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What Is The Difference Between An LOI And A Purchase Agreement?

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Comments & Replies: 11     Views: 11870     Posted By: Jeff Back  Jeff Back, Broker - Restaurant Specialist - SF Bay Area

Topics: Buying A Business, Deal Structures, Selling A Business     Tags: buying a business, deal structures, legal issues, selling a business

Glad to help out Jeff. Here is my contribution:

I typically use a Letter of Intent (LOI) to open negotiations with. This is similar to an offer in the sense that you will list the terms, conditions and contingencies that are immediately acceptable, along with your due diligence requirements. The seller will prefer the price listed on the LOI but I often go in stating "on price and terms acceptable following due diligence of the following items" and add a time line.

Why use an LOI?

It is difficult to get all of the information from a Seller. I use them to show the credibility of the Buyer and because I work with cash businesses and the stated income and expenses need to go through discovery to determine if the value will stand. I have found that a deposit is still necessary in order to prove the credibility of the buyer. In my transactions where an LOI is used a deposit is either placed into escrow or a statement is included into the body of the LOI, that a deposit will be placed into escrow following (some event stated here). Once all is agreed then the Buy Sell Agreement is created and placed into escrow.

This approach may take a little longer but the discovery is worth the time. The buyer will be easier to work with if all the facts are known going in. Surprises kill deals more readily with an offer acceptance format. It is easier to remind the buyer that this is why we started with the LOI. It is also better for the seller to see the outcome. If the business doesn't sell following the scrutiny, the seller will have gained knowledge that may allow for better preparedness for the next offer.

Would like to hear from other brokers and agents about their definition and thoughts . . .

Contributor: Transactional Attorney

An LOI is typically a non-binding agreement that the parties use to start negotiations when there's serious interest on both sides, but not all deal terms have been agreed to yet. An LOI will typically include the proposed purchase price, terms, and the timeline for transaction to move forward.

Some of the best advice I ever got was when I was one of the sellers in a company I started and grew with my partners to #25 on the Inc. 500 and $60,000,000 in revenue. When we received an LOI from a potential purchaser I was ready to celebrate. After nine years I was more than ready to enjoy the payoff from the hard work we had all put in to build the company. But before I could start spending anything, one of our advisors told me, "Mark, we're on the 5 yard line, and we have 95 yards left to go...celebrate when we cross the goal line."

The lesson I took away that I share with my clients is that from the seller's perspective it's important not to consider an LOI a "done deal". While buyers should not submit LOIs unless they have serious and good faith interest in pursuing a transaction, some will use them as an opportunity to shop multiple businesses at the same time. A savvy seller with multiple potential buyers may not take an LOI seriously, and it's possible you could lose a deal to another buyer who starts with a formal purchase agreement.

A purchase agreement is a binding agreement that includes all of the terms of the transaction, including financing and earn-outs (if any), non-compete provisions, allocation of the purchase price across the business assets, and the representations and warranties the buyers and sellers are making. Depending on where you are with the transaction you may just not have enough information to draft a worthwhile purchase agreement.

Buyers will often start with an LOI when they're initially investigating a business purchase rather than with a complete purchase agreement. An LOI allows a buyer to show that they're interested enough in a transaction to proceed with due diligence, but may not have enough information to draft a complete purchase agreement yet.

As a rule of thumb, the more involved the transaction and larger the size, the more likely you'll be to start with an LOI rather than a purchase agreement. Nonetheless, an LOI can be used effectively in any size transaction if both the buyer and seller are sincere and simply need more time and information before they can draft a formal agreement.

Most of the LOI a has non-binding clause in it. Which means Buyers and Sellers are not obligated to follow through with the LOI, even if both parties agreed and signed the LOI. Some Buyers and Agents like to start the negotiation with the LOI, but in the end, the agreement needs to be on a purchase agreement to be binding.

Contributor: Business Broker - Preschool Specialist

For a small business or even mid-sized one, where there might be several parties looking at the opportunity, the LOI is not going to be very effective. The seller isn't going to waste time considering an LOI if there is plenty of interest already in the listing. I have seen businesses sell in less than two weeks. I had several inquires about one particular listing, and for several of them, because I interviewed them about their background, I knew the business would be a good fit for them.

