When is Renegotiating Post LOI Appropriate?

12 Mar When is Renegotiating Post LOI Appropriate?

Shoot The Moon

When is Renegotiating Post LOI Appropriate?

Play Episode Pause Episode

Mute/Unmute Episode Rewind 10 Seconds 1x Fast Forward 10 seconds

00:00 /

RSS Feed

Share

Link

Embed

EPISODE TRANSCRIPT

Mike Harvath  00:08 

Hello and welcome to this week’s Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket world headquarters in Bloomington, Minnesota, as you know, if you tune in regularly, Revenue Rocket is the world premiere growth strategy and M&A advisor for tech enabled services companies. With me today are my partners, Matt Lockhart and Ryan Barnett. Welcome guys. 

Matt Lockhart  00:30 

Thank you, Mike, thank you, Mike. Exciting day. Also excited for our talk, Ryan, what are we talking about? 

Ryan Barnett  00:37 

Yeah, today we are talking about deals that are past a stage in which terms have been agreed. So when you think about our business, we’re M&A advisors for IT services firms. So when we typically strike a deal, a letter of intent is published, and that letter of intent is exactly what it says. It’s an intent to acquire a business, and it’s issued by a buyer and it’s given to a potential seller. There’s a lot of work to get to a letter of intent that takes a look at the valuation of the business and you’re coming together to essentially agree to terms. Well, a lot of things can happen after a letter of intent. And so when you think about the process of an M and a deal, you start with that letter of intent is that maybe your starting point, you’re going to go through due diligence, and buyers are going to find a few things, and there’s typically going to be between, I’d say, 60 and 90 days between the signed letter of intent and the close execution of the process. What we want to talk about today is what happens if things are perhaps changed, and you have to take another look at that letter of intent, and you have to take another look at the deal, and how do you effectively renegotiate to get to a point to represent fair value of the deal going forward. So Mike, Matt, you brought up the topic here today. Mike, why don’t you get us started off, when is it appropriate to start thinking about taking a look at a letter of intent that’s been signed and taking another look at it and adjusting it for fair value? 

Mike Harvath  02:18 

Yeah, good question. Ryan, so if you assume your post letter of intent and you’re in a due diligence period. Oftentimes, what’s found in due diligence may vary from what was discovered in the valuation phase of a transaction, and that’s what tends to drive creating an LOI. A buyer typically does a valuation, analyzes a business determines fair value, then you come to a defined price and terms sort of transaction that’s documented in the LOI. Now, if everything is aligned from the information that was provided to the buyer, and that stands a test of diligence, or in some cases, a detailed diligence, like a quality of earnings analysis, then everything will proceed according to plan, and you will then close the transaction with the same terms price and terms as outlined in the LOI. But if the business conditions have changed, whether positively or negatively, or there’s a something that’s discovered in due diligence. Let’s say it was how revenue was recognized, or could be a multitude of things that determine that the actual profitability of the business is different than what was contemplated in the LOI, either positively or negatively, then that would likely warrant a renegotiation of those deal terms, those deal price and deal terms. 

Ryan Barnett  03:54 

So if I part of this Mike and just set in a foundational stage, so if you’re new to M&A, typically a letter of intent is non binding. And Matt tell us why let letter intent, what’s what’s binding and non binding mean in the context of of a deal like this. 

Matt Lockhart  04:14 

Yeah in an a letter of intent, the the the terms and the overall enterprise value are set forward and and agreed upon, however that is not binding that is finalized in the in the final definitive agreements, legal agreements, purchase agreement, etc, etc. Typically, the only things that are binding in a letter of intent are the exclusivity period, and harkening back to the confidentiality aspects that have already been executed in an NDA, those are important binding terms within the letter of intent. And so. While it is the other terms within the letter of intent are very important. They really are setting the stage for what will be agreed upon in the final agreement. And so Mike started out and and, you know, sort of stating there are aspects, there are changes that can occur within either of the two businesses that cause rightfully so, renegotiation of you know those terms, be it structural terms, you know, earn outs or seller notes or equity, you know provisions equity participation and or an agreement upon, you know fair value, fair enterprise value for a transaction and and so important to distinct, as you say, Ryan, the binding terms of a letter of intent versus, you know, what is set forth in in the final definitive agreement? 

