Letters of Intent: What to Negotiate Before You Sign

What an LOI is

A short document, usually two to five pages, in which the buyer proposes the price, structure, and key terms, and both sides agree to work toward a definitive agreement. Most of it is non-binding. A few sections, typically exclusivity, confidentiality, and expense allocation, are binding. It is signed after the buyer has reviewed the offering memorandum and met the owner, and before diligence begins.

Terms to settle in the LOI

Price. Obvious, and still often left vague. Give a number with any adjustments spelled out. Do not give a range. If the price is plus inventory, say so and say how inventory is counted and valued.

Structure. Asset sale or stock sale. This decides the tax outcome for both sides and should never be left for the purchase agreement.

Cash at closing versus seller financing. How much is paid at closing, how much is a seller note, the note's interest rate, term, security, guarantee, and standby terms if there is an SBA loan. A buyer who wants a note should propose the terms in the LOI, and a seller should not accept "seller financing to be negotiated."

Earnouts, if any. Amount, metric, measurement period, how the metric is calculated, what the buyer is obligated to do to support it, and what happens if the buyer sells the business during the period. An earnout described in one sentence in an LOI becomes twenty pages in the purchase agreement, all drafted by the buyer's attorney.

Working capital. Whether the deal includes working capital, and if so, what the target is and how the adjustment works. For most small businesses the price is cash-free and debt-free with the seller keeping receivables and paying payables, or with a defined working capital peg. Buyers who leave this open often come back at closing with a large adjustment.

Purchase price allocation. At least the principle. Tangible assets at fair market value, a nominal non-compete, the rest to goodwill. This affects the seller's tax bill and is easier to agree now than later.

What is included and excluded. Equipment, vehicles, inventory, the name, the phone number, the website, the customer list. Real estate, if the seller owns it, and whether it is sold or leased. The owner's personal vehicle, artwork, and anything else the seller keeps.

Transition. How long the seller stays, at what compensation, doing what. Thirty to ninety days of full-time transition is typical, sometimes followed by a consulting period.

Non-compete. Term, geography, and scope. Three to five years within a reasonable radius is common, and California enforces it under the sale-of-business exception in Business and Professions Code section 16601. A seller planning to stay in the industry in some form needs to carve that out here.

Employees. Whether the buyer intends to offer employment to all employees, and whether key employees need to accept offers as a closing condition.

Contingencies. Financing, lease assignment, license transfer, diligence. Each one with a deadline. A financing contingency with no deadline is an option for the buyer to walk at any time.

Timeline. Diligence period, target closing date, and what happens if the buyer misses them.

Exclusivity. How long the seller agrees not to talk to other buyers. Thirty to sixty days is reasonable. Ninety days or more is a lot to give away, and the seller should be able to end it if the buyer misses a deadline.

Deposit. Some sellers ask for a deposit into escrow at LOI, refundable if diligence fails and forfeited if the buyer walks for no reason. It is not universal in small business sales, but it separates serious buyers from the rest.

What buyers try to leave open

Working capital, allocation, the seller note terms, and the earnout definitions. Each one is a place where a buyer's attorney can move value to the buyer in the purchase agreement. When a buyer says "we can work that out in the definitive agreement," the answer is that it is easier to work it out now.

What not to do

Do not sign the first LOI that arrives because it exists. If there are other buyers in the process, tell them an offer is in hand and give them a short window. Competition at the LOI stage produces better terms than any amount of negotiation after it.

Do not give long exclusivity without milestones. Tie it to the buyer delivering a lender commitment letter, completing diligence, or delivering a draft purchase agreement by defined dates.

Do not agree to a price that depends on diligence confirming numbers you have not already documented. If the add-back schedule is supported, diligence should confirm it. If it is not, expect a retrade.

Do not let the business slip. The period between LOI and closing is when a buyer looks for reasons to renegotiate, and a soft month is the reason they find most often.

A worked example of what gets lost

A seller receives an LOI at $1.8 million, cash at closing, with "customary working capital adjustment, purchase price allocation to be agreed, and a seller note to be discussed." The seller signs it, grants sixty days of exclusivity, and stops talking to the other two buyers.

Thirty days later, the buyer's draft purchase agreement arrives. The working capital target is set at $220,000, based on the highest month in the prior year, and the seller's business typically runs at $150,000, so the price is effectively $70,000 lower. The allocation puts $400,000 on equipment worth $180,000, which will cost the seller about $70,000 in additional tax. The seller note is now $270,000 on full standby for ten years, unsecured. The buyer's attorney describes all of it as customary.

The seller's choices are to accept, to negotiate from a position where the other buyers have moved on, or to walk and restart. Most sellers in that position negotiate and end up somewhere around $1.65 million in economic terms with a note they did not want. The LOI said $1.8 million.

The same seller, with an LOI that stated cash-free debt-free with inventory at cost, allocation at fair market value with residual to goodwill, and no seller note, would have closed at $1.8 million or would have known before signing that the buyer's price was something else.

A short list for reading an LOI

Is every dollar of the price defined, including how and when it is paid. Is the structure stated. Is working capital either excluded or defined with a target. Is the allocation principle stated. Are the seller note terms complete. If there is an earnout, is the metric, period, and calculation stated. Are the contingencies listed with dates. Is exclusivity tied to milestones. Is the transition defined. Is the non-compete defined. If any answer is no, the LOI is not ready to sign.

Why the LOI sets the deal

The purchase agreement will follow the LOI closely. Attorneys draft from it. Lenders underwrite from it. A term that is in the LOI is very hard for a buyer to walk back without looking like they are retrading. A term that is not in the LOI is fair game.

We negotiate the LOI on the seller's behalf with the terms above as the checklist, and we do not recommend signing one that leaves any of the money terms open.

This article shares our opinion and general information. It is not legal or tax advice. Always speak with a licensed attorney for legal advice, and a qualified tax professional for tax questions, before you act.