For many business owners going through the merger and acquisition (M&A) process, receiving a letter of intent (LOI) feels like the finish line. After months of preparing financial information, meeting with potential buyers, and responding to due diligence questions, the LOI provides tangible proof that the deal is coming together.
Many of the economic outcomes in the sale of a business are often determined before the purchase agreement is drafted. While the purchase agreement is the legal document that’ll govern the final transaction, the framework established in the LOI often dictates how negotiations unfold.
The LOI’s primary purpose is to establish the major business terms of a proposed transaction before both parties commit substantial time and money to accounting reviews, legal documentation, and other due diligence. It should create clarity around purchase price, transaction structure, working capital expectations, treatment of cash and debt, post-closing employment arrangements, exclusivity provisions, and the anticipated path to closing.
While the LOI shouldn’t attempt to solve every issue that appears in a purchase agreement, it should clearly define the general economics and deal terms that matter most to the seller.
Because so much value is shaped at this stage, sellers should follow these 10 key steps before signing an LOI.
Too many sellers focus exclusively on headline purchase price while overlooking provisions that can materially impact ultimate proceeds. For instance, a $10 million offer with no seller financing and earnout may be substantially better than a $15 million offer with significant contingencies.
Many sellers become fixated on maximizing enterprise value while failing to acknowledge that deal structure often drives actual economics and after-tax proceeds. That’s why sellers should make sure these questions are addressed in an LOI:
One of the most common sources of post-LOI disputes between buyers and sellers involves working capital. Virtually every business requires a certain amount of working capital to operate, and buyers generally expect that a normalized amount of working capital remains in the business at closing.
When working capital concepts aren’t adequately addressed in the LOI, disagreements can emerge over calculations, historical benchmarks, seasonality, and accounting methodologies. Those disagreements frequently occur after the seller has already granted exclusivity and surrendered much of their negotiating leverage.
Waiting until the purchase agreement stage to negotiate these concepts often creates friction and increases the risk of value erosion.
Many buyers assume a business will be delivered on a cash-free, debt-free basis. This means the seller will retain all cash owned by the business and settle all debt obligations of the business. While this concept sounds straightforward, disagreements regularly emerge regarding specific debt obligations.
Therefore, the LOI should provide clarity around what liabilities are included in the definition of “debt.” Specifically, the LOI should clarify how customer deposits, deferred revenue, payroll obligations, tax liabilities, capital leases, and other on- or off-balance sheet liabilities will be treated.
A clear LOI provides enough specificity to avoid fundamental misunderstandings regarding the balance sheet that’ll ultimately be delivered at closing. Clear definitions reduce the chance that a buyer later attempts to reduce value through revised interpretations.
Earnouts can be effective tools for bridging valuation gaps between buyers and sellers. They can also become some of the most contentious provisions in the entire transaction. When buyers and sellers disagree about enterprise value, earnouts often seem like the perfect compromise. Unfortunately, many earnouts are poorly structured and difficult for a seller to achieve.
If an earnout exists, the LOI should establish the fundamental framework, including specific performance metrics, measurement periods, and payment timing. Leaving those elements for later negotiation often creates unnecessary risk and uncertainty for a seller.
For many founders, the future for their employees is almost as important as valuation. The LOI is often the first opportunity to understand the buyer’s plans regarding management, retention, employment arrangements, key employee incentives, transition support, and leadership continuity.
These topics may not directly influence the purchase price, but they often provide clarity on a buyer’s vision for the future of the business.
After signing the LOI, the buyer will incur significant accounting, legal, and other due diligence costs. In return, the buyer will understandably require the seller to exclusively negotiate with them during a set period of time. No provision in a typical LOI has a greater impact on leverage than exclusivity.
From the seller’s perspective, however, exclusivity creates risk. Once a seller exits a competitive process, leverage declines dramatically because the seller has essentially taken the company off the market. Every day spent in exclusivity increases the buyer’s opportunity to identify issues, renegotiate terms, or attempt to improve their position.
Therefore, sellers should pay close attention to exclusivity length, extension rights, diligence milestones, financing deadlines, and termination provisions. A carefully structured exclusivity period can help preserve momentum while protecting the seller’s leverage.
A buyer will typically want the seller to indemnify them against certain known or unknown risks associated with the company. Additionally, the buyer will often require the seller to escrow funds to satisfy any future indemnity claims.
A well-drafted LOI should establish a framework for seller indemnification provisions. The seller should negotiate for limits on indemnification claims, along with limits on the amount and length of an escrow account.
A signed LOI has little value if the buyer can’t complete the transaction. A buyer with proven acquisition experience, committed capital, and a clear financing strategy may ultimately provide a far better outcome than a buyer offering a higher price but lacking execution certainty.
Therefore, the LOI should include the buyer’s sources of capital used to acquire the business, including any financing contingencies. The LOI should also include any internal or investment committee approval processes or requirements the buyer must adhere to.
Keep in mind that failed transactions are expensive. Beyond professional fees, they consume management’s time and create uncertainty among customers, vendors, and employees. Before signing the LOI, sellers should have confidence that the buyer possesses both the financial capacity and organizational commitment necessary to complete the acquisition.
Many M&A deals experience challenges because buyers and sellers have different expectations regarding the due diligence process. Some buyers sign LOIs with the intention of conducting broad diligence later, while others perform substantial due diligence before submitting an offer.
That said, the LOI should clearly outline what due diligence remains to be completed, the anticipated timeline, required management involvement, and what level of access the buyer will require. Having transparency early in the process reduces the likelihood of unexpected requests that disrupt the seller’s management team and operations.
The most successful transactions are rarely negotiated by business owners alone. Sellers should seek guidance from experienced M&A attorneys, investment bankers, tax advisors, and transaction consultants for their help understanding market terms, identifying risks, and maximizing after-tax proceeds.
Ultimately, the greatest misconception about the LOI is that it’s merely a preliminary document. In reality, it’s often the seller’s best opportunity to shape the economics and structure of a deal before exclusivity takes effect. Sellers who recognize the importance of the LOI and negotiate accordingly put themselves in the strongest position to achieve a successful sale of their business.
