Why is it that you should never rush into an LOI (Letter of Intent)?
The two main reasons are not spending all the time and expenses of going through due diligence on an awful deal.
Here are the seven steps you need to take to create your pre-LOI checklist.
1. Create Process Maps For The Transaction
The process maps that you make should represent the entire M&A lifecycle.
The M&A life cycle consists of the following phases:
Strategy
Valuation
Financing
Structuring
Due Diligence
Negotiation
Closing
Integration
As you can see, the LOI initiates the second half of the M&A lifecycle, which takes up the most amount of time and expenses.
Use Lucid Charts to create a shared map for the buy-side and sell-side. Process mapping is beneficial in SMB deals where the seller doesn't have transaction experience.
And doesn't know what they must provide and who they have to engage like lawyers and tax advisors.
At the same time, you want an internal process map for the buy-side that indicates who is responsible for each item to ensure that efforts aren't duplicated.
Steps that are commonly skipped in due diligence that can lead to a disaster revolve around the tax laws and industry regulations.
So, make sure that each of these items gets its own square on your map.
Then hold an early management meeting to review your internal process map and its sequence.
Your legal and outside tax counsel should be at this meeting or provide input on the drafts if you’re a small team.
Adding a timeline to both process maps will ensure that everyone adjusts their schedule.
Even more so, if your target acquisition is an S corporation, its election terminates the day of the close.
2. Set Your Criteria And Adhere To It
Here are some variables for your own criteria that will let you quickly filter through deals and spot any red flags:
Headcount
Years in business
Location
Revenue
Gross Profit
EBITDA or SDE (SDE multiples are preferred on deals under $2M)
Asking Price
Multiple on the ask
Cash Flow
Churn
Debt
Accounts Receivables and turn over
Break-even point
The seller's financial contributions
Real Estate
Any and all possible carve-outs (FF&E, Inventory, Vehicles, and Materials)
Why is the target for sale, and has it recently been a part of a failed transaction?
Set Your Targets
You want to look at market trends to verify that your acquisition is lined up for a future exit.
Then get your tax and legal counsel to go through any needed pre-transaction structuring to meet your tax and legal goals.
This step is also where you run your buy-side financial projections and identify how you can best leverage the target with your current assets and skills.
Note: The improvements that you can make to the target do not affect the transaction, and you don't have to disclose said improvements to the seller. Like with a fix and flip real estate deal, the property is worth what the market says it's worth today. At the same time, if you're in an auction, this will tell you your ceiling bid.
3. Engage Independent Tax And Legal Counsel
Some people might see this as doing due diligence before you have a deal, but that is what the previous step was for.
Furthermore, you want to do this step right before both sides have agreed on the final draft of the LOI so that you don't risk any unneeded expenses.
At the same time, if you have a strict criteria where all of your deals are roughly the same size, in the same industry, and in the same state, then whatever feedback they provide you with will overlap with future deals.
The first question that you should be getting outside input on is whether to conduct an asset or stock purchase and what are the legal and liability exposures of each?
Also, inform them if any of the target's owners will have any rollover equity.
Next, is an income tax “gross-up” required by the seller(s)?
Other commonly overlooked items in LOIs are the success-based fees and deductions for the transaction costs on the sell and buy-side.
Ask about the Rev. Proc. 2011-29 Safe Harbor even if this election isn’t available in an Internal Revenue Code (IRC) Section (Sec.) 338(h) (10) transaction.
If your target operates internationally, get a second pair of eyes on forms 5471, 5472, 8858, 8865, 8893, and FinCENs for penalty exposures with the IRS.
And if income tax reporting should include global intangible low-taxed income (“GILTI”) with the 10% tax correctly applied, and IRC Sec. 250 eligible deductions for foreign-derived intangible income (“FDII”) and GILTI?
Verify with the seller if they have employee benefit plans. If your target has a plan set up, get an employee benefit plan specialist to review Form 5500.
Lastly, if your target is an S corporation, success-based transaction costs can be leveraged by avoiding the IRC Sec. 338(h) (10) Election and structuring a qualified F-type reorganization instead.
4.Operational Due Diligence
You can't understand the target processes and systems from the financials or verify if it even has any at all.
The easiest way to verify operations is to ask for a business plan and validate how well the seller adheres to it.
If no business plan exists, the next best option is to whiteboard or Lucid chart all of the target's processes with the seller on Zoom.
To get a feel of the target’s customer journey map out their processes in this order Marketing > Sales > Delivery (quality control) > customer relations (Ascension/Up sales) > Advocation & Promotion (Testimonials & Referrals).
At the same time, ask for or create a responsibility chart with key employees and their compensation agreements.
And ask about their employee versus independent contractor exposure.
This will help you with your integration projections more than anything.
5. When Available Spend Extra Time Reviewing The Quality Of Earning (Q of E)
If you’re working on larger deals with Q of E reports, these are the six main questions you want to ask yourself.:
Has the target had its financials audited on a yearly basis?
If yes, by whom and what is their reputation and quality?
What adjustments impacted the earnings and balance sheet accounts?
Are the judgments and estimates within reason?
Is there sufficient separation of duties for internal controls?
On public targets, is the management's discussion and analysis (MD&A) clear and complete?
Plan For Integration
I know you're probably sick of process maps by now, but you want to revisit the integration phase of your process map and its timeline.
So that you don't forget to move essential pieces on the board while in the heat of closing.
The culture fit is another deal-breaker that you won't get from the financials. If everyone in the company gets along with the seller and you don't, it might be worth moving on or putting the second in command through a personality test to see if you can use them as a proxy.
A great personality test is Understand Myself by Jordan Peterson.
It lets two people take the test and outputs three reports, two individual reports, and a compatibility report for the pair.
You also want to run background checks and perform due diligence on the seller, officers, and directors.
If part of your integration has action items that take time, you can get a head start on them, like planning for a digital launch, getting sponsors, or negotiating certain joint ventures (JVs).
Lastly, this is where you plan out your break glass in case of an emergency backout plan.
Draw a line in the sand and plan on how to mitigate your losses if you walk away.
Backout plans will usually be in the form of an exit agreement.
On the other hand, if you’re concerned that your seller might back out on you, a breakup fee (clause) can be added to the LOI where they pay any of the transactions expenses accrued by the buyer at the point that they back out.
Fernandez hopes that you always go through this checklist in advance of every LOI that you sign.
You can thoroughly go through this list in a few days instead of wasting weeks or months on a deal that just isn't worth it.
If you want help with your pre-LOI due diligence or with structuring your final deal stack (financial engineering), ASE is like your personal board of directors (BoD) at a fraction of the cost.