Letter of Intent When Buying or Selling a Business: What Should Be Negotiated Before You Sign?

Then the lawyers start asking questions.

What assets are included? Is the transaction cash-free and debt-free? How much working capital must remain in the business? Who keeps the accounts receivable? Is inventory included in the purchase price? Will the seller finance any portion of the transaction? Is the buyer's obligation contingent on financing? How long will the seller remain involved after closing? What happens if due diligence uncovers a problem?

For business owners who have never been through a merger or acquisition, this can seem premature. After all, isn't the letter of intent just a non-binding outline that will eventually be replaced by a definitive purchase agreement?

Yes—and that is precisely why it matters.

A well-drafted letter of intent, commonly called an LOI, establishes the basic economic and structural expectations around which the parties will spend the next several months conducting due diligence, obtaining financing, negotiating definitive agreements, and preparing for closing.

Although many provisions of an LOI are expressly non-binding, a poorly negotiated business term does not become easy to renegotiate merely because it is legally non-binding. Once the parties have agreed on the basic economics of the transaction, attempts to materially change those economics later can jeopardize the deal.

For both buyers and sellers, the time to identify the major business issues is before signing the LOI—not after everyone has already spent significant time and money trying to close.

What Is a Letter of Intent in an M&A Transaction?

A letter of intent is a preliminary agreement describing the principal terms under which a buyer proposes to acquire a business.

Depending on the transaction, the LOI may address:

• the purchase price;

• whether the transaction will be structured as an asset purchase or equity purchase;

• what assets and liabilities are included or excluded;

• cash, debt, and working capital treatment;

• accounts receivable and inventory;

• seller financing, earnouts, or rollover equity;

• buyer financing;

• due diligence;

• the seller's post-closing transition obligations;

• restrictive covenants;

• confidentiality;

• exclusivity or a “no-shop” period;

• anticipated timing for closing; and

• conditions that must be satisfied before the parties are required to close.

The LOI is ordinarily followed by a much more detailed asset purchase agreement, stock purchase agreement, or membership interest purchase agreement. That definitive agreement may ultimately be dozens of pages long. The LOI may be only three to six pages. The difference in length should not be confused with a difference in importance.

Is a Letter of Intent Binding?

The answer is usually: some of it is, and some of it is not.

Most M&A LOIs expressly state that the principal transaction terms—including the proposed purchase price and obligation to consummate the acquisition—are non-binding unless and until the parties execute a definitive purchase agreement.

However, certain provisions are commonly intended to become binding immediately. These may include:

Confidentiality. The parties may be prohibited from disclosing information about the proposed transaction or using confidential information for purposes unrelated to evaluating the acquisition.

Exclusivity or no-shop provisions. The seller may agree not to solicit, negotiate, or enter into a competing transaction for a specified period.

Access and due diligence. The LOI may establish the buyer's right to receive financial, operational, legal, and other information concerning the business.

Expenses. The parties may agree that each side bears its own legal, accounting, and transaction expenses.

Governing law and dispute provisions. These provisions may govern disputes arising from the binding portions of the LOI.

For sellers in particular, exclusivity deserves careful attention. Once a seller agrees not to entertain competing offers for 60 or 90 days, the buyer has effectively taken the business off the market while it conducts diligence and pursues financing. If the buyer later walks away, the seller may have lost months and potentially other interested purchasers.

Calling the LOI “non-binding” therefore tells only part of the story.

Purchase Price Is Only the Beginning

One of the most common mistakes in negotiating an LOI is focusing almost exclusively on the headline purchase price.

Suppose a buyer offers $2 million for a business. That number sounds straightforward. Economically, however, a $2 million transaction can mean very different things depending on the remaining terms.

• Is the entire $2 million paid in cash at closing?

• Is $300,000 paid through a five-year seller note?

• Is $250,000 contingent on the business achieving future revenue targets?

• Will $200,000 be held in escrow?

• Does the seller need to leave $400,000 of working capital in the business?

• Does the seller retain the company's accounts receivable?

• Is excess cash distributed to the seller before closing?

• Who receives the benefit of inventory already purchased?

Each of these terms affects the actual economic value of the transaction.

A seller should therefore evaluate an offer based not simply on purchase price, but on what the seller will receive, when the seller will receive it, what remains at risk after closing, and what must be left behind.

Working Capital Should Be Addressed Early

Working capital is one of the most common sources of disagreement in privately held business acquisitions. Many transactions are negotiated on a “cash-free, debt-free” basis, with the seller expected to deliver a normalized level of working capital at closing.

But what does “normalized” mean? The parties may need to determine:

• which current assets and liabilities count toward working capital;

• the appropriate working capital target or “peg”;

• whether the target is based on a trailing 12-month, seasonal, or other historical average;

• how accounts receivable are treated;

• whether customer deposits and deferred revenue are included;

• how inventory is valued;

• how accrued payroll, bonuses, commissions, and paid time off are treated; and

• how the post-closing calculation and true-up will work.