Ryan Barnett  06:06 

Yeah, thanks for setting that up. And And Maddie, you suggested a few ideas of why someone might look at renegotiating the terms of the agreement. Mike, can you expand a little bit? What have you seen in deals? And Matt, I’d love to hear your opinion here, too, of what is worthy of going back to the table and looking in at that letter of intent and coming back and finding what changes in that time frame should business owners and buyers and sellers be aware of. That could trigger a relook at at the terms. 

Mike Harvath  06:44 

Well, I think you know what happens is, you know in due diligence, part of what due diligence is about is certifying the cash flows and the assumptions that were made in calculating fair value in the loi, right and fair value is determined by, typically by the buyer. When they make an offer that’s fair value as they perceive that they’re willing to pay for the business. And we can argue the term fair whether that makes sense for the seller, but regardless, that’s the offer that they determined to be fair value. It’s typically indexed on a multiple of profit or a multiple EBITDA. You years use the term EBITDA, which is earning before interest, depreciation, taxes and amortization, and it is a situation where most deals in our industry are indexed on that number. And so in order for a transaction to occur, and this is an important point for a buyer to make the investment in your business, they have to be confident in what that cash flow will be post close in order for them to calculate their return on investment. So they do quite a bit of work in diligence to determine, do we have a number where we can get confidence around where we feel it’s low risk that moving forward, the business is going to deliver this level of profit? And if the answer is yes, and it aligns exactly to where they were with their or very closely, I should say, to where the LOI assumptions were. Then it doesn’t warrant every negotiation, but if there’s things that were found in due diligence that change that number, and those things could vary from, you know, add backs and the difference of opinion on Add backs for owner benefit to things like, you know, your standard chart of accounts and how you apply certain costs in the business and the SGA side of the ledger, and the variety of things that may be what we’ll call non standard compared to what would be considered A generally accepted accounting principle or gap fits vastly off of those sort of standards as well established in the accounting world, and it may deviate or change that EBITDA number and the confidence of what the profit contribution will be in the business. Or it could simply be that the business condition changed. For example, the seller lost a contract right and in the future, means those future cash flows will be under pressure, or maybe they gain some new contracts that they hadn’t, you know, thought about or even pretended prior to signing the letter of intent you know that may warrant a renegotiation with an upward value, or finished a period that is ahead of their forecast a lot of times. Let’s say you’re looking at what we’ll call sort of a 11 one forecast, right? You’re sitting in November, or maybe a, more accurately, you know, a 10 two forecast in October, or two months to go in the year, and you forecast a certain. Revenue bid at the end of the year, and someone makes a letter of intent, puts a letter forth in your business, and then you finish the year. You’re still in progress. You haven’t closed yet on your transaction, and you and you, you outperform that that forecast, right? That would warrant a renegotiation, for example. So anytime the that number changes, and it changes either due to discoveries and diligence or changes in business conditions. Those things would likely initiate a renegotiation, whether that’s initiated by the seller in the case of an over performance scenario or or in the case they found more EBITDA pursuant to the diligence face, or, you know, some downward pressure on that EBITDA number due to, you know, either accounting approaches or methods and or lost business. You know, in a situation like that, typically a buyer would initiate that renegotiation. But in either case, they’re likely warranted based on the change in that business condition or discoveries and dealing. 

Ryan Barnett  11:01 

So when a this scenario happens, and both parties it sounds going to be a bit of negotiation, quite literally. Matt, what role does an advisor play in this, in understanding the situation and and how can an advisor best help in in understanding how you can get to the right outcome. 

