047 - The LOI Blueprint: How to Protect Yourself When Buying a Business

A lot of people think of a letter of intent or an LOI as just a formality or a simple piece of paper. Well, it's a lot more than that. And having the right LOI can help save you time and money on a deal. Today, we're going to take a dive into what an LOI is and how you can structure it to your advantage when you're trying to buy a business.

So an LOI is more than just a formality or more than just a piece of paper. On the one hand, it is usually a non-binding agreement between a buyer and a seller. It is something that a buyer writes up and proposes to a seller that says, this is how I'm going to buy your business. And then that seller accepts the LOI or asks for revisions or whatever, and then they settle on something.

And because it's non-binding, a lot of people will kind of rush through it. And in some ways, I do kind of encourage people to get an LOI signed so that you can move forward to the more serious aspects of a deal. However, there are aspects in the LOI that the more refined they are, the easier the deal will be and the less likely it will be to fall apart at a later stage. So it is fairly important that you get the details right from the start instead of waiting to the later stages of the deal.

So I'm going to break down kind some of the the do's and don'ts of an LOI and how you should think about the facts that go into the LOI. At a high level, all the LOI is doing is saying, I intend to buy your business and this is how I intend to do it. And what that intend to do it or how you intend to do it means is what you're gonna pay for it, how you're going to fund it, whether it's all cash, whether it's a certain percentage as a loan from the bank or the SBA, whether you expect seller financing, whether you're bringing in partners, all those kinds of details of just kind of high level of how you intend to finance it so that you're giving the seller confidence that you know what you're talking about.

You're not just pulling a number from thin air and saying you're gonna make it work. And then later on in due diligence, you come back and say, oh yeah, that number that I told you, that's not gonna work with the loan that I'm gonna get and the interest rate. It's just not feasible. you should have thought about that ahead of time and you should put it in the LOI so that the seller feels comfortable and knows what your plan is.

If things change down the road and things do change from time to time, the interest rates might change, the loan structure might change, the bank might have told you that they do up to 80 or 90%, but maybe when they see the deal in detail, they're only going to go to 70 or 75 and you need to renegotiate a couple pieces. And that's bound to happen. That's okay. But the more thought you put into it upfront and how you're going to structure it and how you intend to structure it in good faith, the better off the relationship will be going forward.

In addition to just the price and the how you're going to pay for it, things like the terms. So if you are asking the seller to carry a note that you put in there, what you expect, how much you expect them to carry, what percentage rate, how long are you going to take to pay them? Are you going to pay them concurrently with the bank? or are going to pay them after you pay the bank?

So all of those kinds of details are important to have right up front. Don't just say seller financing and then move on because the seller might be thinking, okay, great, I'll finance 10 % at a 20 % interest rate. While you might be thinking, I'm going to have the seller finance 90 % at a 5 % interest rate. Those are two very different things.

So they need to be clear right in the LOI of what your expectation is to get the deal done. when the seller says yes or no to that LOI, you're agreeing to some of the key principles right up front, especially on that seller financing piece. In the LOI, you're also gonna wanna talk about your timeline, from how long you're gonna take to do due diligence, when you expect to close, how long you expect the seller to stick around and help, and how that structure is gonna work. What other expectations you might have?

Are there key employees that you think are vital to that business and... put the closing contingent on those employees still being in place or having new updated employment contracts in some industries? Are there certain customers that you need to keep in order to be viable? So that could be another expectation.

Customer XYZ needs to still be purchasing at the same level by the time we close. Do you need a new lease? Are you in a leased space? And do you need to have a negotiation with the landlord about your long-term viability?

You don't want to buy a business with the lease expiring the next year without a plan for a longer term lease. One of the advantages of getting a bank loan is that usually the bank will require you to get a lease for at least the term of that loan. However, that means that you need to go negotiate that with the landlord. So one of your expectations in the LOI can be subject to me securing a lease at a affordable rate.

And if you can get into detail of what you think that rate needs to be, that's even better. Cause that shows the seller. that you're thinking through everything carefully. So all of these key points, as many of them as possible should be in the LOI so that the seller is on the same page with you going forward and you can kind of work through these things.

