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Transcript
Hello and welcome to M&A Murders and Accusations. The Good, the Bad, and the Ugly of Selling Your business. We dig into what you need to know and how not to kill the sale of your business. Now here's our host, Rick J. Krebs, Mergers and Acquisitions Advisor.
Hello, everyone! Welcome to my podcast, M&A Murders and Accusations, brought to you by Rick J. Krebs from the mountains of Utah, Heber City. And welcome to the show today. I've got a great show for you. I'm excited to share this information so you don't jeopardize your deal. Hi, today we're going to talk about the key elements of a Letter of Intent. First of all, people get Letters of Intent or they get Indications of Interest. There are slight differences between the two. One is a little stronger; however, each of them has both binding and non-binding terms. So, when you get a Letter of Intent, before signing it, spend a little money. Have your attorney look over it. Make sure that by signing it, you're not incriminating yourself or getting into any problems. I would recommend having an attorney look at it. I'm not an attorney. I look at them all the time, but I always recommend my clients take a look and have someone else have a second set of eyes on it. It's the single largest financial transaction in your life; you've got to get it right. It never hurts to pay a few bucks, crack open that wallet, pay a few dollars, and have someone else look at it, not to jeopardize the deal. And we're going to talk about that in this podcast, but just to look at it and see what you're getting into, what you need to know if you sign that. So, I'm going to refer to my notes here a little bit, but the name of this show is "What Every Seller Needs to Know About Letters of Intent," or IOIs, which is Indication of Interest. There are some similarities and there's some differences. We're not going to go through it today, but these are the things that should be. So, let's back up and talk about each of these. When you have a business for sale, if you're less than a million and a half, typically, they'll go ahead with the Purchase Contract, and that is signed at the front and is actually finalized at the end. But anything that's over a million and a half generally has a Letter of Intent or, and right, basically, that's a Letter of Intent to purchase. It's like dating; I tell this to all of my sellers. I say, this whole process is like dating. You go on the first date, which is your first phone call. That's when you meet; that's when it's all fun and games. You get to know each other. You know if you like each other, you like what you see, and then you want a second date. You don't typically ask in-depth questions on that first date. You know, if you're dating someone, you don't ask them the color of their underwear on the first date. You don't go there, right? Maybe after you get to know them a little bit or something, you might do that. Yeah, but you know, depending on who you are, you don't go in for the kiss on the first date or the first meeting. It's just inappropriate. Same way with business, and there are certain things that you ask, certain things that are appropriate at their time. So, when you sign a Letter of Intent, this is like putting the ring on the finger; this is when you are engaged. You are committed to each other. However, each of you can back out at any time, right? If you don't like what you see, you can certainly back out. That's the time you could ask, "What color and where are you from, for instance?" It's time to get personal. It's time to really take a deep look at who you're going to marry, and the marriage is when you sign the contract with them. And look at the transaction like a marriage, not like a divorce. Sometimes people think it's like a divorce; you're just going to throw the keys in the cabinet and look out over the sale on this. Not the case; you're going to have to work with these buyers. Typically, there's a seller carryover for two to five years. So, you're going to want to have a good relationship working together. And remember, if it's your fiancee, you don't beat them up too bad, and they're not going to want to marry you. So be courteous, be kind, but you've got to get to the bottom of the issue. So anyway, now this is when you're dating. When you've gone on a few dates, you know you like each other, and you're ready to take the next step. You're ready to put the ring on the finger to show commitment; that's the Letter of Intent. So, the key elements of every Letter of Intent: One, you should have a working capital target or you should agree on the calculations of working capital. Get your CPA. Typically, a working capital target is the average working capital over the last 12 months. You're going to want to make the calculation of what that is, and you're going to want to know what to expect. So as you negotiate, you can go in there and the sellers typically want to have a low working capital target number, because if it ends up being higher, closing, the dollar-for-dollar, it increases the purchase price. It's that simple. But if you don't know what it is, you don't know what to negotiate, and you end up cutting yourself. Your working capital can kill your deal if you don't have that in your Letter of Intent, because it would be a surprise at the end. And I've seen it where it just becomes a grinding part with the buyer and seller if it's not handled properly. So, if you are a cash basis taxpayer or cash basis person with your financials, you're going to need to make some calculations to calculate working capital properly. You're going to need to calculate accounts receivable. You need to calculate any allowance for doubtful accounts. You're going to need to calculate accruals. You know, do you have vacation rentals that aren't showing on the financials so you need some help from your advisor, your monetary advisor, or your CPA to calculate working capital and to calculate these accruals. There are some other things that catch you all deferred revenue, which is a liability that counts against you. Sometimes that's not booked; you're looking for unbooked or unrecorded items on the P&L balance sheet. Another one I see that is common is prepaid items, deposits, billings in excess of revenue, and revenue in excess of costs for engineers is another thing that can catch you. It could be hundreds of thousands of dollars. So, take a look at working capital, pin it down, paint it out. Your foe is the seller; your foe wants it low; the buyer wants it high. That's a general rule. The definition of working capital is not the definition that's used. What's