Matt Lockhart  11:28 

Yeah, great question. Ryan, I think that the the two words that sort of come to mind are transparency and practicality, right? So transparency is is driving an agreement on, on, on the facts, if you will, the numbers, the data that demonstrate and correlate to an understanding of fair value, right? And I use the transparency and practicality to to try to remove the emotion that is natural, right? When there’s a change in the process and people are like, wow, wait a second, right? We agree. And it’s like, okay, well, things have changed, right? Let’s let’s gain agreement first, that that the situation has changed for a variety of reasons that might you know detailed out, and they’ve changed for the better, and or in somebody’s eyes, maybe change for the worse. But nonetheless, there is a change that needs to be recognized and and and and understood as transparently as possible, via the data that is at hand, and and once there is, I think, an agreement that the situation has changed, then it is easier to move into the practical aspect of, how should that change be represented via renegotiation in in the deal itself. And again, you know, harkening back to the change, potentially in enterprise value and or change in the term structure that has been that was previously agreed upon, and, you know, at the same time, making sure that the reasons that the firms came together and executed a letter of intent. Are still, are still there yet you know you, you, you complete a deal sort of based upon, you know, an agreed upon value. As importantly you you complete a deal because of the expected value of bringing the two firms together and and the the expected values really are should be well understood at that point and continue to be highlighted, because the real winning occurs once a deal is completed. And so important to try to keep it transparent and practical, so that both parties can move together towards that. You know, the bigger goal of going and winning together once a transaction is completed, yeah, 

Ryan Barnett  14:46 

ultimately, you’re gonna have to work together, and you’re gonna have to be part of an organization that comes together. So Matt, I think you did a nice job of explaining, taking the emotion out of that chat when you first see the. Option there. There’s a, I think, perhaps a visceral reaction, and when you get down to it, there’s a lot of education of why you need to make a move and execution on making that happen. Mike, is there anything that happens on a legal or contractional consideration? I mean, is there things like termination fees or even ethical or legal considerations that parties should have to be considering if they’re renegotiating an LOI. 

Mike Harvath  15:34 

Well, you know, fortunately, deal termination fees aren’t commonly used in our industry. I don’t want to say never used, because we certainly have them in certain transactions. They do occur. And I’d say, if anything, they’re starting to show up in some ways more than they used to. But I’d say as a general statement, most of the time the lion, bass, Lion, chair. Of the time, termination fees aren’t part of a transaction. So they wouldn’t necessarily apply here most of the time, depending on the language, though, in a letter of intent of a termination fee applies it may it may impact a deal to renegotiate, I would say most of the time, not because if there’s a change of business condition. Usually there’s a qualifier and a letter of intent pursuant to what we call a breakup fee, and it wouldn’t constitute a breakup typically, a breakup fee is implemented when someone just walks away from the deal without merit, versus a change in business condition creating an impasse. So just want to make that clear. But you should know that. You know it could warrant reissuing a letter of intent to document that renegotiated term, price and terms to help the lawyers guide the lawyers in drafting and and finalizing the definitive agreement. Usually, most legal teams work off the letter of intent, the non binding agreement to work on their documents. There’s value in re crafting a letter of intent and to re codify the both parties intent. To streamline the legal process. That’s not always required, but it certainly makes it easier. We’ve had situations where deals have been renegotiated, kind of in the throes of the definitive agreement being in process, and it can be challenging, because oftentimes on both sides of the legal aisle, there’s multiple parties touching those agreements based on their expertise. For example, someone who deals with employment law might be involved with drafting employment agreements. Someone who’s may touch those agreements and render opinions about tax ramifications and tax structuring, not to mention the lawyer that’s involved as a lead M and a lawyer. So, you know, it’s not atypical, especially as transactions get larger, to have sort of a legal team that’s working on these agreements, and without the guiding light of documentation of an LOI, things can get kind of confusing. If there’s been a renegotiation, who has the ball, what is the price? You know, is there it can get a little messy and require, in this case, much, much more management by an M and A advisor. Lisa, that’s been our experience. So regardless of whether an M and A advisor is involved or not, we think certainly loi should be reissued if a renegotiation is to occur, just to get alignment and to also, probably more importantly, facilitate the communications on both sides of the aisle From a legal perspective. 