These issues can move the effective purchase price by tens or hundreds of thousands of dollars.

A buyer who believes the seller agreed to deliver $500,000 of working capital and a seller who believes the business is being transferred without working capital do not have a minor drafting disagreement. They have materially different understandings of the transaction.

The LOI does not necessarily need to contain the final working capital calculation. But it should establish enough of the framework that neither side is surprised when the definitive agreement is negotiated.

For a deeper discussion, see our guide to working capital adjustments in business sales.

What Happens to Accounts Receivable?

Accounts receivable deserve particular attention in an asset purchase.

The parties should determine whether receivables are:

• purchased by the buyer;

• retained by the seller; or

• subject to some alternative collection arrangement after closing.

If the seller retains its accounts receivable, the parties should also consider what happens when customers send payment to the buyer after closing, whether the buyer will assist in collection, and how payments involving both pre-closing and post-closing invoices will be allocated.

For some businesses, accounts receivable represent a substantial portion of the seller's expected proceeds. Leaving the issue unresolved until the definitive agreement can materially change the economics the seller believed it accepted.

Inventory: Included in the Price or Added at Closing?

Inventory treatment varies significantly by transaction and industry. The LOI should make clear whether normal inventory is:

• included in the stated purchase price;

• purchased separately based on a closing inventory count;

• included only up to a specified amount; or

• subject to adjustment for obsolete, damaged, or unsalable inventory.

This becomes particularly important for businesses with significant seasonal inventory. A $2 million purchase price plus $500,000 of inventory is obviously not economically equivalent to a $2 million purchase price including $500,000 of inventory.

Yet parties sometimes reach the purchase-agreement stage before discovering that they had different assumptions about precisely this issue.

Asset Purchase or Equity Purchase?

The LOI should ordinarily identify the anticipated transaction structure.

In an asset purchase, the buyer acquires specified assets and assumes specified liabilities of the business.

In an equity purchase, the buyer acquires the ownership interests in the company itself. The entity generally continues to own the same assets, owe the same liabilities, and remain party to its existing contracts.

The distinction can affect taxes, liability exposure, contracts, licenses, employee matters, financing, and required third-party consents.

The parties should therefore avoid treating transaction structure as something the lawyers can simply “figure out later.”

For more on this issue, see our discussion of asset purchase agreements versus stock purchase agreements.

What If the Buyer Needs Financing?

If the buyer intends to finance the acquisition, particularly through an SBA 7(a) loan, financing should be addressed early.

The LOI should make clear whether the buyer's obligation to close is conditioned upon obtaining financing and, where appropriate, the basic parameters of that financing. Financing can affect much more than the buyer's ability to fund the purchase price. A lender may require:

• appraisals or business valuations;

• life insurance;

• landlord consents;

• lien releases;

• seller-note subordination;

• minimum buyer equity;

• organizational documents;

• financial information;

• specific closing documents; and

• changes to aspects of the transaction structure.

A transaction that works for the buyer and seller but does not satisfy the lender may not close. Buyers using SBA financing should therefore involve their lender—and preferably transaction counsel—early enough that financing requirements do not emerge for the first time shortly before closing.

Due Diligence: What Is the Buyer Entitled to Investigate?

The LOI typically provides the buyer with an opportunity to conduct legal, financial, tax, operational, and commercial due diligence.

This process may include review of:

• financial statements and tax returns;

• accounts receivable and accounts payable;

• customer and vendor contracts;

• leases;

• employee and independent contractor arrangements;

• compensation and benefits;

• intellectual property;

• licenses and permits;

• litigation and threatened claims;

• taxes;

• insurance;

• equipment and other assets;

• loans, liens, and other indebtedness; and

• customer concentration and supplier relationships.

Sellers sometimes view extensive diligence requests as evidence that the buyer is becoming difficult or distrustful.

Buyers sometimes treat every diligence discrepancy as justification for renegotiating the transaction.

Neither approach is particularly productive. The purpose of diligence is to determine whether the business being purchased is materially consistent with the business the parties contemplated when negotiating the LOI—and to identify liabilities and risks that must be addressed before closing.

A good LOI gives the buyer adequate opportunity to investigate the business without giving the buyer an unlimited option to keep the seller tied up indefinitely.

How Long Should Exclusivity Last?

Exclusivity is one of the most consequential binding provisions for a seller. During the exclusivity period, the seller typically agrees not to solicit or negotiate with other potential purchasers.

The buyer understandably wants exclusivity. Conducting diligence, negotiating documents, obtaining financing, and paying professional fees is expensive. A buyer generally does not want to invest those resources while the seller shops its offer to competitors.

The seller, however, assumes a corresponding risk. An exclusivity period that is unnecessarily long can allow an unprepared buyer to tie up the business while financing stalls or diligence proceeds slowly.

