The importance of a LOI when buying a business
Surely you have heard of the expression “words are gone with the wind.” Keep this phrase in mind when you are planning your M&A strategy. You must understand that there is a great difference between a handshake with verbal agreement and a letter of intent. When buying a business, one must write down everything. It is necessary because throughout the conversations amongst each other ambiguities are generated. It’s called selective hearing, when one only hears and listens to what is most convenient for them.
Perhaps you did not know this but during a negotiation there are three conversations being produced: the conversation of the seller with himself, the one of the buyer with himself, and the one with each other. It happens often that when one is speaking the other is not listening because they are invested in the conversation with themselves or they are thinking of what they are going to say next. Consequently, a dialog like this is produced:
Buyer: “we agreed on this”
Seller: “we never made a deal on that”
Buyer: “but I told you and you agreed to it”
Seller: “no, we never even spoke about that”
It does not necessarily mean that the seller is a liar, he was just not listening.
This is why it is important to have your advisors write a letter of intent of everything that was agreed upon between the seller and the buyer, if possible have both parties sign the document. The letters are key to a smooth corporate operation.
What is a LOI and why is it necessary when buying a business?
The letter of intent (LOI) is a document that is relevant during the selling of a business, due to its implied jurisdictions. This document contains the main points that have been agreed upon by the buyer and the seller.
It is of vital importance that all relevant aspects of the agreement are written down since thereafter, you, as a buyer will invest in auditors and legal advisors. If it’s the case that the most important and relevant points were not addressed in the LOI, then it is possible that the process will fall apart and everyone involved waisted their time and, in your case, a lot of money.
The agreement should include if the deal is about capital extensions, a purchase of financial assets and financial liabilities or shares, the price, percentage at purchase, what form of payment will be used, payment deadlines, adjustment formula for price and any other sort of reimbursement ( consulting fees for the buyer).
An agreement of confidentiality and a term of exclusivity (in which the seller cannot negotiate with other buyers) that proceeds with due diligence and a contract of trade. Often a deadline is placed for the signing of the contract and a calendar of financial performances.
There can be an incorporation of the type of banking debt that will be used for the purchase.
In various occasions it is established what the due diligence will cover, but of course, the seller should facilitate the information necessary for the due diligence.
In this agreement you must establish that the business will continue to be managed until the purchase in the manner established. It shall remain intact and without any alterations of significance to the working capital nor the relationship with the providers and clients; you cannot distribute dividends or make extraordinary expenses or sell financial assets; it is prohibited to sign other contracts different to those of the normal management, change salary or compensation plans etc. For this type of action, written authorization of the buyer is required.
You must condition the validity of the agreement until you are satisfied with the due diligence, to obtain the financing necessary from the banks and, of course, until there is no substantial changes in the financial or operative aspects of the company.
Moreover, it is recommended to make an agreement that states that if the seller retracts himself or leaves the sell, he should pay the expenses of the due diligence. This is crucial because the seller can become nostalgic in the final steps of the sale and cancel the process.
The LOI is what you will present to the banks so they can begin financing what was agreed upon. Do not let the “words are go with the wind,” if you truly desire to buy the business.
As the days pass, the world that we take part in becomes more globalized, buying a business presents itself as a magnificent path towards new markets or to reinforce a competitive position. The biggest challenge that emerges with these opportunities is knowing how to approach them to be able to maximize profit and not be deceived. If you are planning on buying a business and you are looking for advising, do not hesitate to contact us for strategic advisory!