Ryan Barnett  19:00 

Yeah, that’s great, great insight, Mike and Matt. Kind of last questions I have here is, and I think you’ve really worked through this, but how does it, how does the tone of negotiation change when a renegotiation is introduced? Most loi and to kind of go with that is, do people use a a renegotiation as a Is that an indication that one party might be looking for an excuse to back out of the deal completely? Is there, is there a lot it feels like there’s a lot of risk that happens post loi, when this happens, and want to get your feedback on that, 

Matt Lockhart  19:37 

yeah. I mean, it certainly can. Ryan, I mean, it can be an indication that that, you know, a party is attempting to, you know, simply change the game, if you will. And I think that that’s why, if, if the facts. And the data supports, you know, on an objective basis, an appropriate discussion related to fair fairness, fair value and or fair term structures, then you know, and we’ve done this numerous times, it is understood, it is agreed upon, and you are, you know, you’re right back on the train, moving towards the bigger goal of coming together and winning together. If there aren’t the appropriate conditions, the appropriate data, the appropriate change in business conditions. Then it, it, it very well, you know, may not be agreed upon. And the the entire process can, can, you know, go to the wayside, right? And, you know, important, I think that. I think that’s the kind of the most important thing for for everyone listening and and if you’re in this scenario, that it, it absolutely does need to be justified, and it needs to be justified and backed up with the facts. And if that is the case, then both parties can make the appropriate and informed business decisions. And these are business decisions, right and and you know, managed appropriately can be very successful towards the end goal that both parties have to come together, if, again, if it’s not supported, and it is, is just seen as more subjective, then, you know, certainly puts the deal and the future relationship at risk. 

Ryan Barnett  22:00 

No thanks. Matt. Mike, that’s the last question I had here, and I heard there’s certainly times in which the business change could happen. It’s a relatively open area and how much change that might be. But if there’s meaningful business change in they could adjust revenue profit. There could be a chance in that you take a look at the letter of intent and renegotiate, having an advisor by your seller to help you through that process is extremely critical. Is doing this alone and can just cause a lot of lot of issues and challenges. It’s not necessarily the end of the world. If something gets renegotiated, I heard that and that you can come together. You’re ultimately going to be working together in the future. And so this is another part that happens, and as long as that definitive agreements aren’t signed, you’re going to be able to work through. Thanks, Matt, pardon me, Mike, any last part and thoughts? Any anything else you’d like to wrap with? 

Mike Harvath  23:11 

Well, you know, I think it’s important to note that it’s easy to get tunnel vision in a time of renegotiation. And I would say this is a point of stress. It reminds me of situations. You know, for those of you that know me, you know that I’m a fairly active scuba diver, and so I’ll draw an analogy to scuba diving, and when you’re under stress and underwater situations, there’s a thing called tunnel vision. You get concerned about that with divers that are under stress, either because they haven’t it’s a new environment or a stressful situation. Maybe they haven’t been in and they can make mistakes with tunnel vision you can’t see you know too far ahead of you, or understand the full scope of your position and condition. The same thing happens, frankly, in M&A negotiations, oftentimes, people that are parties to the transaction get tunnel vision, and when they get television, they make bad decisions. They can make emotional decisions that wouldn’t, wouldn’t negatively impact the transaction or maybe even put the transaction at risk. That is probably one of the primary reasons for having an objective third party, M&A advisor assist you, because we have the luxury of perspective, and the perspective of doing multiple, having done many, many transactions, but also the perspective of how we address some of these challenges in the past, and then, as a result, you know, we don’t much lower likelihood that we’ll get tunnel vision or make some of this mistakes you’re likely to make as an individual who is a party to transaction that becomes under stress. And so, you know, put my plug in for making sure you have a. Right advisors on your team and help you avoid some of the tunnel vision when you get under stress in an M&A transaction, and certainly a renegotiation post loi can be one of those times, for sure. We’ve certainly seen it with buyers and sellers over the past, in the past, and I think in our own situation, we add a lot of value in those environments when we can help be the objective third party that can sort of guide your way out of that stressful situation. So with that, I think we’ll tie a ribbon on it for this week. Shoot the Moon podcast. Encourage you to tune in. Next week, we’ll unpack additional ideas, tips and tricks about growing your IT services, business and or getting an M and A deals done that make it a great week.