Now, I'm going to take a kind of a deeper dive into each of these elements just so that you can get a better understanding of how important each section of the LOI is. Let's just start out right with the price. So in the LOI, you could easily just write a price in there. I will purchase your business XYZ for $1 million.

Okay, is the inventory included in that? Is real estate included in that? What's included, what's not included? Is there any working capital?

Are you purchasing the assets of the business or are you purchasing the entity structure? All of those things need to be spelled out specifically so that there's no confusion later on. You don't want to get all the way to the closing table and then The seller sees the closing statement and says, wait a minute, you're only giving me a million dollars? What about the $400,000 in inventory I have?

And you say, I said a million. And the seller says, I assumed that the inventory was on top of that. So spell out the price. The price is never as simple as just a price.

Make sure that it is specific to what is included in that price and what is not included in that price, just so that everybody is on the same page from day one. One of the ways that you can phrase that is purchase price of million dollars, inclusive of all furniture, fixtures, equipment, inventory, or you can say price is a million dollars, inclusive of all furniture and fixtures and equipment with inventory to be purchased separately at cost at closing. So this is where you would have that fixed million dollar price.

And you might know that they have roughly two or $300,000 of inventory. that you would count right before closing. And then that's a separate addition onto that million dollar price. So just make sure that you're spelling out what the price is and what it's for right upfront in the LOI.

Deal structure. So I kind of touched on this already. Are you buying the assets or are you buying the entity? Each different type of purchase has advantages and disadvantages for both you, the buyer and the seller.

Usually buyers like to do an asset purchase, which is where the buyer forms a new entity and buys all of the assets, including the name, equipment, everything from the existing business and puts it in their new entity name. The seller usually prefers to do a stock sale because they can save on taxes that way. I've done other whole videos and episodes on this, so feel free to take a look for those videos and we'll link them up so that you know how to structure the deal in that in terms of an asset versus stock sale.

Either way, That needs to be explicitly stated in the LOI because it has tax implications for the seller, which affects what they can put in their pocket at the end of the day after the sale. The financing structure, I touched on already, laying out exactly what you plan to do. So if you're paying a million dollars, the price is a million dollars, you put in there. I plan to put $100,000 down out of my pocket.

I plan to get a $600,000 or $700,000 loan from a bank. with SBA backing and the remainder I plan on seller financing from you for this term, this time period, this interest rate. This gives them exactly an understanding that you've thought it through, that you know how you're going to pay for the business. It's not just throwing a number out there and then going and figuring it out later.

Doing that also helps you understand as the buyer whether or not this deal is going to make sense. Sometimes it might not make sense if you have to get too big of a bank loan or too big of a sell-alone or if you're willing to put more cash down, it might cash flow more, but the returns might not be as good for you. So thinking through that structure also helps you as a buyer realize whether or not this is gonna be a good deal for you or not. Another aspect of the LOI is your earnest money, your down payment, your deposit as a gesture of goodwill towards the contract.

typically this can be anywhere from one to 5 % of the purchase price. You could be writing that check with the LOI, but more commonly, You're going to be making that deposit after you've gone through due diligence and when you're signing an actual purchase and sales agreement. But you're still laying it out in the LOI, how much you're prepared to put down as an earnest money deposit so that the seller can see how serious you are. Even after that due diligence period, it could still take a couple of months to close and there still might be other hurdles or other issues that come up.

The more money that you are willing to put down as earnest money shows the seller how serious you are about this deal. You know, just part of that negotiating process in the LOI and putting it in the LOI so that it doesn't need to be negotiated later is helpful. You might be thinking, okay, I'll put down a thousand dollars. And when you get done with the LOI and you're moving towards the purchase and sales agreement, if the seller sees that in the purchase and sales agreement, they might say, are you serious?

Only a thousand dollars down on a million dollar purchase. You got to put something more substantial than that. And so you don't want it to be a confrontation point after the LOI. So just put it in upfront, let them know what your plan is.

The due diligence period. So in the LOI, one of those term items is going to be a due diligence period. You need to specify how long that due diligence period is. How long do you think you're going to need to substantially vet the entire business?

