The deal process guide, Part 1: What to expect before you sign a letter of intent

By Max Oltersdorf
CEO and Co-Founder at Quiddity

So you’ve decided you’re going to sell your business. You’ve followed the advice outlined here and have a growing, profitable business that buyers are interested in. You’ve decided whether you’re going to hire a business broker or do it yourself, you know what the difference is between potential buyers and you’re ready to entertain offers. This post will outline exactly what a standard PE process looks like and how to navigate it.

Overall the process can be broken down into two stages: Pre-LOI and Post-LOI. LOI stands for Letter of Intent, which is the original written offer that a firm will present you with. In the pre-LOI stage, you get to know potential acquirers, negotiate terms, and evaluate offers. In the post-LOI stage, you’ll provide information to the buyer and finalizing details of the agreement. Today we'll discuss what to expect pre-LOI.

Before we start, it’s important to note that every private equity process is different but most, if not all, will have the aspects described below. You'll see a lot of words like "usually," "likely," and "probably" in this post, all of which reflect the difference in process from firm to firm.

Broken down, the pre-LOI process is as follows:

Easy as pie! Let’s get started.

Pre-LOI: Getting to know each other

The pre-LOI stage is concentrated on getting to know potential buyers, doing mutual diligence, and negotiating terms of a potential deal. Whether you’re using a banker or running your own process, you’ll likely have multiple firms interested in buying your company.

Initial conversations

Each potential buyer will generally start their engagement with a 30-minute or hour long call where they’ll ask you about the basics of the business, the industry, your customers, and how your company measures up to the competition. If you haven’t already sent them your financials, they’ll likely ask for them directly after this call. They probably won’t ask you anything that you don’t know off the top of your head and you should come prepared with questions of your own (more details on how to handle this call here). Be honest with potential buyers; anything you hide they’ll find out in the post-LOI diligence period anyway.

In-depth conversations / initial diligence

Depending on the mutual interest of your initial conversations, buyers will likely want a follow up meeting to hash out additional details. If this is an in person meeting, they’ll book a half-day of your time and come out to see the company.

In the initial in-person meeting, come prepared to discuss the company in depth as well as what you want to see in a potential offer. In my experience, some specific points of discussion include:

  • Plans for future growth
  • Your go-forward role with the company
  • Competitive dynamics in your industry and geography
  • Specific questions on the financials provided
  • Employee org chart and key employees
  • Deal timeline and process
  • In-depth discussion of potential offer terms and conditions

Walking away from this meeting, you should have a great understanding of what will be asked of you throughout their process and the basic terms of the deal.

Negotiation of terms

This is the trickiest part of the pre-LOI discussion and will likely have terms that you’ve never come across. Luckily, once you understand what is being negotiated, it’s fairly easy to understand how all the terms work together towards the total value of the offer. We’ll go through and discuss provisions that PE firms generally put in agreements so you can understand how they work.

Headline valuation and deal structure

The valuation and deal structure is at the core of any LOI. This is the amount that you would tell people if they asked how much you sold your company for. However, the majority of PE firms don’t structure their deals as a cash payment, and even if they do, it’s very unlikely that you receive 100% of the headline value upon deal close.

Broadly speaking, the deal can be broken down into three distinct parts: cash at close, earnout, and sellers note.

Cash at close is the amount of cash that you will receive upon deal close. However, this will often include a portion that goes into an escrow account. This is the buyer’s way of holding some of the payment hostage to ensure that you’ve presented your company accurately. If a deal has $5m of cash-at-close, the buyer might put 10% of that in escrow to be paid after 12 months. In addition, if you’re running a working capital deficit, you may need to leave additional cash in the business to finance that. In the end, $5m of cash-at-close might only translate to $4m - $4.5m in your bank account at the close of the deal. Both the escrow timing and amount can be negotiated, as can the amount of working capital you leave in the business.

The earnout is generally used if you are staying on in a significant role post-close. Usually, earnouts are performance based and tied to growth targets, profitability targets, or revenue targets. If you’re selling 100% of your business and the buyer wants to keep you engaged, they might structure a deal that relies heavily on an earnout. It is important to keep in mind that an earnout is not guaranteed so make sure you’re accepting realistic targets that are within your control.

The seller’s note is essentially cash payments spaced out over time after deal close. Buyers include this because they can use cash flows from the business to pay off the seller’s note, meaning that their equity contribution into the business at close is smaller and they receive a higher return on their capital over time. Generally a seller's note will be anywhere from 6 months - 5 years in length.

All else equal, you should value cash-at close the highest, followed by sellers note, followed by an earnout.

Time to close / deal exclusivity

Once you sign a letter of intent with a private equity firm, they’ll want time to perform exclusive diligence and prevent you from shopping their offer to other parties. The diligence process will cost the PE firm hundreds of thousands of dollars so asking for exclusivity is fair. The LOI will outline the exclusivity period and may also outline a target close date. Generally 90 days is fair for exclusivity.

Non-compete agreement

Private equity firms aren’t stupid. They rightly assume that if you’ve built a great business, you know the industry better than they do and can build another great business in the same industry. Most LOIs will include terms that restrict your ability to found a new business or advise competitors in the same industry. The terms of these are negotiable but anything from 2-5 years is standard.

Plan for management post-close / employment agreement

Your buyer is likely going to want to know if you are going to stick around with the company after seven or eight figures has hit your bank account. In this part, don’t be shy about your needs. If you’re ready to go sit on a beach in Hawaii, don’t agree to stay on for two years. Try to agree on an engagement level that works for both parties but remember that, if they own the company, they have the ability to fire you at will in most states. They hope that this keeps you motivated to perform post-close and it gives them peace of mind that they have recourse if a key player (you) checks out post-close. Make sure you know the terms of your employee agreement before you sign the LOI. $150,000 - $250,000 starting salary plus bonuses tied to growth is typical.

Assumptions made by the buyer

The buyer will likely include some version of the financial data you provided them during the diligence process. This is to confirm that you are on the same page with the financial information provided. They will be testing these numbers with auditors and lawyers during the diligence process so make sure they are correct before you sign.

Wrap up on terms

These are the basic terms that you should expect to see in every letter of intent. Understanding them and how they represent transactional value is extremely important in making sure you’re getting the best offer possible.

Don’t be shy about telling potential buyers what the most important terms are for you. If you want an all-cash deal and want to leave upon deal close, definitely make that known before you sign anything.

What to do with a finalized LOI

Congratulations! You have an offer in hand that you feel good about and you're ready to sign. But wait! Before you sign, make sure you have a deal lawyer or advisor review the terms. Spending some money now on a couple hours of a high-quality lawyer will be worth your peace of mind that the terms outlined on paper don't include any gotchas or gimmes.

LOIs are generally non-binding agreements except for the exclusivity period for dilligence. If there are terms you feel weren't represented properly, you can always bring those up again before closing the deal.

Once you sign, congratulations! You’re agreed in principle to the terms of your sale and now it’s time for the PE firm to kick off the diligence process for your company!

Conclusion

Meeting potential buyers and negotiating terms can be intimidating but it doesn't have to be! By learning what to expect in advance, you set yourself up for success. Bottom line, as long as you know what you're looking for and are honest about your needs, there shouldn't be a problem. Most acquirers have a ton of expertise in founder-owned transactions and will be able to explain details to you. There is no shame in asking questions.

Get through the pre-LOI phase? Check out the next article in this series here

Best of luck and feel free to check us out at GoQuiddity.com if you're thinking about selling.

Max

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