In my previous postings, I discussed various aspects of a letter of intent used for a sale or acquisition of a business. I pointed out why, in most if not all cases, there are significant benefits for both sides that merit the use of a LOI. In Part II of this series, I examined the typical terms in the context of an asset sale contained in the sample LOI you can view by clicking here. In this Part III, I will explain the rationale and reasons behind the common LOI terms, using the sample LOI as the model.
In the sample LOI, under the caption “Buyer’s Conditions to Closing,” the first condition is that the buyer will be provided with all requested due diligence materials to enable it to determine whether to proceed with the closing. If the buyer demands complete freedom to determine whether to proceed, the seller will want the buyer to complete the due diligence as soon as possible. The compromise should be that the buyer will complete its due diligence before the signing of the definitive asset purchase agreement. If it’s not completed by then, but remains a condition of closing, the signing of the definitive agreement will have little, if any binding effect on the buyer to close: until the buyer has determined it is satisfied with the condition of the business, the buyer would have the right to walk away from the deal. Therefore, it is important that, before the seller is locked into the deal by signing the definitive agreement, the buyer be similarly obligated. If the time-frame for signing and closing is tight and the due diligence cannot be accelerated, other options such as walk-away fees or limiting the buyer’s absolute discretion to walk away should be considered.
The second condition to closing, namely that there will be no material adverse change (MAC) in the assets and business being sold, is usually a condition to the closing of all business acquisitions. The issues to negotiate with such a condition primarily relate to how the existence of a claimed MAC will be determined to be triggered. For example, sometimes either threshold dollar amounts will be used or percentage change thresholds will be used. Oftentimes the parties do not specify thresholds (and may leave those specifics to the definitive agreement) because of reluctance to spend the additional time negotiating those specific details at the LOI stage.
The third condition to closing found in the sample LOI obligates the seller to preserve the value of the business being acquired and not alter in a material manner the overall state of the business (e.g., the seller will not sell any fixed assets and will not enter into any material contracts unless doing so is within the ordinary course of seller’s business), without first obtaining the buyer’s approval. Unless the seller has already committed to or intends to take any of the action prohibited by this condition, it is unlikely there would be any significant negotiation focused on this condition. A seller should be forecasting events which could occur 60 to 180 days out to determine if any exceptions need to be negotiated into this standard condition to closing.
The fourth condition to closing may result in an adjustment to the purchase price post-closing. This condition is not a true condition to closing in a strict sense, but is contained in the LOI because it may change the purchase price. Assuming there is a triggering of the purchase price adjustment, then the price adjustment itself will not actually occur until after the closing occurs. The rights and obligations of the buyer and seller involved in a price adjustment are enforced post-closing, so this provision can also be thought of as a post-closing covenant of the parties. In any event, regardless of how it is labeled, it can have a significant effect on the economics of the deal for either the buyer or seller.
The purchase price adjustment in the sample LOI is tied to any change in the assets of the seller from a specified balance sheet date. Presumably the specified date is the date used by the buyer in determining the price to offer for the business. If the price was based at least in part on the balance sheet value of the assets, this price adjustment approach would make sense. If the buyer used a valuation approach that was based on net income or earnings of the target (e.g., based on EBITDA), then a different potential price adjustment mechanism may be used. Potential price adjustments can also be based upon other aspects of the business being acquired such as the level of working capital at the closing.
The fifth condition to closing in the sample LOI requires the founder/s and the Chief Technical Officer to sign non-compete agreements . Buyers usually want to obtain non-competes from the key senior management team of the target to protect and preserve the goodwill of the business being acquired and for which the buyer is paying significant consideration. Under California law, however, non-competes are unenforceable except in very limited circumstances. One of those circumstances is in connection with the sale of business. And to be enforceable under that circumstance, only the equity owners of business being sold may be precluded from competing with such business. There are limits imposed under the statutory exception permitting a non-compete agreement in terms of the scope and duration of the non-competes, but those limits are beyond the scope of this blog. It is simply worth noting that the scope and duration of any non-competes are usually heavily negotiated. From a seller’s viewpoint, it usually is better to address the scope and duration in the LOI so that the seller will have a better idea of how reasonable the buyer will be and how much of an issue the non-competes will be before the seller agrees to an exclusivity or no shop provisions as part of the LOI terms. If a buyer desires to have any non-equity owners enter into a non-compete, the buyer will need to offer an employment or consulting agreement to such individuals. In other words, the buyer will need to employ and pay such individuals not to compete during their employment.
The sixth condition to closing is very standard and straightforward and requires the seller to obtain from any applicable third parties (including any governmental agencies) any necessary consents or approvals (or waivers) to transfer to the buyer any of the assets, leases or contracts being acquired by the buyer in the acquisition transaction. The buyer, of course, does not want to become involved in any disputes with any third parties over the validity of the transfer by the seller to the buyer of any of those assets, leases or contracts for which it is paying consideration to the seller at the closing of the asset purchase transaction.
The seventh condition is also standard and requires the seller to provide to the buyer clean title to the assets and any other properties being purchased by the buyer. Obviously, like the condition describe immediately above, this is a key term for the buyer and again there is little negotiation over this condition. If the seller has financed the purchase of any of its assets, or if it has bank financing that includes a blanket security interest, or if there are any other secured creditors with liens on any assets to be transferred to the buyer, coordinating obtaining lien releases from multiple parties simultaneously with the closing and the paying off the monetary obligations owed to such creditors can be a significant logistical challenge. An experienced law firm can provide much needed assistance in this reg
In my next blog post on LOIs, I will discuss the pros and cons of dealing with the indemnification obligations of the seller and to a lesser extent the buyer, as well as the terms in the sample LOI dealing with the seller’s employees.