Common LOI mistakes
The Letter of Intent (commonly referred to as the LOI) is the single most important document for an Independent Sponsor. It is a simple, yet critical, agreement between the seller and the Independent Sponsor. While LOI’s can vary in their length and detail, there are two main components that all LOI’s should have.
The LOI agreement outlines the negotiated purchase price between the Independent Sponsor and the seller. Both the seller and Independent Sponsor have signed the agreement, yet it is a more binding document on the side of the seller. The LOI is still subject to the Independent Sponsor’s further due diligence and if in that due diligence process something “comes up” that makes the deal unacceptable, the Independent Sponsor can walk away (usually with no penalty). Rather than walk away, another option the Independent Sponsor has is to renegotiate the purchase price (but note: the seller is then under no obligation to accept the new price).
The LOI agreement provides a certain exclusive time period in which the Independent Sponsor can conduct further due diligence, raise the capital needed and document the deal. The Independent Sponsor must close it within that time period or risk losing the deal/the exclusivity. During this exclusive period as outlined in the LOI, the seller is prohibited from discussing the company with other parties who may be interested in purchasing the company. The exclusivity period is whatever the Independent Sponsor and the seller agree to but is usually no fewer than 90 days.
It is critical for an Independent Sponsors to get the signed LOI. It gives the Independent Sponsor exclusivity and without it many capital sources aren’t even interested in reviewing the deal. Here are a few common mistakes Independent Sponsors should avoid when negotiating and getting to a Letter of Intent with a seller.
1. Over Negotiating
The LOI is a rather simple agreement usually only a couple of pages long. As stated above, its main purpose is to outline the purchase price in broad terms and provide a time period of exclusivity for the purchaser. In the agreement the Independent Sponsor should not go into fine details, but KEEP IT SIMPLE. Until the LOI is signed the Independent Sponsor and the seller are still in a dance with no obligations on either side. Many times the seller has never sold a company before and is often overwhelmed by the process; an Independent Sponsor must not add to the seller’s uneasiness. If you have agreed to a price and a negotiated exclusivity period… GET THE AGREEMENT SIGNED. That is not to say the purchase price can’t include seller notes, an earn out or even a formula regarding the working capital adjustments, but it must be simple. Do not "over lawyer" it. The actual Purchase Agreement which comes later will cover the details. Frisch Capital has seen numerous deals never even truly get started because the buyer over negotiates the terms of the LOI, upsets the seller and the seller walks away from the deal before the LOI is even signed.
2. Paying too much
For the Independent Sponsor, agreeing to a purchase price with the seller is obviously important in the process of getting an LOI. However, the capital sources (who will finance the Fundless Sponsor's deal) do have acceptable purchase price ranges that they are willing to consider given a company’s size, growth potential, industry etc. Since the Independent Sponsor is responsible for setting the price and basic terms of the purchase, it would be wise for the Independent Sponsor not to go too far outside those ranges. It is important to realize the deal must be attractive to capital sources. Anyone can purchase a company by out bidding the competition. However, it is a fine skill to be able to negotiate a good purchase price that is acceptable to both the buyer and seller AND the capital sources. Independent Sponsors must be careful they don’t over pay just to win the deal.
3. Not allowING enough time to close the deal or engage firms to help in the process
Before obtaining the LOI, an Independent Sponsor often spends time doing some initial due diligence. During this phase, the seller will often share financials and a certain amount of other information on their company. However, sellers are often reluctant to let you fully “scrub” deeper until after the LOI is signed. Once you get the signed LOI and the exclusivity period begins, the Independent Sponsor is able to conduct detailed due diligence, have further in-depth management discussions and engage firms to: conduct a Quality of Earnings report, raise the needed capital and begin legal documentation. BUT ALL OF THAT TAKES TIME. Many Independent Sponsors have only a few people (if that) that can do all of this work much less in a short time period. It is critical that Independent Sponsors engage help early after signing an LOI and give themselves enough time in their exclusivity under their LOI to be able to get everything done.
This past year Frisch Capital had an Independent Sponsor approach them regarding a transaction. When we asked to see the LOI we were pleased to see that the LOI had a 120-day exclusivity period. But our enthusiasm quickly turned to disbelief when we realized that there was only 10 days remaining in the LOI. The Independent Sponsor had spent the first 110 days conducting additional due diligence, industry studies, management interviews, etc. While the work the Independent Sponsor was doing was important and further confirmed that the transaction was going to be a success, it became too late to be able to secure the necessary capital to close the deal. Unfortunately the Independent Sponsor did not engage us early enough to close within the exclusivity period. Almost immediately after talking to us, the Independent Sponsor’s exclusivity on the LOI ran out and the seller went with another buyer.
Common LOI lengths of exclusivity are 90-120 days often with an automatic extension. Nevertheless, LOIs can run longer and 150 to as much as 180 days is not unheard of. The more time an Independent Sponsor can get for exclusivity in the LOI, the better. The automatic extension (usually 30 days) is also important. This is usually based on “good faith” and given to the Independent Sponsor because he has the capital sources in place and they may need more time to document the deal. The bottom line is that Independent Sponsors must engage outside firms early and give the outside firms and themselves as much time as possible in the LOI to complete their work on the transaction.
4. Not being patient nor understanding the Seller
Many companies that are sold to Independent Sponsors are being sold by their founders or second or third generation family members that have grown up in the company. There is a lot of emotion, history, and significance tied up in the company. For many sellers, the company is part of their identity and the employees are like family. For many family run businesses, this might be the first and only time they have ever sold a business. They often are not familiar with the process of selling a company. Independent Sponsors must understand this! Their relationship with the seller is paramount and having the seller trust them is as important as the purchase price. Trust takes time to earn and can be broken quickly. The more trust the seller has with the buyer, the more forgiving they will be during the process when things don't or the timing doesn't go exactly according to plan. Many Independent Sponsors win deals not because they offer the most money, but because the seller likes them and trusts them.