Making offers (IOIs and LOIs)
Making offers quickly and often in your search is critical to buying a business. As in sports, taking frequent “shots on goal” is always better than waiting for the “perfect” opening. After all, the offer is the first step on the path to “closing” on the business you acquire!
If you are not making 2-3 offers a month, then there is a problem in your prospecting campaign, you are risk averse, you are being too selective or just fearful of making a decision without sufficient information.
More, less formal offers are best
For clarification, let’s establish the difference between an IOI (Indication of Interest) and an LOI (Letter of Intent). The IOI is similar to a term sheet, outlining the offer terms, written in plain language, a single page in length, and prepared after signing an NDA and reviewing financials. Some searchers move directly to LOI, but I feel that the informality of the IOI is better suited to the early stage of negotiations. The LOI can confuse or even scare the seller, but is worth the time and effort to spell out in writing as many of the specific terms as can be agreed upon.
The LOI looks more like a legal document and formalizes many of the details that will be present in the final Purchase and Sale Agreement. The LOI is signed by the seller after the initial rounds of IOI’s are complete. Its purpose is to “lock in” the seller and take their business off the “market” so you can begin due diligence. The LOI gives you and the business owner “closure” after the very challenging negotiation process.
Move quickly to get your offer on the table
The IOI stage is too early to do much detailed analysis. This is not the time to spend your own valuable time or intern resources digging deep into the company or industry. Instead, you should determine whether the seller is serious about moving forward with the basic structure of the deal. Base your offer on financial statements going back 3 years and don’t expect a CIM (Confidential Information Memo) unless it is a brokered deal.
Besides price, you want to clarify what is included in and excluded from the purchase. You need to get the concept of a seller note on the table early so the owner does not expect an all-cash closing. The seller will also want to know their expected role going forward and for how long they will be expected to remain after closing.
Most prospects won’t have an EBITDA breakdown – you will have to estimate it. Initially, it might take a few weeks to craft an IOI after financials are provided, but experienced searchers get this down to just a few days, or less if they know the industry. The key here is developing the “add backs” to Net Income that show the cash flow value of the company once you own it. These are derived from discussions with the owner about non-recurring expenses like personal travel, auto leases for family members, country/athletic club memberships, and a myriad of others. One searcher mistakenly classifed owner “distributions” of profits as an add-back, when it was never on the income statement as an expense – a 3.5x multiple quickly turned into an unattractive 5.5x!
No does not mean no
Hearing “no” from the seller should be treated as “no for now”. Remember that the seller may not yet be comfortable with the reality of selling their business, or with seeing a hard price put on his or her legacy.
These rejections should be revisited with regular 30-day follow-ups. During the life cycle of a search, many early IOI’s will resurrect themselves. Don’t be discouraged by repeated negative responses, persistence will pay off.
Sellers undergo life changes, their other offers fall apart, or they simply become more comfortable about selling. Of course, when a resurrected prospect calls, take a deep breath and prepare them for a lower offer, with statements such as “market conditions have changed, and I have been moving forward with other interesting opportunities.” They are getting back in touch with you for a reason!
Since it takes a while for your proprietary search campaign to yield results, early on in your search you can start with CIMs (Confidential Information Memo) from brokers to gain experience. Often times these broker sourced opportunities do not make it through to closing and often return to the market.
Where to start your offer
Early in your search, you want to start off with low anchor points. You can’t afford to overpay for the business and you need to gain experience for what your investors will finance and what to expect from sellers. You would rather have a good business at a great price than a great business that you are overpaying for. Avoid the tendency to focus too much on what the seller is “asking for”. Instead, offer a below-market valuation that will be the beginning of a negotiation.
Depending on the industry and strength of historical performance, offering 1-2x multiple below industry “going rates” is a good place to start. Your search effort should yield sellers who have a special affinity for you, allowing them to justify a reduced multiple.
