Those seeking to start or grow a business often look to acquisition strategies to achieve those goals. Once a prospective buyer has identified a potential business to acquire and engaged in preliminary talks with the seller, an important next step is often overlooked.
Prior to the purchase and sale agreement and anticipated closing, it is in the best interest of both parties to formalize the potential acquisition with a letter of intent.
Imagine a young entrepreneur named Lola finds a sign company she is interested in buying from Juan. They start talking about the potential purchase and what it might look like.
Juan might share with Lola a price that he is looking to receive on the sale and share, in a general sense, the revenue or profit to support the proposed sale price.
If a letter of intent is skipped, several potentially unforeseen risks can arise, even if the parties begin working on a formal purchase and sale agreement.
First, look at the deal from Juan’s perspective. Lola is going to expect Juan to share specific financial information with her before she can commit to the purchase. This means that Juan will be forced to open his books and share important information about his company.
The disclosures might include trade secrets or customer lists or other confidential information that Juan needs to share in order to substantiate his sales strategy and prove to Lola she should pay the asking price.
Lola might tour Juan’s sign company and meet his employees. This means that Lola is getting free exposure to Juan’s business and will be gathering important information and connections that might allow her to compete with Juan.
Assume then that Lola completes her investigation and decides not to buy (and accordingly not to sign any formal purchase and sale agreement). Instead, Lola sees an opportunity to compete with Juan. Armed with all of Juan’s trade secrets, she opens her own sign company and goes into the business on her own.
Juan has spent time and energy that is not only wasted, but he has facilitated a competitor into his marketplace.
From Lola’s perspective, she is also at risk.
As she walks down the road of inspections and due diligence over the course of weeks or months, her attorney might be contemporaneously charging big bucks in the negotiation and drafting of the purchase and sale agreement. As Lola and Juan get close to the final document, Lola finds out that Juan was simultaneously courting another buyer and using Lola to raise the bid on the company, but with no intention of actually selling to her. Lola is out her time and money on the deal.
A letter of intent solves these challenges and more. So, imagine again Lola and Juan start talking about the sign company, and Juan again discusses what the sale might look like and what he is looking to receive from the sale. Lola is interested.
Now, they engage attorneys to draft a letter of intent. The letter of intent expresses Lola’s intent to purchase the business at the price that Juan has suggested. Recognizing the fact that Lola hasn’t yet fully investigated the company, the letter of intent is typically not binding regarding any requirement to actually purchase the business. So, how does a non-binding agreement help?
The letter of intent is binding on other matters. It generally requires that, in exchange for investigating the company and learning seller secrets and both parties spending time and money, they each agree to certain conditions that are binding.
They will generally agree, and be bound, to things like: (1) keeping all information confidential (non-disclosure); (2) not competing against the seller … ever (non-competition); (3) not soliciting customers or employees from the seller (non-solicitation); (4) a period of exclusivity where they can only discuss the purchase and sale with each other.
With the letter of intent, Juan can feel secure in opening up his books and records for inspection to help Lola determine if she wants to purchase. Lola can feel confident that she is able to spend the time and money to investigate without losing the opportunity to purchase to another buyer.
Though the potential for another legal document can seem overwhelming or unnecessary, the benefits to both parties are clear.
If you are looking to purchase or sell a business, keep the letter of intent at the front of your mind before getting too deep into negotiations and talk to your attorney for guidance.
Beau Ruff, a licensed attorney and certified financial planner, is the director of planning at Cornerstone Wealth Strategies.
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