Now, who do you think made it into escrow with a purchase offer? One party was ready to write an offer {purchase agreement} in just a few days after seeing the listing, even before they saw the location, because they knew where it was, they understood the potential, and I had given them some of the basic financials on the business. What about the others? They called a week or so later with further interest, but it was too late for them.

The point is, if a business looks good, don't hesitate or over-analyze it. A standard purchase contract has contingencies laid out that allow time to review the information about the business, and to cancel if there are issues that are problematic. Of course, you don't want to make offers frivolously, brokers that sell businesses won't take you seriously if you do.

But if there is something that shows up in your review even after a contract is signed, there should be a no-fault escape out of the contract. So, the broker you refer to is probably correct here, the purchase agreement is more likely to get the job done for you.

There is no absolute rule about when to use a letter of intent (LOI) or a purchase offer/agreement. The letter of intent often starts a transaction for a larger business - selling price in excess of $1 million ó rather than a purchase offer form. Thatís because attorneys for the parties often get involved in a larger deal and are expected to write the sales contract in a way that addresses all of the issues related to the transaction.

An agreement for purchase and sale of a smaller business with a sub-$1 million value often can be completed using the standard language usually found in preprinted purchase offer forms / purchase agreements. The purpose of the letter of intent is to outline the basics of a deal and make sure the parties agree about price, payment terms and the assets included in the sale. But much of the detail is missing and is added later once the buyer and seller are on the ďsame pageĒ regarding essential elements of a transaction.

Besides price, terms and assets included, the issues related to a business sale involve covenant-not-to-compete, any training agreement, handling of inventory, receivables and payables, statements from both parties that the information they have provided is accurate and remedies available to each party should the other party not live up to the agreement. Unless the broker can offer a good reason to start with a LOI, you should propose writing an offer to purchase.

Once it is negotiated, amended as needed, and signed, it becomes the sales contract.

An LOI is a Letter of Intent, but it really is a letter of serious interest. The buyer wants to find out if the seller is interested in selling in a price range the buyer has in mind based on the minimal information already provided to him. If the seller wants $1 Million all cash and the buyer is thinking half that amount and the buyer wants the seller to carry half the purchase price, it would be logical to find out if the seller would like to consider the buyer for a deal.

LOI can be as simple as having a price and terms to as complicated as 100 pages covering every aspect of the future sale. In some cases the LOI is almost as binding as a purchase agreement. This of course would be on bigger deals that justify spending over $5,000 in legal fees.

A purchase contract or agreement is exactly that. It is a legally binding contract, with a deposit attached.

This means that buyer has already done a lot of due diligence and is committed to buy the business, unless he discovers some important undisclosed fact. Purchase agreements should not be used until a few hours have been spent on financial due diligence studying the full financial statements for the last 3 years. Report from the seller or broker giving estimated or average expenses and profit are not full financial statements but fluff. Fluff is a term used in selling cars to excite the prospect to buy. The car salesman tells you the car has wings and drives itself. You cannot hold a car salesmanís feet to the fire, when you sue him for false advertising.

Always use an LOI (Letter of Intent), for negotiations, based on fluff and only go to a purchase agreement after you and your CPA are 80% sure the deal will fly, subject to review of the full accounting records, tax returns, and lease.

There is a growing trend for brokers, under instructions from their sellers to want buyers to put up deposit checks in order to show the seller he is serious. This is not reasonable because the buyer is already going to hire an accountant or other expert to help with due diligence which is a real indication of seriousness. A buyer might respond by saying that I will write an offer, based on the sellers fluff if the seller will agree to cover the CPA review costs if the financials are not as represented by the seller before the offer was written. This allows both buyer and seller to show their seriousness.

Contributor: Business Broker, SF Bay Area

Thanks Jeff for starting this discussion - I have been asked this question many times in the past as well. Here is my response:

Both LOI and PA accomplish the same goal but the path taken to arrive at that result is very different. In small businesses most business owners prefer Purchase Agreements.

