A letter of intent for the purchase of a business sets forth the major deal points for that transaction, including the purchase price, the structure of the deal (asset purchase, stock purchase, etc.), whether an earnout will be utilized, and so forth. The letter of intent is almost always non-binding, meaning that deal points may be modified as the parties mutually agree during the course of due diligence and drafting final documents.
The fact that the letter of intent is non-binding and chiefly addresses business points of the deal sometimes lulls business owners into a sense of complacency on the legal aspects of the deal, with the mindset being that the lawyers can hash out the legal terms later. This mindset can be bolstered by the boilerplate language used in letters of intent on legal items such as indemnification, where the letter of intent may just generally state that the parties will indemnify one another pursuant to standard indemnity terms.
Why Boiler-Plate Shouldn’t Be Ignored
Business owners would be well served, however, by taking the time and using counsel to put some concrete terms around the important legal aspects of the deal. Although the letter of intent will be non-binding, having these terms addressed will set the expectations for both sides of the deal, and without a major issue arising during due diligence, it will be difficult for a buyer to justify making significant changes on these legal items. On the contrary, if important items are not addressed, a seller is left to try to negotiate mid-deal, where the buyer has an exclusive period of 90 days or so where the seller is unable to sell to anyone else (generally one of the only binding terms in a letter of intent), and seller is incurring significant costs like attorney and other adviser fees. This circumstance gives a seller less leverage to negotiate important legal terms.
So what are these important legal points a business owner will want to address in that letter of intent? Indemnification is one major item. Rather than say indemnity will be provided pursuant to “standard terms”, the letter of intent should address several things, including: (1) an indemnity basket or cap for the seller, as well as the survival period for indemnity claims; (2) the exceptions to the basket, cap, or standard survival period; and (3) the use of any escrow or setoff for indemnity purposes.
The Indemnity Basket
An indemnity basket functions like a deductible, where generally the business owner is not liable to indemnify buyer until losses exceed a set threshold amount. Then, once that amount is met, the seller is liable for indemnification for the entire amount of any loss. An indemnity cap is a limitation on the amount seller will owe for indemnity, generally an amount in the range of 10-20% of the purchase price. One can see that having an indemnity cap limiting the amount of the indemnity obligation would be crucial for a seller. Lastly, it is important to address the survival period for representations and warranties, which governs for how long a buyer may make an indemnity claim for breach of representation and warranty. Generally speaking, this survival period is between 12 and 18 months.
The most common exception to the application of the basket or cap, or to the survival period, is for fraud perpetrated by the seller. For example, if a seller has willfully concealed a problem with the business resulting in a loss, it is fair and reasonable to say that loss should not be excused or capped, and that if the loss arises after say a one-year survival period, the defrauding seller should not be able to avoid liability for the loss.
Escrow Equal to Cap on Indemnity
Finally, buyers generally like to set up an escrow where a portion of the purchase price will sit for the survival period to ensure payment of any indemnity obligation that may arise. Typically, the escrow amount will equal the cap on indemnity. If an earnout is contemplated, buyers may also demand the ability to “set off” any amounts owing on an indemnity claim against any earnout payments owing to a seller. Say, for instance, that seller claims $200,000 in damages for an indemnifiable claim and has an upcoming $500,000 earnout payment to a seller. The buyer in this case would unilaterally deduct the $200,000 from the payment owing and remit only $300,000 to the seller.
With all the possible permutations in the indemnity provision, one can see that it’s helpful at the outset to nail down items like the amount of the indemnity cap, the use of an escrow, etc. Doing so will also reveal whether the buyer is contemplating inserting exceptions to the cap or survival period that are outside commercial norms. Finding this out sooner, and addressing it before a buyer is in the thick of the deal process, will provide a better negotiating position.
What About Earnout
Another important item to flesh out in the letter of intent is how the earnout will be treated. Generally speaking, an earnout will be tied to EBITDA or some other measure of financial performance, i.e., the seller will receive X amount of money based on company performance. Defining clearly in the letter of intent how that benchmark is measured is crucial. Will certain revenues be excluded, how is the time period for such benchmark calculated and will any adjustment be made for deals booked prior to the cutoff where revenues have not been collected yet? Each particular scenario will raise its own questions, but much better to address those specific questions upfront.
Lastly, on the earnout, a seller has the ability to categorize a portion of any earnout as deferred purchase price rather than income, which results in preferred capital gains tax treatment on that portion of earnout as opposed to an ordinary income tax rate. The resulting difference in proceeds can be substantial, so it is well worth putting in the letter of intent what the amount of fair compensation for services provided will be, with any earnout monies over that amount to be treated as deferred purchase price.
Selling a business is a complex and time-consuming process in the best of circumstances. Given that, it makes good sense to address the important issues at the initial stage in detail to provide a clear forward path. Whoever said an ounce of prevention is worth a pound of cure may not have worked in the M&A space, but they were right on the money when they said it.