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Using a Letter of Intent to Reduce Risk in the Process of Purchasing a Business
Buying or selling a business is not to be entered into lightly. It is a multi-step process that has inherent risk and, when done correctly, great potential reward. The steps in the process are intended to minimize as much risk as possible and to ensure that the price is a fair reflection of value. One of the most expensive and time-intensive parts of purchasing a business is the formal due diligence. This is one of the final steps and generally should be done only where the buyer is close to certain that they want to buy the business. The letter of intent is an important tool prior to embarking on formal due diligence to minimize risk and avoid later headaches, for both the buyer and the seller.
A letter of intent within this context is a document that sets out some of the terms of a potential transaction in the future, and sets expectations for what is to occur between that time and the time the transaction is completed. It provides both parties with assurances that the other is serious about moving forward, assuming no major issues are uncovered in the formal due diligence process. It also ensures that both parties do not have misunderstandings on the most important final terms of the sale. It is not generally binding on the final purchase agreement, but some of the terms are binding.
Some of the issues that are generally addressed in a letter of intent are: The purchase price, exclusivity, access to the business, a break-up fee, and confidentiality.
The final price may or may not be in place at this point. If it is, it can be spelled out in the letter of intent. If not finalized, it can be expressed in a potential range. The price in the letter of intent is not necessarily binding to the dollar, but provides a number that is an expectation that should hold, depending on the results of due diligence.
Most letters of intent state that during a period of time in which the due diligence process is done, the seller will not negotiate with other buyers or solicit buyers for the business. This is a huge benefit, and perhaps reason enough in itself for a buyer to insist upon a signed letter of intent. A buyer must expend the time and money to ensure they are making a good decision, and benefit from an assurance that it will not be wasted by the seller offloading the business to someone else during that time.
Access to the Business
In order to perform the due diligence process, a buyer often needs to view sensitive documents, perform environmental or other testing, or speak to suppliers and customers of the business. The letter of intent can set expectations of how access to these things will be achieved.
One of the benefits of a letter of intent is the peace of mind it provides to each party that the other is acting in good faith, working towards the transaction. As a sign of this intent and good faith, some letters of intent include a provision requiring a party to pay a fee if they ultimately back away from the deal. This can be structured so that the buyer may back out if certain information is discovered, but would require payment if either party has a change of heart for any other reason. From the buyer’s perspective, it gives further assurance that the seller will not seek offers or otherwise sell the business while the buyer is doing its homework.
Letters of intent commonly include a provision requiring the buyer to keep confidential sensitive or private information inevitably obtained during the detailed audit of the seller’s business during the process. It is also vital that the seller make sure that there is no improper sale of stock (where applicable) during the sale of the business by people with insider information about the sale.
Putting these terms in writing prior to performing formal due diligence reduces the risk that one of these major terms will be a sticking point in final negotiations. Discovering these deal-breakers prior to the formal due diligence saves both parties time and expense associated with that time. It also can save the parties from considerable aggravation that results when they are learned after the time and money is spent.
It is imperative that you go about the sale of a business in the right way. There are a myriad of variables that can affect the value of the business. A trusted attorney will be an invaluable tool in guiding you through the steps that will ensure a good decision with minimized risk and as smooth a transaction as possible.
GDP Business Blog
Mesa, AZ 85213