A Purchase Agreement is a binding agreement subject to a list of contingencies. You are stating that assuming the due diligence verifies everything that you were told about the business, the lease is approved, and you have financing approval, and any other specific contingencies (like getting license or franchise approval) you will purchase the business on the specified terms within a specified time period. Except for the specified contingencies both Buyer and Seller are bound by it.

Further there is usually a deposit that is held in Escrow. If during due diligence you discover that things are very different then Buyer can attempt to renegotiate or back out of the deal and get the deposit back. The LOI on the other hand is a non-binding letter of Intent and either side can back out for any or no reason.

In most cases there is no deposit and usually buyers want to have a period where Seller needs to take the business off the market. This generally puts the Seller in an extremely unfavorable situation. LOI makes sense in larger deals where until you have conducted due diligence final terms of the purchase agreement canít be determined.

With LOI, a Definitive Purchase Agreement is negotiated after the Due Diligence has been completed. Since the deal can fall apart either during due diligence or during the negotiations for the Definitive Purchase Agreement, the Seller would have taken the business off the market for a length of time without any compensation or commitment from the buyer.

I have rarely seen a LOI being used for deals under $1 Million in purchase price.

I would consider a Letter of Intent the pre-game to the main event. Typically LOI's are more common in business opportunities that are larger, though I've deal with ones for under $50k as well, so this is ultimately Buyer-dependent.

Usually LOI's are non-binding, they are not legal documents obligating either party, rather, they are used to outline simply a general understanding of the terms and conditions of a purchase, the Buyer wants to review TUVWXYZ, and then the asset purchase agreement will be executed.

I prefer to skip the LOI when I possibly can b/c I find them to be a waste of time because I place Buyer due diligence conditions that are open ended and protect them so they can terminate the agreement if the Seller's Company fails a rigorous due diligence examination. But that's just my professional opinion.

Contributor: Business Broker - Lliquor Stores, Markets, Hotels, N CA

LOIs are commonly used in mid to large businesses because the due diligence process can take 6 to 12 months. LOIs do not contain all of the details that a contract may have. For a small business the due diligence process is no longer than 30 days even if the Seller does not have proper documents, because the Buyer can physically observe the sales and invoices by standing behind the counter.

If the Broker writes the proper contingencies in the contract then you are fully protected to break the contract at anytime if any information is not acceptable to Buyer. Buyer can sign a contract, but does not have to open Escrow until he/she is satisfied with business information.

Contributor: Business Appraisals, Valuations Advisor

The letter of intent is the best way to start. A letter of intent should say that it is not a binding agreement and also should list the contingencies, such as subject to financing and due diligence. You donít want to waste money preparing a legal document at this point in a possible purchase.

A purchase agreement should be prepared by your attorney and is binding when signed. It should be the one of the last documents signed after you have agreed to all the purchase terms.

Replies To This Comment
In my experience for most small business transactions, Letter of Intent (LOI) is a distraction that will prolong and possibly endanger the deal going through. The only real purpose for the LOI is to keep the seller from negotiating with anyone else while negotiating the deal and going through due diligence with the buyer proposing the LOI. For a deal that will take 6 to 12 months to conclude this would make sense; but in almost all small business sales, the most efficient process is the broker's standard contract of sale submitted as an offer by the buyer.

In the offer, the buyer can present all their terms and conditions and the seller can negotiate these until both parties have reached agreement. At that point, the seller has just about an absolute obligation to sell, despite any other offers he may receive after that; but, the seller can certainly take "back up" offers in case the first one falls through. The standard contract will provide for a due diligence period during which the buyer can confirm or refute the representations made by the seller and during which the buyer can terminate the contract and recover the deposit. From making the initial offer, to reaching an agreement, to conducting due diligence, no more than 20 business days, about a month, should pass. That's just about as much time as it might take to negotiate a LOI.

I had one deal within the past year where the buyer, who worked for a large firm dealing in 8- and 9-digit deals, insisted on a LOI for $300,000 business. It complicated the process, frustrated the seller, incurred unnecessary legal fees, delayed due diligence, and ultimately led to the deal following through. In my opinion, apply the "KISS" principle--keep it short and simple. Avoid the LOI whenever possible.

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