M&A Letter of Intent: Valuation and Deal Structure
Valuation is the key number everyone looks for in an M&A deal. Usually the valuation appears in the third or fourth paragraph of the LOI (letter of intent).
Buyers often load up their LOIs with a bunch of boilerplate in hopes of differentiating themselves from other Buyers, but this boilerplate isn’t what’s important; the valuation is. The valuation in the LOI should be a static number (as opposed to the range typically seen in the IOI).
The structure of the deal is also very important, and frankly, many first-time Sellers overlook it. The valuation may provide an eye-popping number, but the devil is in the details. Here are some deal-structure questions to consider:
How much of that valuation does Buyer pay in cash at closing? Cash at closing is the most important detail for any Seller because Seller can’t spend a note, an earn-out, or stock. Cash is king, and a wise Seller places a premium on getting actual cash as opposed to a promise to maybe get some cash at some point in the future.
How much of the valuation is in the form of a contingent payment? Contingent payments include earn-outs, notes, and even stock in Buyer’s company. These forms of payment are contingent because Seller may or may not eventually receive that money.
If the LOI includes contingent payments, what are the details?
How much money is in the form of a note? What is the interest rate, and when does Seller receive that money? Does the interest accrue (all the interest is paid when the principal is paid)?
Is the note amortized (Seller receives interest and principal payments)? Or is the note interest only (Seller receives regular interest payments and a balloon payment at the end), and if so, how often are the interest payments due?
What are the specifics of any proposed earn-out? Seller should be most concerned with one thing: how she gets her money! You can structure earn-outs in virtually limitless ways, but the earn-out should be simple and easy to understand. The more complex the deal, the less likely Seller ever sees any money from the earn-out.
How easily can Seller convert any stock to cash? If the stock is thinly traded (doesn’t trade many shares daily) and is on a lesser exchange (OTC or Pink Sheets), Seller has a lower probability of converting that stock to cash than if the stock were a high-volume stock on NYSE or NASDAQ.
No single contingent payment structure is right or wrong for any given deal. Each deal is different. Seller needs to confer with her advisors and weigh the merits of a particular offer.
Buyers, if a Seller rejects your offer after reviewing it, provide that reluctant Seller with a detailed calculation of the deal. Many Sellers simply look at the cash at closing and they may miss the true value of the deal. Calculate the proceeds over time. Add in earn-outs, notes, stock, and so on.