NOTE: This article originally appeared on Xconomy.com on June 28, 2016.
You might know it as a letter of intent or a term sheet. Maybe you’ve heard it referred to as an MOU, or memorandum of understanding. Whatever you call it, this document of about five pages is a summary of the terms of a deal the parties hope to close down the line.
If buyers and sellers don’t have a meeting of the minds early on in the game, it’s possible that, deeper into negotiations, the proposed terms in the definitive agreement could derail weeks of work, wasting everyone’s time and energy. The MOU’s goal is to make sure everyone is on the same page.
Key Components: What appears to be a simple, straightforward document has the potential to scuttle a deal, so it’s vital to understand the MO of an MOU. First, let’s cover basic components you’d see in a letter of intent for a startup M&A deal:
- The sticker price: The cost to acquire the target.
- Price adjustments: Possible reductions (due to debt or liabilities exceeding assets) or increases (based on financial performance).
- The structure: Will the deal be an asset sale? A merger? A stock sale?
- Payment form: Stock, cash, or a combination.
- Escrow and indemnification: How much money to set aside, and for how long, to protect the buyer.
- Exclusivity: Whether the startup must consider only this deal during the buyer’s due-diligence period.
A letter of intent isn’t binding. Neither side is obliged to close the deal. The buyer can bail if due diligence reveals troublesome news, such as significant undisclosed liabilities or litigation with the potential to drain a startup’s resources. A startup might balk at the buyer’s proposed package for management retention and compensation.
Even a “non-binding” document can, however, contain provisions that are binding. The two big ones are confidentiality and exclusivity. Confidentiality requires the parties to keep the substance of the talks under wraps. The exclusivity provision, also called a “no shop,” bars the seller, for a specified time period, from soliciting competing offers or negotiating with another prospective buyer who appears with an unsolicited offer.
Keeping the Faith: Respecting exclusivity is a core component of “negotiating in good faith.” Both parties are expected to act honestly, remain engaged, and commit to the process, which may or may not culminate in a deal. Acts of bad faith can include refusing to respond to the other party or proposing terms—such as attempting to renegotiate the sales price—far beyond those covered in the letter of intent.
Escrow: The parties typically agree to set aside 10 percent of the purchase price in an escrow account. This money will cover any breaches by the seller of the terms of the acquisition agreement, such as not disclosing a pending lawsuit or other liabilities.
The funds usually remain in escrow for 12 to 18 months before being released to the selling stockholders. Some buyers may prefer to tie the escrow period to the completion of the business’s next audit, which is, ideally, when any undisclosed liabilities would come to light.
I encourage sellers to press for escrow terms to be spelled out in the LOI. Don’t assume that if it’s not mentioned there, then it won’t be in play down the line. Better to resolve it now so onerous terms don’t pop up in the definitive agreement.
Retention Packages: Letters of intent typically don’t delve into the details of the compensation package for key employees because buyers often believe it’s too early in the process to hash out specifics like salaries, severance, or grants of stock or options.
But sellers should raise these issues, first among the founding team and management and, if applicable, with a few key employees, and then with the buyer before entering into a period of exclusivity. This is especially important if salaries and equity compensation are material points in the transaction.
If you’re selling, it’s preferable to get as much of this in the LOI as possible. Because while you’re bound by a “no shop,” you’re simultaneously agreeing to forego other opportunities. That’s a major concession for any startup. So make the exclusivity period worth your while.
Ultimately, the relatively scant MOU doesn’t carry the weight of a signed, sealed, and officially binding document. Its value, though, is in its ability to succinctly set the tone and terms for the deal on the horizon. Memo to self: Get the memorandum of understanding right, and it will smooth the path for the transaction that follows.