Typically, this can be anywhere from 30 to 90 days, depending on the size of the business, the industry it's in, and the complications or seasonality or other issues that might come up. The other thing I like to do is put in the LOI specifically when that due diligence period starts, because you need all of the documentation to do the due diligence. If you put in a 30 day due diligence period, but the seller doesn't send you the documents until 28 days after you sign the LOI, you might not have enough time to actually get your due diligence done.

So you want to specify when the due diligence period starts. And usually I say something to the extent. of due diligence period of 30 days to begin when the last item on the appendix XYZ is delivered to the buyer. And then in that appendix, you list out all of the different items and documents and things that you need to do your due diligence.

And that's going to vary a little bit by industry. And we will go over that a little bit more in another video, but essentially you want things like the tax returns, the QuickBooks statements. So you can compare them side by side, key contracts from customers, lease information, any contracts they have with key employees, any employment records in history, W3s, which is the record of what they've paid in IRS taxes for employees, what they've paid all their employees over the last couple of years.

These are just a handful of things to get started. And again, depending on the industry, you're going to want to see a lot more information and make sure that that is clear in the LOI. And they might tell you when they're going to sign the LOI, Yeah, we can give you this, this, this and this, but we don't have this and we don't have that. And then you know upfront and then you can remove those items before you even get into it.

That way you're not sitting there 10, 15, 30 days into this waiting for these documents because you asked for them after the fact and they can just tell you upfront. Yep, that doesn't exist. We don't have that. If you can't move forward with the deal without that, then better we know now and we just go our separate ways.

Making sure that that due diligence period and what it entails is all laid out specifically so that everybody is on the same page. Another piece of the LOI is going to be a closing timeline. So we have our due diligence period, that 30 to 90 days, whatever it is. You're also going to want to put an estimated closing timeline in there.

It doesn't have to be a specific date, but it could be something to the extent of 60 days or 90 days after due diligence is complete. So maybe you have a 90 day due diligence period in there, but you're done with due diligence after 40 days. So you sign off that due diligence is good. You're moving towards a purchase and sales agreement.

The closing timeline could be 60 days after due diligence is complete. Or it can be connected to something else. Maybe a key piece for the seller is they want to close this tax year. So that could be a key thing.

That closing will definitely be before December 31st of the year. Or maybe the seller wants to wait until the following tax year for some reason. If that's to their advantage and your advantage, maybe you put in closing will be after January 1st. of the following year, but not later than XYZ day.

So that everybody's on the same page. You want to narrow that in as much as possible. And it's subject to change, especially if you're getting a bank loan or an SBA loan, there's going to be fluctuations in that closing timeline, just based on the way the banks work. But you want to try to dial it in and you want to do your best effort to stick to that.

So make sure it's a realistic goal for you and make sure it's realistic for the seller as well. Seller support. So this is an aspect of How much do you want the seller to stick around after the sale? Do you want them at all?

Do you want them every day, all day, for a week, a month, a year, two years? Are you going to pay them for that or not? All that needs to be laid out explicitly in the LOI. Again, it is negotiable.

You're writing them this letter. They're not just going to sign it and say, good. They might come back and say, oh, okay. you might say, I want you to stick around for six months, 20 hours a week, unpaid.

They might come back and say, uh, six months isn't going to work because in three months I already booked an around the world cruise with my wife. So I'll give you three months, but I'll work 40 hours a week, but I'm not going to do it unpaid. want a modest salary of something for that time. So all of those things can be worked out.

And instead of a salary, you, maybe you up the purchase price a little bit. So you can get that in a loan package from the bank. You can kind of go back and forth on that. So instead of saying, okay, I'll pay you the thousand dollars.

I'll just give you. three months times $1,000 a week would make the purchase price go up $12,000. That may or may not be good because you might get two weeks into that arrangement and realize, I don't need this person. What am I, what do I need them for?

I don't want them. I don't need to pay them anymore. Again, even specifying that in the LOI of up to six months at a XYZ salary per week for so many hours a week. That way you can always let go of the person if you don't need them anymore.

You you might realize, I thought I was going to need this person all the time. I don't need them at all. So specifying that explicitly of what you expect from them after the sale. Non-compete clauses.

