Why Transaction Structure Should Be Negotiated Before the LOI

Transaction structure before the LOI deserves as much attention as the purchase price itself. The best time to negotiate both is before the seller commits to one buyer. During a competitive sale process, several buyers may be pursuing the same company. The seller has alternatives and negotiating leverage. That leverage should address more than purchase price.

A buyer may offer an attractive valuation while proposing terms that materially change the seller’s economics. Those terms may affect taxes, closing proceeds, future payments, retained ownership, and post-closing responsibilities. The Letter of Intent provides an opportunity to resolve these issues before the seller grants exclusivity. Once exclusivity begins, the negotiating environment changes.

A $10 Million Offer Has Many Possible Outcomes

Suppose a buyer offers $10 million for a business. The buyer might pay the entire amount in cash at closing. Alternatively, and more frequently, the offer may include several different forms of consideration.

Part of the consideration might consist of a seller note. Another portion might depend on achieving future performance through an earnout. The buyer might also require the seller to reinvest proceeds through rollover equity. In addition, the buyer may expect the seller to remain with the company for several years. That involvement may include employment, consulting, or other transition responsibilities.

Each proposal may still carry a $10 million headline purchase price. However, the timing, certainty, and economics of that purchase price may differ significantly. That is why price and structure should be negotiated together.

Start With the Form of the Transaction

One of the earliest questions involves what the buyer actually proposes to purchase. An asset sale and an equity sale may produce substantially different legal and tax consequences. Those differences may affect the seller’s expected after-tax proceeds. Waiting until purchase agreement negotiations to address this issue creates unnecessary risk. By then, the seller may have granted exclusivity and invested significant time in due diligence. The buyer also knows that restarting the process would create delays and uncertainty for the seller. Addressing the proposed transaction form earlier preserves more negotiating flexibility.

Determine How the Purchase Price Will Be Paid

Next, the seller should understand how much of the proposed value arrives at closing. Cash provides immediate liquidity. A seller note shifts part of the purchase price into future payments. An earnout makes additional proceeds dependent upon future performance. Rollover equity presents a different proposition. The seller reinvests part of the transaction value into the post-closing ownership structure.

These forms of consideration should not remain vague when the seller selects a buyer. A seller choosing between two competing offers needs enough information to compare their actual economics. Otherwise, the seller may select the highest headline price without selecting the strongest financial proposal.

Working Capital May Quietly Change the Economics

Working capital deserves similar attention because it directly affects what the seller delivers at closing. A buyer generally expects the business to transfer with sufficient working capital to support normal operations. The disagreement often involves what “normal” means.

Historical balances, seasonality, recent growth, and unusual operating conditions may influence the appropriate target. The parties do not need a final working capital calculation when signing the LOI. They should establish the general methodology and identify significant disagreements before exclusivity. A poorly defined working capital provision may create substantial purchase price dispute shortly before closing.

Post-Closing Involvement Is Part of the Deal

Sellers should also address what happens to them after the transaction. Some buyers need only a short transition period. Others expect the seller to remain actively involved for several years. That difference may materially change the attractiveness of the transaction.

Employment terms, consulting arrangements, restrictive covenants, and rollover equity may keep the seller connected to the business. These provisions become especially important when the seller’s objective involves retirement or another immediate transition. A seller should not discover late in negotiations that the buyer expects a fundamentally different post-closing relationship.

The Negotiating Environment Changes After the LOI

Before the LOI, the seller may have several interested and qualified buyers. If one buyer insists on unfavorable terms, another buyer may provide an alternative. That competitive tension gives the seller leverage. An LOI is generally non-binding regarding the parties’ obligation to complete the transaction. However, certain provisions, particularly confidentiality and exclusivity, are typically binding. Therefore, signing an LOI generally removes that advantage for a period of time. The seller stops negotiating with competing buyers while the selected buyer completes due diligence.

Weeks or months may then pass before the definitive purchase agreement reaches completion. During that period, the buyer learns more about the company. The seller also becomes increasingly invested in completing the transaction. A buyer seeking to change an unresolved term now negotiates from a stronger position. The seller may still reject the change. However, doing so could mean terminating the transaction and returning to the market. That is a very different negotiating position.

Use the LOI to Establish the Economic Framework

An LOI should not attempt to become a complete purchase agreement. Many legal provisions require due diligence and detailed negotiation before the parties finalize them. The important distinction involves material economic terms. Purchase price, transaction form, consideration structure, working capital, and significant seller obligations belong in the early discussion. Tax consequences should also receive attention before the seller accepts a structure.

This is where coordination among the seller’s M&A advisor, CPA, and legal counsel becomes especially valuable. The M&A advisor evaluates the offer within the competitive process. The CPA evaluates the expected after-tax economics. Legal counsel identifies structural issues that should receive attention before exclusivity. That work does not require resolving every detail before signing the LOI. It requires identifying the terms important enough that the seller should not postpone them. The LOI should narrow the remaining issues, not postpone the most important economic negotiations until the seller has less leverage.