used is what you negotiate. So, you're going to negotiate every part of that working capital. I recommend you take numbers from the balance sheets so those calculations are there in the Letter of Intent. The purpose is to arrive at a common understanding and expectations. The buyer's expectation and the seller's expectation. So, anything that could be a potential deal killer is the second item that you want in your Letter of Intent. You absolutely have to have if there's an issue. Since we have a cabinet shop that we're selling, and they've got a lot of work in progress, right? Accounting definition says that should be included in working capital. We're excluding it because they've got a lot of projects that are in process. Some of them are 99% done, and they just have to bill and they haven't collected the check. We need to make sure those things are fairly allocated and handled in the LOI. That's the thing that you want. Any Letter of Intent, how that's going to be handled. And anything that might be an issue, anything that might be a concern, or it might be unique to this type of business, absolutely has to be in the Letter of Intent. Number two, thing: Calculation of cash flow and/or EBITDA. So, you don't want to align your expectations of how they're calculated, whether they're calculated on the cash basis, on an accrual basis, a modified accrual basis, or a full GAAP basis. Is this cash flow calculated as Seller's Discretionary Earnings (SDE) or EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization? It's kind of spelled weird, EBITDA, and I wonder how to say it, but it's important to know how that's calculated, how they're calculating it compared to how you are. Again, it will kill your deal if you don't do this. You get close to closing, and the seller is saying it's one way; the buyer is saying it's somewhere else come through due diligence. You spend $20,000 to $30,000 on your due diligence and getting through it, and then you guys are arguing about how to calculate SDE or EBITDA. So, you've got to make sure you're aligned with the buyer. Okay, number four: Allocation of assets. So when you sell the company, you have to file a form called Form 8594, IRS Form 8594. Look it up, what that is. You have to agree on how you're allocating the assets of the business. Both the buyer and the seller have to agree and align, and they each fill out that form. The IRS checks it and makes sure that how that form is completed makes sure there's an agreement. So, if the buyer is saying one thing, seller saying something else, the numbers don't line up, it can trigger an audit. Form 8594. Learn about it and know about it. Don't let it kill your deal because that pass-settlement allocation can oftentimes mean a huge swing in your taxes, hundreds of thousands of dollars, sometimes millions of dollars, swinging your taxes based on how you allocate the assets, which are sold in a stock sale. You don't have to worry about it. If it's a Section 338(h)(10) election sale, you do have to worry about it. So, make sure that you allocate your assets, and you agree to have your assets allocated right up front or the formula. Again, you don't have to pin down numbers; if you just agree to the formula in your Letter of Intent. Next item: Earnings adjustments or financials. So oftentimes, I see sellers that are cash basis or accrual basis, modified accrual basis with their financials, meaning they're not capturing all of the accruals but some of them they are AP usually but not their vacation accruals or anything like that. So make sure that you come to align on your accounting methods and what is expected. I've been involved in transactions where, you know, we literally spent weeks and weeks converting cash basis financials to accrual basis financials, and it's a huge undertaking. So, and we knew upfront. It was not a big deal to my sellers because they knew that was part of the deal. They knew they were cashing a big check at the end, so it was worth it. But it required, you know, their accounting team, bunch of accountants from the buyer's side, myself, and just a lot of hours to convert those over. It was a durable medical equipment company, and it was very complicated, as it can be. So make sure you're aligned on how it's going to be calculated and if they expect you to convert from cash to accrual or cash to a full GAAP basis. Very important. Any employment agreement. If there's going to be an employment agreement or you as the owner, you want the terms of that or the basic terms. You don't need to, with this, like when you get engaged, you want to specify every single little thing. But some of these details are worked out, but make sure that you at least know the basics of what that employment agreement is going to look like, what they're going to pay you, how they're going to pay you. Are you okay with the salary moving forward, bonuses, and also the expectation as far as the number of hours per week? Does the buyer expect you to be there for 40,
