Letters of intent are written offers that contain various clauses pertaining to purchase price, included and excluded assets and liabilities, buyer-seller exclusivity, financing, and more. Through our experience in reviewing these offers, we’ve found a number of LOI requests that should be carefully examined.
Some inexperienced buyers might not realize they’re submitting abnormal requests. Regardless of intent, watch out for the following three requests.
1) Free Consulting: Free employment / consulting (or part of purchase price for more than 30 days): It is not unusual for buyers to request that the seller continue with the business post-transaction to advise the new operator of the business. The agreement to continue this employment or consulting relationship should not be done for free considering the amount of the seller’s time is consumed. We do not advise that sellers agree to provide this service for greater than 30 days without additional or separate compensation.
2) No Expiration: Indefinite LOI (doesn’t expire): Letters of Intent (LOI) are designed with an expiration date to keep things moving in an orderly fashion. The longer a transaction takes to close, the more likely things will go awry for some reason or another (you might’ve heard the phrases “time kills deals” or “deal fatigue”). Sometimes sellers receive LOIs that do not expire. This puts them in a position to continue pursuing a transaction indefinitely. We do not advise that LOIs with these terms get accepted because it is not prudent for a seller to allow this type of indefinite due diligence period. Letters of Intent are best designed with deadlines that allow for sufficient, not excessive, diligence and execution. We recommend an exclusivity period to last no longer than 60-90 days with the possibility of extension if mutually agreeable.
3) Seller-Financing: Significant seller financing (more than 30-40% of deal): It is common for small business transactions to involve some form of seller financing. Instead of an all-cash transaction, part of the purchase price is in the form of a note to the seller that is to be paid off in the future (typically over a 3-5-year period). Seller financing is a useful tool that allows would-be buyers access to deals that may not be feasible without additional capital. Additionally, requests for significant seller financing are customary when the business relies intensely on the present owner’s involvement and that owner will need to take place in an extended transition; and/or, when there is significant customer concentration in the business. It is reassuring to buyers when sellers are open to this source of financing because it shows that they believe the business will continue to thrive into the future and the terms of the note will be met.
Significant owner financing, which we define as over 30-40% of total deal value, is a red flag for sellers. The larger the note, the less cash received upon the closing of the transaction. This automatically adds risk that the seller will not be fully compensated for the sale of their business. When seller financing is greater than 30-40%, it is leaving a lot of risk on the table for a seller relinquishing control of their business.