Set a fixed price rather than a multiple of EBITDA. In fact, never even verbalize a multiple to the seller! Too many deals die with a change in the TTM (trailing twelve months) EBITDA. When earnings trend upward as you near closing the seller will expect a higher price. This wreaks havoc on the capital raise from banks and investors. On the flip side, when earnings drop, sellers have a hard time swallowing a downward price adjustment. A fixed-price offer supports the sellers’ natural fixation on what they will receive at closing.
Be sure to build in a “cushion” that you are comfortable with for the inevitable “surprises” you find during due diligence. “Re-pricing” or “Re-trading” while under LOI is one of the best ways to destroy trust with your seller. You can expect to find discrepancies that may justify a price adjustment, but doing so puts the transaction at risk. Having a 5% margin of error will avoid the seller losing confidence in you. Best to leave the seller with the impression that you are committed to the terms in the LOI.
Also, avoid quoting a price range. With a range, you are thinking the low end and the owner is out discussing a sale at the high end with friends, advisors, and significant others. If and when you start to drive down to the lower end of the range, you risk seller disappointment and mistrust. Don’t set yourself up for these emotional reactions trust.
You may be tempted to bridge a valuation gap with an earn-out. The seller does not deserve to reap the rewards of your efforts in the future, you are compensating the owner for what they have done, and not what you will be doing with the business. Generally, these end up creating conflict with sellers. Once you own the business, you control expenditure levels and the accounting statements. The seller may complain and perhaps bring legal action over how earnings are reported. If the seller is your landlord and visible in the local community, this can get messy. Many banks prohibit seller payouts in many cases for 2 years and are not anxious to support variable payments to ex-owners.
Similarly, avoid re-engaging the seller by rolling some of their valuation into equity. Research shows that the relationship between sellers and searchers typically erodes over the years – buyer’s remorse or plain disagreement with post-close business decisions. Avoid thinking your case will somehow be different.
Enhance the total value in the IOI.
While most sellers understand the time value of money, they will fixate on the total value of the IOI. Simply state the elements of the value.
Total Consideration of $x,xxx,xxx:
• Cash at Closing
• Escrow for Working Capital and other adjustments paid 12 months after closing
• Seller Note – interest rate(5-7%), first payment after 2 years and balloon date, 5 to 10 year amortization schedule
• Seller Non-compete/Non-solicitation payments over 5-7 years
Build flexibility into the seller note structure by starting high, in the 50%+ range. Seller notes range from 20% to as high as 60% of purchase price, and discussing this with the seller early on is important. Securing interest and principal “holidays” up front will help ease early cash flow requirements. SBA lenders require no payments to the seller for 25 months. Once the business is running well, you may be able to replace seller financing with lender financing, so be sure to stipulate in the LOI that there are no pre-payment penalties. Paying principal on a 10-year amortization schedule with a balloon payment in 5-7 years allows you to back load your cash flow. This element of your IOI Term sheet is very negotiable, so give yourself plenty of room.
Assigning value to Non-compete/non-solicitation allows tax-deductible payments to the owner and inflates the total price. These payments can also be variably structured over a 5-7 year time frame to allow for less cash flow impact early on in your ownership.
The devil’s in the details of the IOI
The terms of your offer can be critical to your success running the business later on. The purpose of additional terms is to prevent misunderstandings that get in the way later, to speed the process along.
Additional non-financial terms:
• Purchasing assets, excluding cash, not stock
• Excluding debt, obsolete inventory and 90+ day old receivables
• Leasing building/property with option to purchase
• Compensating seller after closing for advice and support
• Expiration date of IOI
Over-communicate exact inclusions and exclusions. Most sellers have an incomplete understanding of working capital. While they expect to keep the cash they have in the business they are emotionally attached to their receivables, arguing that they did all the work to create them and therefore should keep them. Being reminded that you are purchasing their “on-going” business and that they keep the cash sounds rational but is rarely accepted by the seller without extensive dialogue.
Conversely, being intentionally vague about obsolete inventory and older receivables raises the opportunity for a discussion about accounting practices and disputes or expectations of selling off old supplies as further negotiation rounds.