and you think you're going to be there for 10? It's not going to work, and it could jeopardize your deal. So, negotiate that upfront and in your own line. You don't have to worry about it later. The next thing is a consulting agreement. Sometimes they want you to act as a consultant after close and after the training period, and as a consultant, you need to be paid. And so, you're going to want to negotiate the terms of that and put them in your LOI. Never assume just based on a conversation that it's going to happen. It has to be in writing or it doesn't exist. I'm going to say it again: it has to be in writing where it does not exist. Then you need to specify the type of transaction it is. Is it a stock purchase? Is it an entity purchase, stock or entity? Or is it an asset? Or is it a hybrid Section 338(h)(10) hybrid? We're going to talk about that on another podcast. Basically, that lets you treat it for legal purposes as a purchase of the entity and for tax purposes as a purchase of the assets. And there's another one now where they're dropping companies into an LLC and putting it into an S corporation. It's a little bit complicated, but I'm seeing more and more of those now, and they're treated as asset sales. Okay, holdback amounts. One kind of dirty little secret in every purchase is that where you're, most every purchase has a holdback, meaning you don't get all your cash upfront. Generally, they're going to keep some of that cash; you're going to hold it back until they finalize all of the numbers. And you need to know what that expectation is. Are they going to hold back 50%? Are they going to hold back 20%? 5%? But that should be in the Letter of Intent. How much is it going to be? What triggers it to be released? How does that work? Certain binding provisions in a Letter of Intent: binding provisions of exclusivity, meaning just like putting a ring on the finger, you're exclusive. You're not out dating; you're staying with that one person. So usually, the exclusivity period is 60 to 90 days through due diligence. Meaning you're not negotiating with anyone else, and by signing your Letter of Intent, you've committed to that. You have the right to market and to negotiate with other buyers during that exclusivity period. The reason buyers want it in there is they don't want you to be dating other people on the side while they're preparing for a marriage, right? Plus, if someone else comes in and offers more money, the buyers have spent a lot of money. I've seen buyers spend a quarter million dollars plus in their due diligence, and only bring teams of people in a tremendous amount of effort and cash expenditures and time expended to work towards a closing; they don't want someone else coming in and stealing it from them. Okay, but binding provisions, exclusivity, and non-disclosure, meaning that you don't disclose that it's being sold to anyone outside of your advisors, your advisory circle. You can say that it's under contract and tell other buyers that it's under contract, but you don't go blabbing to your customers; you don't go blabbing to your employees unless the buyer agrees that you should speak to them beforehand. So, another one is an indemnification or a non-solicitation clause in the NDA. So, if you don't have a non-solicitation or a non-circumvent clause in your NDA, you need to put it in your Letter of Intent. That means they are not to solicit or contact employees, vendors, customers, anyone like that. And you have a period in here, from say 12 to 18 months after the Letter of Intent is terminated, should it be terminated? You don't want them coming after your employees; you don't want them coming after your customers and your vendors. Going in and looking into the list. And I've seen a lot about this stuff over the years. I've seen the bad, but you know, want to make sure that that's in your NDA or in your Letter of Intent. So, I'm going to repeat: go through the event. First one is you want to make sure your working capital target is there. Calculation of cash flow or EBITDA, allocation of the assets or IRS Form 8594, accounting methods and how they're calculated. Make sure your employment agreement terms are pinned down, same with your consulting agreement. Access to employees, vendors, and customers; is the buyer requiring access to them? When is it done and how does that work? So, if they want access to a key employee, that is not done until the rest of the due diligence is done, and you're 90% of the way there. There are certain things that you do in sequence as you're going through this. You make sure that it's done at the appropriate time, and if they want to talk to a customer, which rarely happens, but sometimes it... You make sure that you have a great how that's going to work and what the timing of that is. You don't want to do that until the very, very end until every other "t" is crossed and "i" is dotted through financial due diligence, operational due diligence, and it's all done except for that lady singing, as we say sometimes. Anyway, consulting agreement, asset purchase, what type of transaction it is, what's the deal structure. You need to know about holdback amounts, binding provisions, and a non-solicitation clause in your NDA. These are the main points of the Letter of Intent or Indication of Interest to make sure that you put them in every single one, and you will not jeopardize your transaction. This is Rick J. Krebs, thanking you again for joining our show today, all things M&A, selling the business. Bye! Thank you for attending our podcast. We invite you to join us for future episodes of M&A Murders and Accusations. The Good, the Bad, and the Ugly of Selling Your Business. You can also visit us at www.bsalesgroup.com or email Rick directly at rick@bsalesgroup.com.