Letter of Intent: Structure of a Deal
Jason and I have engaged in a little foreplay with you in our Letter of Intent series. While you might think the length of time that has passed since my last post is excessive, it’s often the length of time that passes between the first overture and an actual LOI (although there are plenty of situations where the buyer and the seller hook up after 24 hours, just like in real life.)
As with other “transactions”, there’s a time to get hot and heavy. In most deals, there are two primary thing that the buyer should have on his mind – price and structure. Since the first question anyone involved in a deal typically asks is “what is the price?” we’ll start there.
Unlike in a venture financing where price is usually pretty straightforward to understand, figuring out what the “price” is in a merger situation can be more difficult. While there is usually some number floated in early discussions (e.g. “$150 million”), this isn’t really the actual price since there are a lot of factors that can (and generally will) effect the final price of a deal by the time the negotiations are finished and the deal is closed. It’s usually a safe bet to assume that the “easy to read number” on the first page of the LOI is the best case scenario purchase price. Following is an example of what you might see in a typical LOI.
Purchase Price / Consideration: $100 million of cash will be paid at closing; $15 million of which will be subject to the terms of the escrow provisions described in paragraph 3 of this Letter of Intent. Working capital of at least $1 million shall be delivered at closing. $40 million of cash will be subject to an earnout and $10 million of cash will be part of a management retention pool. Buyer will not assume outstanding options to purchase Company Common Stock, and any options to purchase shares of Company Common Stock not exercised prior to the Closing will be terminated as of the Closing. Warrants to purchase shares of Company capital stock not exercised prior to the Closing will be terminated as of the Closing.
Hmm – I thought this was a $150 million dollar deal? What does the $15 million escrow mean? The escrow (also known as a “holdback”) is money that the buyer is going to hang on to for some period of time to satisfy any “issues” that come up post financing that are not disclosed in the purchase agreement. In some LOIs we’ve seen extensive details, in so much as each provision of the escrow is spelled out, including the percentage of the holdback(s), length of time, and carve outs to the indemnity agreement. In other cases, there is mention that “standard escrow and indemnity terms shall apply.” We’ll discuss specific escrow language later (e.g. you’ll have to wait until “paragraph 3”), but it’s safe to say two things: first, there is no such thing as “standard” language and second, whatever the escrow arrangement is, it will decrease the actual purchase price should any claim be brought under it. So clearly the amount and terms of the escrow / indemnity provisions are very important.
Well – that working capital thing shouldn’t be a big deal, should it? True – but it’s $1 million. Many young companies – while operating businesses – end up with negative working capital at closing (working capital is current assets minus current liabilities) due to debt, deferred revenue, warranty reserves, inventory carry costs, and expenses and fees associated with the deal. As a result, these working capital adjustments directly decrease the purchase price in the event upon closing (or other pre-determined date after the closing) that the seller’s working capital is less than an agreed upon amount. Assume that unless it is a “slam dunk” situation where the company has clearly complied with this requirement, the determination will be a battle that can have a real impact on the purchase price. In some cases, this can act in the seller’s favor to increase the value of the deal if they have more working capital on the balance sheet than the buyer requires – often the seller has to jump through some hoops to make this happen.
While earn outs sound like a mechanism to increase price, in our experience, they really are tool that allows the acquirer to under pay at time of closing and only pay “true” value if certain hurdles are met in the future. In our example, the acquirer suggested that they were willing to pay $150 million, but they are only really paying $100 million with $40 million of the deal subject to an earnout. We’ll cover earnouts separately, as there are a lot of permutations, especially if the seller is receiving stock (instead of cash) as their consideration
In our example, the buyer has explicitly carved out $10 million for a management retention pool. This has become very common as buyers wants to make sure that management has a clear and direct future financial incentive. In this case, it’s explicitly built into the purchase price (e.g. $150 million) – we’ve found that buyers tend to be split between building it in and putting it on top of the purchase price. In either case, it is effectively part of the deal consideration, but is at risk since it’ll typically be paid out over several years to the members of management that continue their role at the acquirer – if someone leaves, that portion of the management retention tends to vanish into the same place lost socks in the dryer go.
Finally, there’s a bunch of words in our example about the buyer not assuming stock options and warrants. We’ll explain this in more detail later, but, like the working capital clause, can affect the overall value of the deal based on what people are expecting to receive.