If real estate is involved, letting the owner keep the real estate is a good way to reduce debt obligations early on and as long as there is an option for purchase in the 5th year or so. The seller will appreciate the extra security and value from the lease and eventual sale of the property. It would be stretch however to include the lease payments in the financial terms of the IOI. But, be assured the seller will be doing the mental math.
You will likely need the wisdom and support of the owner after closing. Paying a daily consulting rate allows the seller to feel valued while giving you the flexibility to engage the seller as needed.
Always put an expiration date on your offer, with a short 2-3 day fuse, emphasizing that you will be buying a single business and cannot afford to take too much time. Be, reasonable and willing to extend, but start with early dates. This is about “getting to no, fast” so you can move on to then next prospect.
This is a bilateral negotiation, as much as you will hate it
Be prepared to negotiate with the seller and your lenders at the same time. As you are buying only one business, it is critical that you not overpay for it. If the terms you end up with are too favorable to the seller, your investors and/or bankers will push back hard. In my own first LOI, I was devastated when my banker told me they would not provide the financing because they felt I was paying too much, despite my spreadsheets that showed how I could make it work; but they were right!
I typically hear, especially from searchers early in their process, that the “back and forth” negotiation of the IOI is draining, fraught with uncertainty and leaves them feeling exhausted and sometimes taken advantage of. Remember, this is just part of the process and owners have been negotiating with customers, bankers, vendors and employees for years. In fact, one searcher felt like he was swimming with sharks while trying to negotiate with the owners of a scrap metals business whose livelihood depended on their ability to drive “hard bargains.” Avoid the “this is my best and final offer” game, be prepared for multiple cycles.
Be prepared for multiple discussions over weeks, sometimes months. The seller may need time to reflect one of the more important decisions in their life. They will want to thoroughly understand the IOI. Discounts taken for customer concentration, low margins, seasonality, cyclicality, competitive pressures, transition issues, quality, delivery, and service levels are all reasonable factors in your valuation. Seller disagreement sets you up to ask for factual data to justify increasing your offer. It may even allow you to adjust the terms in your favor, extending the payment holiday or reducing the interest on the seller note. Since your financing will be almost exclusively based on historical results, avoid dialog around the seller’s future expectations for the business.
Develop seller confidence
Each occasion to dialog with an owner is an opportunity to build trust. Make small commitments and follow through on them. Continually ask and probe the seller about their motivations for selling, their plans afterwards, and concerns about specific customers, vendors and employees. The more sellers are able to share these with you, the more comfort they develop with the process of selling…just because they have said they are interested, does not necessarily not mean they will make it all the way to closing day with you.
Give the owner some time to review the offer before a face-to-face dialog or meeting. Be prepared for the butterflies in your stomach that will happen every time you click “send.” The feeling that this “could be the one” is exhilarating and terrifying at the same time! It does get easier with time, practice, patience, perseverance and courage.
You also want to subtly communicate that there are other prospects that you have put on hold to focus on this. While you cannot have two signed LOI’s, managing multiple IOI’s at the same is reasonable and customary.
Beware of being shielded too long or too often by an intermediary. It generally means the seller is looking for the “highest” price for their business, and not resonating with other considerations that make searchers so attractive by appealing to their “legacy”, continuity with employees, along with minimal impact on the community, customers and vendors. Let someone else with deeper pockets buy them and move on.
Be fixated on the search, and not the deal
For the searcher, it is not unusual to have a half dozen of these IOI negotiations ongoing at any given time. Avoid fixating on a single transaction. Allocate time to prospecting activities also. Avoid the natural tendency to dig deeper into the target company’s market, industry or financials, since about 80% of these will not turn into LOI’s.
You will learn more with each “shot on goal.” The skills you develop early on in the process pay off handsomely by the time you reach mid-way in your search. Sellers will sense the confidence you have developed to provide flexible solutions to the issues that make each search transaction unique.
I encourage comments from readers and dialog about the topics which allows others to see the commentary and learn both from my views and the views of others; a virtuous learning cycle. Jump right in!