Here are the 7 critical components of a Letter of Intent (LOI) for the acquisition of a lower-middle market manufacturing company, which we’ll discuss in detail later in the article:
1. A Clearly Defined Purchase Price
2. If Financing is Needed – What is Equity Injection and the Financing Source
3. The Terms for Any Requested Seller’s Note
4. Clearly Defined Timelines for Due Diligence, Submission of APA/SPA & Closing
5. What is the Escrow Requirement for Reps & Warranties
6. Working Capital Requirement & the Calculation Method
7. Seller Involvement Post-Closing
I realize there are other components to a Letter of Intent for the acquisition of a lower-middle market manufacturing company. However, as an M&A professional specializing in the sale of manufacturing companies nationally, I see buyers most often either fumble or totally ignore these in their LOIs.
Covering some of the harder things upfront benefits both buyer and seller. Sometimes, the best thing that can happen is to get to “NO” quicker so both sides can move on to an acquisition or to a buyer who is right for them.
Let’s look at each of the 7 components in more detail:
A Clearly Defined Purchase Price
The purchase price should never be something to be determined in due diligence or a range. The buyer is asking the manufacturing business seller to take their business off the market and enter an exclusionary period. The seller has a right to know what your view of value is. The LOI is not binding on the buyer. This gives them an out if the seller has misrepresented any information pre-LOI. Right now, we’re still very much in a “Seller’s Market” with quality manufacturing companies receiving multiple offers. We recently fielded 12 LOIs for the acquisition of an aerospace-related company within a month of listing it. If you’re unclear about the purchase price, no savvy seller will take their business off the market to engage with you.
If Financing is Needed – What is Equity Injection and the Financing Source
Many buyers think this is none of the seller’s business (or the broker). It absolutely is, and here’s why. The amount of equity injection and financing source will determine the likelihood that the financing will be approved. Sellers don’t want to take the business off the market unless there is a high likelihood of success. Not all lenders are created equal. Some are cash-flow-based, and some are asset-based. The deal I described above had excellent cash flow but was asset-light. We quickly eliminated offers where an asset-based lender was being used.
The Terms for Any Requested Seller’s Note
If you’re asking for a seller’s note, be clear on the amount and terms, including interest rate, payment timeline, balloon if applicable, and any standby required by the lender. If you’re not familiar with a “standby,” it’s related to a lender requesting no payment on the seller’s note for a period of time, often on the life of the bank’s loan. In the case of SBA 7A acquisition loans, that could mean up to 10 years. Surprises kill deals. The seller needs to know the terms upfront.
Clearly Defined Timelines for Due Diligence, Submission of APA/SPA & Closing
I always laugh when I see due diligence defined as “to the buyer’s satisfaction” and “the exclusionary period doesn’t end until due diligence is over.” If you can’t clearly define a timeline for due diligence, you shouldn’t be buying a business. Due diligence in the lower middle market is usually 60-90 days but can be 30-45 days for smaller deals. If you have competition for the acquisition, you’ll score points with the seller by providing a deadline for the submission of the Asset Purchase Agreement or the Stock Purchase Agreement. And finally, your LOI should have a target closing date.
What is the Escrow Requirement for Reps & Warranties
This is the most often ignored item in an LOI. Buyers are afraid to bring it up at the time of the LOI, but again, surprises kill deals. In the APA or SPA, the Seller is making representations and warranties about the information that has been provided and the condition of the business. The buyer wants a portion of the purchase price held back for a defined period of time in case the information provided turns out to be wrong or, worse, fraudulent. This is entirely customary in lower middle market M&A, and there’s no reason not to cover it upfront. Here’s a pro tip for sellers. If you’re running the LOI by your attorney and he doesn’t know what a reps and warranties escrow is, run! This is not an attorney familiar with M&A. They will elongate the deal process and might just kill your deal. Yes, I’ve got some nightmare stories on this, but I’ll save that for another article.
Working Capital Requirement & the Calculation Method
This is the second most ignored item in an LOI, and for the same reason. Buyers are afraid to bring it up at the time of the LOI. You should be doing your working capital estimate before submitting your LOI and including an estimated number in your LOI. Also, tell the seller how you intend to calculate it. This will eliminate misunderstandings later. Some people will calculate based on current assets, less current liabilities (not including cash). Others may simplify this and use accounts receivable plus inventory, less accounts payable. At my firm, we proactively ask the client for balance sheets in an Excel format and include this in the data room so that buyers can easily calculate the working capital requirement of the business. Again, covering the hard things first can help both sides and facilitate a smoother transaction.
Seller Involvement Post-Closing
There are normally transition services or a consulting agreement for lower middle market deals that are separate from the APA or SPA. However, there is wisdom in providing the broad strokes of what you expect of the seller in your LOI. I’ll refer again to the aerospace deal I described above. The sellers lived in another state on the other side of the country and only lightly touched the business. One of the 12 offers we received required the founders to work a 40-hour work week for six months. Needless to say, they were not who the seller chose to work with. In this case, there was a very strong GM in place, and there was no need for the sellers to work full-time to facilitate a smooth transition. Buyers can and should have detailed conversations on transition timelines and activity levels in advance of submitting their offer.
Follow these 7 critical components of a Letter of Intent (LOI) for the acquisition of a lower-middle market manufacturing company, and you will increase the likelihood of being selected when you have competition for the acquisition.