Just putting it right in the LOI, making it clear. I don't expect you to go out and start a new business in this industry or in this neighborhood and this geography. Specify that non-compete, how long it's going to be, what geography it's going to be, what constitutes competition. Cause somebody might set something up in a similar industry.

that you consider competition, but they might not consider competition. So just make it clear what specifically is included in that non-compete. An exclusivity clause is a good thing to include in the LOI. Again, it is non-binding, but you wanna make it clear that you are doing your best and you are focusing on purchasing this business.

You expect the seller to be exclusively negotiating with you during this process. Take it off the market. Don't be entertaining new calls from other buyers. that they are committed to you and getting a deal done with you and you only during this period of whatever time period it is.

You can tie it to the due diligence period. You can make it a little bit longer until the LOI is canceled or until the deal closes. So just putting it, making sure that exclusivity is in there. Conditions to close.

Just make it clear. You you have your price and your terms and how you're going to get the deal done with the bank loans and seller financing. but just make it clear that this whole thing is conditioned upon being able to secure financing, being able to secure a lease if necessary, key employees that if you need, key customers, all those things should be kind of highlighted as conditions to close. If they're gonna make or break the deal for you, make sure that you share that with the seller so that everybody's on the same page.

Making sure that there's a binding clause or non-binding clause in there if you so desire, like I said. LOIs are typically considered non-binding. There's usually a non-binding clause in there. If you do go a binding LOI, then you probably want an attorney to review it before you sign it, just to be extra safe.

That is kind of the beauty of the non-binding LOIs is that you get this signed without having to involve a lawyer and start racking up legal bills from this early stage. You have a little bit of a grace period before the lawyers get their hands on it and start going back and forth. And again, this is one of the key points of the LOI and why you want as much of the detail hashed out in this document as possible is because at this point, it's usually just between you and the seller, or maybe there's a broker involved, but the broker's getting paid at closing.

So nobody's spending money on attorneys at this point or negotiators. So you get all of these details worked out between the two of you. And that's less back and forth between the attorneys at two, three, $400 an hour later on. You've got a lot of that detail out of the way and in the documents.

So when you hand it to the attorneys later on, you can just say, here you go. Here's all the details we worked out. I'm sure they're still going to find little things that they suggest adding or subtracting or changing, but at least a lot of the bulk work is done. So some of the common mistakes with the LOIs, if you didn't pick up on them throughout this, focusing only on the price is a big mistake.

Being too vague, not being specific is a common mistake. not asking for seller financing. Put it in there. Don't assume that they're not going to do it.

Don't take the broker's word for it that they're not going to do it. It doesn't hurt to ask. And if it's in writing, when you give it to them, they might be more open to it. Skipping the exclusivity clause.

Don't skip it. You're going to be putting a lot of time and effort into it at this stage. You're to start spending money on professionals like CPAs and lawyers and maybe some other uh fiduciary type people that are looking at this with you and for you. Make sure that they're serious about the deal as well, that there's an exclusivity clause in there.

And then not defining those due diligence expectations, not providing that checklist. Get detailed. Think about all of the possible things that you're going to want to see to make sure that you're getting the business that you think you're getting and lay those all out either right in the LOI or as an appendix to the LOI so that everybody's clear on what they need to get you to do your due diligence properly. So there you have it.

That is an LOI, Letter of Intent. This is where you have a real opportunity to kind of lower your risk in the deal, to make sure that you're going to get what you want out of the deal, and to make sure that you guys are both on the same page and you're able to work together towards that final purchase and sales agreement and to get the financing you need to close the deal. This way, by the time the attorneys get involved, a lot of the bulk of the work is done and it'll help save you on the legal bill in the long run.

So again, if you're thinking about buying a business, you're getting to that seriousness stage. do not skip the LOI. One of the most important documents that you will deal with throughout the deal because it lays out all of that detail crystal clear. If you're interested, you can visit powerofbiz.

com slash LOI and I will have a template there for you to base your LOIs on in the future. Really hope you found this useful. I'd love to hear from you in the comments, on social media, what you thought, what you've done with LOIs. any tips and tricks that you might have to share with others.

So look forward to hearing from you all soon. And then until next time, take care of yourselves. Cheers.