This is Part III in my six-part series on the anatomy of an M&A deal from the buyer’s perspective. To read Part II, which covers screening and valuation, click here.
Buyers who are serious about merging with or acquiring a company typically express their interest to the target through a letter of intent (LOI). As I explained in my sell-side M&A series:
[A] letter of intent (LOI) is a written document that outlines the intentions of the buyer and the seller during a transaction: the price each side is willing to settle for, as well as the general terms of the agreement.
Though usually non-binding, the LOI is an important legal document. The LOI represents a critical step in the M&A process by communicating what the roadmap for the transaction by outlining the valuation of the target and establishing the overall framework for the deal. If the parties disagree over this valuation, negotiations may quickly sour. A low valuation may offend the seller. A high valuation may put the seller at an unmanageable disadvantage. A vague valuation hinders both parties, as buyer and seller attempt to divine what the other is thinking. Indeed, many failed deals can be traced back to imprecise, inequitable, or otherwise inadequate letters of intent.
Accordingly, as a buyer, you need to conduct as much due diligence as possible in order to hone the terms of your LOI. And, because it is the buyer’s position to submit the LOI, time is on your side—not the seller’s. In other words, don’t settle until you have all the information you need.
Doing Your Homework Through Due Diligence
What should you look at during your due diligence investigation of the target? Here are several components of the seller’s business that may uncover key details before you move forward:
1. EARNINGS AND FINANCIAL PERFORMANCE
- Financial information for the past 3–5 years:
- income statements
- balance sheets
- cash flow
- audit reports
- Projections, budgets, and forecasts for the next 3–5 years
- Credit agreements, debts, and contingent liabilities
- Bank and safety deposit box information
2. OPERATIONAL STRUCTURE
- Incorporation documents, and/or corporate bylaws
- Minutes from board, shareholder, and/or executive committee meetings
- Organizational chart
3. CUSTOMERS AND SUPPLIERS
- Schedule of accounts receivable
- Schedule of accounts payable
- List of key customers and vendors
- Insurance policies
- Loan agreements
- Contracts for service suppliers
4. TAX STATUS
- Federal and state returns
- Audit reports and other tax examination records
- Tax sharing/funding agreements
5. HUMAN RESOURCES
- List of employees and wages
- Employment agreements
- Standing of key employees
- Personnel handbooks
- Vacation and sick time schedules
- Employee benefit policies
6. INTELLECTUAL PROPERTY
- Domain names
- Records of claims or disputes made over intellectual property
- List of current stock, including cost, number, and acquisition date
- Inventory schedule
- Estimated valuation of inventory over time
8. OTHER ASSETS AND LIABILITIES
- List of real estate property
- List of equipment, including computers and motor vehicleslu
- Titles for property
- Appraisal of property
9. LEGAL AND REGULATORY MATTERS
- Records of pending or threatened litigation
- Court orders and permits
- Regulatory investigation reports
- Notices of violation
- Contact information for legal counsel representing the company in each matter
If the seller is not forthcoming with these details, consider what their reticence may indicate: is it simply a matter of trust, or might an unsound—or illegal—business practice be lurking under the surface? One way to test the seller’s trustworthiness and ability to communicate is through mutual disclosure: show them your cards and they may be more willing to reveal theirs.
What To Include In A Letter Of Intent
Some buyers submit LOIs before completing their due diligence investigations, while others (perhaps wisely) attempt to gather any and all information before laying their expectations before the seller. Your approach will depend on your overall M&A objectives and timeframe. The more details enumerated above you can synthesize into your LOI, however, the better off both parties will be.
Similarly, the terms included in an LOI vary from buyer to buyer, but here are several provisions found in almost every letter:
PRICE AND PAYMENT STRUCTURE
- Purchase price
- Payment terms and schedule
WHAT WILL BE ACQUIRED
- Buyer’s and seller’s tax responsibilities
- Definition of confidential information
- Exceptions for disclosure (e.g. attorneys and accountants)
- Reciprocity: is the agreement mutual or unilateral?
- Terms of exclusivity (no-shop)
- Length of exclusivity period
You may also need to add language indicating your intention to negotiate in “good faith.” While honest, fair communication seems like a given, common law holds M&A participants accountable for breaches of their duty to negotiate in good faith.
In the fourth installment of this series, I will explore the ins and outs of financing and negotiation, offering an overview of various financing options as well as considerations for building your purchase agreement.
Buyers of all experience levels can benefit from partnership with business transactions attorneys like the ones at Offit Kurman Attorneys at Law. Since 1987, we have been working with clients to achieve their long- and short-term objectives. From pre-transaction planning to closing, we can provide you with the knowledge and confidence to succeed during every stage of the M&A process.