Understanding the Role of MOUs, LOIs and Term Sheets
June 28, 2017 in Brokering
Have you ever gone into a conversation with someone and walked away with a completely different takeaway than they had? Anyone who is married needs to raise his or her hand—immediately. I can’t count the number of times my wife and I “came to an understanding” to find out that I actually didn’t understand what I was agreeing to at all. Hello, Paleo diet, kale dinners, and personal trainer. I didn’t agree to that, did I?
This phenomenon isn’t limited to marriage. In fact, it creeps into about 90% of our verbal communication. Two associates strike a verbal agreement lofty on goals, but limited on details. When it comes to actually executing on the agreement, they figure out exactly how far their “interpretations” were from each other.
The same is true when it comes to selling a business. In fact, it’s the first phase in the selling and negotiation process. You as the owner connect with a possible buyer, talking broadly about them purchasing your business. They agree that they’re interested.
But, the devil is always in the details. And those details need to come out before you can close this deal—or before you agree to too many of your spouse’s “suggestions.” Once you have interested parties verbally stating interest, it’s time to start putting things down on paper. That’s where we get to the crux of the deal.
The Skinny on MOUs, LOIs, and Term Sheets
In a business transaction, we rely on a term sheet, memorandum of understanding (MOU), or letter of intent (LOI) to outline the deal. All of these documents are essentially the same but are formatted differently with the intent to document in letter form the terms to the sale. The goal is to take vague verbal understandings and knock out all the details. We transform Dad’s time-old adage of “one day you will run this business,” into specifics, including when, at what cost and what dad’s role will look like once a child takes the helm.
Let’s start with the most simple one first, the term sheet. At Exit Consulting Group (ECG), we use a term sheet as an almost bullet point understanding. These are your less complex transactions, oftentimes for businesses under $500,000 as well as internal sales.
Next, we’ll go to the heavy hitters, the MOU or LOI. While each has a subtle legal nuance, they both accomplish the goal of outlining the terms for a more complex deal, such as a $1-100 million dollar company.
It’s important to know that none of these are binding contracts. They are just bringing each player to the table and outlining the specific details behind the deal. Once each party signs them, we move into the next phase, but I’m getting ahead of myself. First, we need to outline what you put in these documents.
Note: Letters of intent typically include language to state that the agreement is not binding. Without that disclosure, depending on how it is written and the previous history between the parties, an LOI could potentially carry legal weight.
Step 1: Establish What is Being Sold
While step one sounds basic, it can get complicated really fast. Identify exactly what is being sold and the form it’s being transferred in. First, is this an asset or stock purchase? You can dig into more about the differences of those two, as well as the tax ramifications here.
For an asset purchase, outline all that is included in the agreement. This includes inventory, business assets, current cash reserves, computers, vehicles, intellectual property and more. A lot will be straightforward, but you’ll likely encounter a few “sticky” items. Is your child currently driving a company car? What about you and your spouse? How many personal laptop computers has the business paid for? You get the picture. Small business owners regularly use their business to cover a plethora of “business items” that double for personal use. It’s time to decide if they are included in the asset sale. Here are three often overlooked areas.
When going the stock option route, what percentage of the company are you selling? Are you willing to give up the majority rule with a 51% / 49% split in their favor, sell 100% of the company or are you looking to still have the final say? It all comes out when you put the deal on paper.
Step 2: Define Purchase Price and Outline Payment Method
Now that we know specifically what’s being sold, let’s agree on the sales price. Prepare to start on different ends of the spectrum. In our experience, 99% of the time, the business owner has an inflated view of the company’s worth.
Once you agree on a number, then we enter into the financing question. In short, how will the buyer pay in cash for the business? At ECG, we advise owners to get as much up front as possible. It’s the only guaranteed amount, with any future promises living on rocky soil.
Here are your basic financing options. First, the buyer can pay all cash. While great, it’s a rarity. Second, the buyer can finance it or bring in professional money. We view that as just as good as paying with cash since the owner walks away with everything they are owed. Then we move to the more slippery option, seller financing. Here the owner finances a portion of the sale, sometimes all of it. We recommend keeping this amount as small as possible, but oftentimes it’s a key aspect of an internal sale.
Step 3: Determine Closing Date
Consider this the equivalent of setting a wedding date. If we chose to move forward, what date are we going to seal the deal? This date will need to factor in the due diligence period as well as allow enough time for the lawyers to draw up contracts.
Step 4: Nail Down Owner Exit Details
Owners don’t leave the business the same day the deal closes. In fact, it’s common for them to stay on a period of time following to help execute the transition. This period of time varies by owner, as well as the financing option. It could be a short timeframe, such as thirty days, to as long as a few years. Shorter time frames, such as 30 days, typically forgo compensation viewing the owner’s work as part of the terms of the sale. Once you get into longer periods, both parties need to agree on a fair compensation model for the exiting owner’s time and work. We can get creative in this phase, such as the previous owner staying on six months at full time and then the following 6 months at part time, but they are typically compensated for this time.
At ECG, we strongly encourage owners financing the sale to stay involved with the company to some degree until their note is paid off. Once you fully leave the business, you have no control or say in the direction of the company. When you’re doing seller financing, it all of a sudden becomes a high-risk loan.
Leveraging the Agreement in the Negotiation
To bring back the analogy of dating and marriage, this is merely the initial dating period. In fact, it’s not even exclusive dating. Both buyer and seller are still playing the field, with the owner working to bring in other contenders to amp up the competition.
At this point, the buyer will push for the owner to stop playing the market. It’s in their interest to go exclusive. More competition can only drive the price up. After all, a seasoned buyer is planning on knocking down the price a few notches after they deploy their team of financial accountants and consultants.
That’s why it’s crucial for an owner to bring in multiple buyers. They can encourage one buyer to consider more favorable options if they highlight the deals other buyers are considering.
Signing the Agreement—Going Exclusive
As mentioned, signing a term sheet, MOU, or LOI is not legally locking you into the agreement. But signing it does take you off the market. Congratulations, you are officially dating exclusively. Consider this the same as a house going “under contract.” It’s not sold, but it’s not available.
Then we start the 30 or 60 day due diligence. Professional buyers will bring in hordes of financial analysts and consultants to comb through the business. That’s why at ECG we spend so much time preparing a business to go to market. We limit the ammunition to try and reduce the sale price. Once the due diligence wraps up, cue the lawyers to write up contracts. You can hear wedding bells chiming in the near future because buyer and seller are getting ready to walk down the aisle.
Bringing Your Own Team to the Plate
I’ve written before about the art of negotiation. It’s a calculated dance, ripe with calculated moves and eloquent maneuvers. But, unlike navigating the tango, a misstep in the process of selling your business can cost tens of thousands of dollars, if not more. You need to put your best foot forward at every phase of this process. You don’t want any costly missteps.
That’s where our team at Exit Consulting Group comes in. In the business world, we are expert dancers. We specialize in helping mid-sized businesses plan, design, and execute their business exit, regardless of whether it’s an internal sale or you need someone to help you take your business to market.
After preparing your business to make a splash on the market, we help you find several dates to the dance, overseeing all aspects of the negotiation. Yes, that includes creating a term sheet, MOU, or LOI, whichever is the best format for your company. We work to get you to the “altar” with the best deal possible and the most money in your pocket.
If you’re thinking about selling your business in the next one to three years, contact us today. We have our dancing shoes ready.