Top 9 LOI Gotchas B2B SaaS Founders Should Be Aware Of
1. Purchase price
Obviously the first thing anyone looks for in an LOI! However, the topline number can be deceving. In some cases we've seeen LOIs where the purchase price includes the value that a founder *might* get if and when the acquirer sells the company again, several years from now (!)
It's also common to see part of the purchase price carved out for retention purposes. This can be fine, but also is a way for the acquirer to pretend like part of the bonuses and salaries for the team (which will be their employees now remember) is part of the purchase price, when in fact you personally will never see any of that. You should also be keenly aware of the difference in tax treatment in this case..
Another thing we see very often is part of the purchase price (hopefully not too much) paid as shares in the acquirer instead of cash. This can be straight forward (eg if the acquirer is a public company where you can sell shares easily and the price is simple to determine) or extremely sneaky (a private company that uses their peak fundraising valuation that preferred shareholders got to value the common shares behind a massive preference stack that you get).
If you’re going to take part of the purchase price as shares in the acquirer, then you should be doing due diligence on them.
2. Working capital adjustments.
First off - what happens to the cash in your bank account when you get acquired? As a general matter, most LOIs are "cash free/debt free" - which means you have to pay off any debt the company has, but you can keep the excess cash in the bank account on the day of the close.
The only exception to you being allowed to take all the cash with you is working capital. Okay, so what is working capital? Working capital is the cash that the seller needs to leave in the business to take care of the "normal" day to day operation of a business.
So for example, if you were selling a consulting firm, and you got paid up front for a large project, yet had not started it - the buyer is probably going to ask for at least a large chunk of that money so the project can be delivered.
For SaaS, “excess working capital” is very often $0 (or close to it), particularly if you're paid monthly. However, if you have several annual or longer contracts that pay up front, the buyer might argue that at least part of that cash should be left behind (as they're obligated to service that contract after you drive into the sunset with that new Porsche).
3. Earnouts
Earnouts are basically - you get paid X if certain conditions Y are met sometime after close. Earnouts can range from completely impossible to hit and easily gameable by a buyer, through to extremely easy to hit.
Earnouts that specify both revenue targets and profit targets several years out are examples of the former, while agreeing to work for the company for a year (and they can only fire you "for cause") is an example of the latter.
4. Valuation Basis
Quite often an acquirer will name a price, and then state on what basis this valuation was reached. These range from pretty vanilla (eg "this represents a 4x multiple on ARR" when that is the current ARR you know is correct), but crucially, these can be forward looking statements too - so eg someone could say - "Purchase price of $75m, based on a forecasted end of year ARR of 8m" (usually you or your banker will have provided some at least near term forecast of your revenues). If you miss that forecast during due diligence, then the buyer could very well come back and ask for a price adjustment.
Sometimes the valuation basis are also on terms that can be contentious. For example, if you provided an "adjusted EBITDA" number, then the buyer could provide for a valuation on that basis, and then during diligence, argue that this number has been incorrectly computed and hence valuation should change. So make sure that you’re very comfortable with any stated basis for the valuation in the LOI before you sign it.
5. Key Personnel
Sometimes an acquirer will specify that certain key personell have to agree to new employement contracts with the acquiring entity. This can be fine (eg if it's you and you don't mind working for them for a bit) or it can be pretty tricky (eg a key employee who you know is about to leave and won’t ever work for the acquirer).
This is obviously also further complicated if the employees in question aren’t aware that you’re thinking of selling the company..
6. Financing Contingencies
An LOI can be subject to a financing contingency - that is, where will the buyer get the money from? You should carefully review how likely these are to be achieved, as it's far from unheard of that a seller will fail to get the financing they need and then use that as a reason for a discount.
Usually, a professional buyer who doesn't need a financing contingency will say so - phrasing is usually something along the line of "Buyer has sufficient cash on the balance sheet to complete this transaction" or "Firm BLA will fund this transaction from already committed funds".
This raises another point - it's important that you understand what kind of buyer you're dealing with as it directly relates to the certainty that the LOI will lead to a closed transaction (and cash in the bank for you). It can be quite tricky to determine if XYZ Capital is a well established PE firm with committed capital ready to spend, or just two guys in a garage that will seek financing from investors after you've agreed to the LOI. Often the latter means closing will take a long time and be rather unlikely (at least at the terms agreed to in the LOI)
7. Due diligence & Exclusivity terms
The buyer will usually require a certain amount of time after you sign the LOI, to do their due diligence. This may involve bringing in external consultants such as KPMG or EY to do a Quality of Earnings review, etc. During this period you're not allowed to shop the deal to anyone else.
This is usually 90 days or so (anything less is a bit of a yellow flag in our opinion..), but quite often an LOI will include the right of the buyer to unilaterally extend this period. You definitely want to push back here, as you want the ability to go to other buyers if the acquirer is dragging their feet or seem to be unlikely to close at the terms agreed to. In 2022, we ended up having to find another buyer for a seller as the original buyer was unable to find the financing they needed - if the original buyer had unlimited exclusivity, then they could have scuppered that deal.
An automatic 2 week extension assuming both parties are progressing in good faith is fine, anything more we'd push back on.
8. Escrow
Most buyers will require a certain percentage of the purchase price to be held in escrow for a period of time. It's quite commmon to see 10% for 12 months. The purpose of this is for it to be easier for the buyer to claw back any payment when you are in breach of terms in the contract. Usually the terms in questions are the "reps and warranties". Reps and warranties are statements you make in the purchase agreement - things like "I own this company and yes the cap table is correct". Escrow can also be used to cover liabilities that you agreed to cover as part of the deal (for example, partial tax liabilities that were incurred when you ran the company).
The key thing with escrow is - don't make it too large or too long.
ps. Once you sign an LOI and start negotiating the pruchase agreement, you also don't want to agree to let the reps and warranties for everything last forever. Usually the various reps and warranties are in various baskets with different durations - Fundamental (claims can usually be made forever), IP (usually 4-6 years) and General (12-24 months). Obviously you want to make as many of your reps and warranties as possible in the basket with the shortest duration. A good M&A laywer (no, not your general counsel unless they have M&A experience) will be invaluable here. Please get in touch if you want some intros!
9. Asset or stock sale?
LOIs will specify if the acquirer wants to do an asset sale (ie not buying the whole compnay, only specific assets) or a stock sale (ie the whole company). A buyer will usually favor an asset sale as a) it's simpler as they can pick and chose the assets and liabilities they want and b) there's a tax benefit to an asset sale (as they can re-appreciate the asset). However, usually, a stock offer will be better for the seller (as the tax treatment is usually favorable), which is why the majority of deals we do are stock sales.
In general, you should seek tax counsel as soon as you're reasonably sure you want to sell - there are a lot of ways in which the outcome of a transaction can be radically different - eg if you own a C-Corp that qualifies for QSBS, then if you do a stock sale then your capital gains could (at least partially and in terms of federal taxes) be zero, but if you agree to an asset sale in that instance, you could easily be paying 40-50% of the proceeds in tax.
If your company (and you) are not based in the US, this becomes even more important as does general tax planning prior to closing a deal.
In summary..
LOIs are not binding documents (usually), but it’s still extremely important to understand what they mean and the implications of the contents. A buyer will usually be extremely reluctant to improve terms agreed to in an LOI, so it’s best to clarify any issues before signing it. That also allows you to properly compare LOIs - it could well be that the one with the highest purchase price number is not the best offer.
If you’ve received an LOI and want some guidance (or even help getting more and/or better offers) please feel free to get in touch here or just email einar@discretioncapital.com