article was originally published in Forbes.
Signing a letter of intent (LOI) that outlines the key provisions of a prospective deal is an exciting milestone for sellers, who have likely spent a great deal of time, energy, and money getting to this point. But, once the LOI is executed, the seller’s negotiating power decreases significantly. This loss of leverage stems from the agreement requiring temporary exclusivity from the seller and the negative signal other buyers perceive if the deal ends up falling apart.
Why LOIs Require Exclusivity
An LOI usually includes an exclusivity period, during which the seller is prohibited from speaking with other potential buyers. While this lock-up period is disadvantageous to the seller, it is nearly universal because the buyer wants some comfort before spending the significant time and money required to conduct extensive due diligence on the company. Aside from spending countless hours of their own time, the average buyer will spend out-of-pocket well over six-figures in accounting, legal, and consulting expenses. The buyer will analyze every aspect of the business relevant to the transaction price. Few buyers would be willing to proceed with this kind of commitment without an agreement by the seller that they are exclusive.
Typically, the LOI represents the last opportunity for the seller to fully exert their bargaining power over the transaction. Once the LOI is signed, the seller can no longer use the potential for other, higher offers to negotiate a better price. Sellers should proceed cautiously before granting such exclusivity. The best way for sellers to limit the risk of a deal going wrong after signing the LOI is to be candid and forthcoming about any bad news that may be uncovered during due diligence before entering into an exclusive agreement. “It is always in the seller’s best interest to push for an LOI that is as detailed and clear as possible — this will limit the number of material terms that remain open and subject to buyer pushback as the parties’ focus shifts from substantive negotiations to execution,” said Anthony Arnold an M&A Partner at Barnes & Thornburg, LLP.
Maximizing Your Payout
The price the buyer proposes in an LOI is not the same as the final payout. Instead, it is the highest possible price that the buyer would pay for the business. While buyers are likely to ask for concessions if negative information is discovered during due diligence, never in the history of deals has a buyer voluntarily offered to increase their offer based on being pleasantly surprised. One of the biggest mistake sellers make is putting out aggressive projections that they can’t possibly hit and failing to disclose potential risks. Remember, the LOI is non-binding. “The most important financial terms in LOIs are almost always qualified with a ‘subject to buyer’s due diligence’ statement — and that is an opening that is substantial enough for even the most generous buyer to drive a truck through,” said Arnold.
While it may seem counterintuitive, it is nearly always better to share bad news early while you still have negotiating leverage associated with a competitive process, rather than praying that the buyer fails to discover it. The more bad news there is to uncover after the LOI is signed the lower the price will go, likely resulting in longer, more extensive (and expensive) diligence by the buyer— Significant trust and goodwill is also often lost in the process. From a practical standpoint, the fatigue and significant financial expenses the seller has incurred makes it psychologically challenging to walk away, leaving the seller vulnerable to agreeing to unfavorable price and term concessions.
While it is possible to reject any concessions a buyer may request and try to remarket the business once the exclusivity period has expired, this is generally a very unfavorable situation as the seller is likely to face scrutiny from the same potential buyers for a second time. This time, however, they know that the “winning” bidder got a look behind the curtain and found something they didn’t like and will generally assume the company is “damaged goods.” Moreover, given these other interested parties were not selected the first time, they are unlikely to offer nearly as generous terms. As a result, it is not uncommon after a failed LOI for a seller to remove the company from the market for 12-18 months to try and reset expectations and achieve a clean slate again.
Caveat Venditor
Given the above dynamics, some unscrupulous buyers will initially propose terms that they have no intention of honoring with the intention of forcing a seller into a disadvantageous negotiation. Similarly, given its non-binding nature, some buyers view offers as a “free option,” reflecting a much lower commitment level to proceeding than the fully motivated business owner. They can strategically abuse the power associated with exclusivity and the stigma of a failed deal to extract pricing concessions. Consequently, it is extremely important to vet potential acquirers before signing an LOI by asking them about their track record of closing and funding sources and to also conduct comprehensive reference checks to get a sense of their reputation and integrity.
Conclusion
Most sellers believe that a signed LOI is essentially the finish line of a transaction, however the truth is that there is a lot of uncertainty and work between it and closing. They should take steps to assure that they stand in a sound negotiating position before executing an LOI, as their ability to adjust terms and prices will be limited once exclusivity is in effect. Additionally, sellers should invest the time to validate the character, commitment level, and ability to close of a prospective buyer before signing on the dotted line.