The appropriate period depends on the transaction, but sellers should pay attention to:

• the initial exclusivity period;

• automatic extensions;

• the circumstances under which exclusivity terminates;

• whether the buyer has actually begun its financing process;

• diligence deadlines; and

• whether extensions depend upon meaningful progress toward closing.

The goal should be enough time for a serious buyer to complete the transaction—not an indefinite free option on the seller's business.

What Will the Seller Do After Closing?

Particularly in closely held businesses, the seller may be critical to an orderly transition. Customers may know the seller personally. Employees may rely on the seller. Vendor relationships may have developed over decades. Important institutional knowledge may exist nowhere except in the seller's head. The parties should therefore discuss the seller's post-closing role during the LOI stage. Questions include:

• How long will the seller remain involved?

• How many hours per week are expected?

• Is transition assistance included in the purchase price?

• Will the seller receive additional compensation?

• Will the seller remain as an employee or consultant?

• Is the seller expected to introduce the buyer to customers and vendors?

• What happens if the buyer wants additional assistance?

“Seller will provide reasonable transition assistance” sounds innocuous until the buyer expects six months of full-time assistance and the seller expected to retire two weeks after closing.

Restrictive Covenants Should Not Be an Afterthought

A buyer purchasing a business generally expects that the seller will not immediately open a competing business and solicit the customers whose goodwill the buyer just purchased.

Accordingly, M&A transactions commonly include noncompetition and nonsolicitation covenants, subject to applicable law. The LOI may address the expected scope of those restrictions, including:

• duration;

• geographic territory;

• prohibited competitive activities;

• customer nonsolicitation;

• employee nonsolicitation; and

• permitted activities or investments.

For a seller, these provisions can materially affect what he or she is permitted to do professionally after closing. They should not first appear in a 60-page purchase agreement after the principal economics have already been negotiated.

Should Indemnification Be Negotiated in the LOI?

Not every LOI needs to contain a detailed indemnification framework. Nevertheless, in larger or more complex transactions, the parties may benefit from establishing important expectations early. For example:

• Will a portion of the purchase price be escrowed?

• How long will seller representations survive?

• Will there be a cap on the seller's liability?

• Will small claims be excluded?

• Will the buyer have setoff rights against a seller note?

• Are certain matters—such as taxes, ownership, or fraud—treated differently?

A seller who believes all liability ends at closing and a buyer who expects the seller to stand behind the business for several years may discover a significant disagreement very late in the transaction.

Not every detail belongs in the LOI. Material economic assumptions often do.

The LOI Should Be Detailed—but Not a Purchase Agreement

There is a balance.

If every possible issue must be resolved before an LOI is signed, the parties can spend weeks negotiating what amounts to a miniature purchase agreement before the buyer has even completed due diligence. That defeats much of the purpose of the LOI.

The better objective is to identify the terms that are economically or strategically important enough that a disagreement later could derail the transaction. The definitive agreement can then address the details. A useful question is:

“If the other side took a materially different position on this issue three weeks from now, would I reconsider the deal?”

If the answer is yes, consider addressing it before signing the LOI.

When Should You Hire an M&A Attorney?

Ideally, before the LOI is signed.

Many buyers and sellers contact transaction counsel only after executing an LOI because they believe the “legal work” begins with drafting the purchase agreement.

By that point, some of the most important negotiating leverage may already have been used.

An M&A attorney reviewing the LOI does not need to turn a five-page document into a fifty-page agreement. The objective is to identify the handful of issues that matter enough to resolve—or at least flag—before the parties commit substantial time and money to the transaction.

That can save both sides from discovering six weeks later that they never actually agreed on the same deal.

The Bottom Line

A letter of intent is not simply a ceremonial step between a handshake and a purchase agreement. It is the blueprint for the transaction.

The strongest LOIs do not attempt to anticipate every provision that will eventually appear in the definitive agreement. Instead, they establish a sufficiently clear understanding of the transaction's price, structure, economics, financing, diligence process, timing, and major risk allocations so that both sides can proceed knowing they are working toward substantially the same deal.

For buyers, that means understanding what they are actually acquiring and preserving the ability to investigate it.

For sellers, it means understanding not merely the headline price, but what they will receive, what they must deliver, what obligations remain after closing, and how long their business will be taken off the market.

Spending a little more time on the LOI can feel frustrating when both sides are eager to move forward.

It is considerably less frustrating than discovering months later that the parties agreed on the purchase price—but never agreed on the transaction.

Auxo Law PLLC represents buyers and sellers in privately held business acquisitions, including asset purchases, equity transactions, SBA-financed acquisitions, due diligence, purchase agreement negotiation, and related business transactions throughout Colorado and New York. If you are considering buying or selling a business—or have received an LOI and want to understand what you are agreeing to—contact Auxo Law to discuss the transaction.