Deal Documents

What Belongs in an Acquisition Letter of Intent

An acquisition letter of intent sets out the price, structure and key terms of a proposed deal before the definitive agreement is drafted. It should cover purchase price mechanics, form of consideration, working capital peg, financing and diligence conditions, exclusivity, timing and treatment of key employees, and it should state clearly which provisions are binding and which are not.

What is the purpose of a letter of intent?

A letter of intent, sometimes called an indication of interest at an earlier stage or a term sheet, records the agreement in principle between a buyer and seller before both sides spend heavily on legal fees, diligence and financing. It sets expectations on value and structure so that surprises do not emerge after weeks of work. For the seller, a well drafted letter reduces the risk that a buyer will use exclusivity to renegotiate price later. For the buyer, it secures a period of exclusivity in which to complete diligence and arrange financing without competing bidders. A vague letter defers hard questions to a point where the seller has less leverage and the buyer has sunk more cost.

The letter is also the first document a lender will read. Acquisition lenders want to see purchase price, sources and uses, the equity contribution, any seller financing and earnout terms, and the timeline to closing. If the letter is silent on those points, the lender's term sheet will be built on assumptions that may later conflict with the purchase agreement, delaying financing approval at the worst possible moment. Sharing a draft letter with the intended lender before signing is a simple way to surface those conflicts early.

How should purchase price and structure be described?

Price should be described with enough precision that both sides calculate the same number at closing. Most private company deals are priced on a cash free, debt free basis, which means the headline figure is an enterprise value. The seller keeps excess cash and pays off funded debt and debt like items at closing, and the price is adjusted if working capital differs from an agreed target. The letter should define what counts as debt, including items sellers often overlook such as deferred revenue, accrued bonuses, unpaid taxes, deferred compensation, customer deposits and capital leases.

Structure covers whether the deal is an asset purchase or a stock or equity purchase, and how consideration will be paid: cash at closing, seller notes, rollover equity, earnouts or some combination. Each element has different risk. Cash at closing is certain, while seller notes are subordinated credit exposure to the buyer, and earnouts depend on future performance that the buyer controls. The tax treatment of the structure can shift value between the parties, so it should be identified in the letter rather than discovered during drafting.

• Enterprise value and the cash free, debt free basis
• Definition of debt and debt like items
• Working capital target or peg and adjustment mechanism
• Asset purchase versus equity purchase
• Form of consideration: cash, seller note, rollover equity, earnout

Why does the working capital peg matter so much?

A business needs a normal level of working capital to operate, and the buyer expects that level to be delivered with the company. The working capital peg is the target amount, usually based on a trailing average of monthly net working capital adjusted for seasonality and unusual items. At closing, if actual working capital is above the peg the buyer pays more, and if it is below the buyer pays less. Without a peg, a seller could accelerate collections, delay payables or run down inventory before closing and effectively take cash out of the business that the buyer paid for.

The peg is one of the most negotiated numbers in a lower middle market deal because a small change can move the price materially. Letters that say only that the business will be delivered with a normal level of working capital invite disputes. A better letter states the methodology, such as the twelve month average of net working capital excluding cash, debt and income taxes, and commits both sides to finalizing the number during diligence using the quality of earnings work.

Which conditions and protections belong in the letter?

The letter should list the conditions the buyer expects to satisfy before closing: satisfactory financial, legal, tax and operational diligence, financing approval, third party consents such as landlord or key customer approvals, regulatory clearances and execution of employment or consulting agreements with key people. It should also preview the main risk allocation terms of the purchase agreement, including the expected scope of representations and warranties, indemnification caps and baskets, escrow or holdback amounts, and whether representation and warranty insurance will be used. Previewing these terms prevents a buyer from presenting an aggressive indemnity package after exclusivity has begun.

Treatment of people often matters as much as price. The letter should address the seller's post closing role, compensation, noncompete and nonsolicit terms, and any retention arrangements for key employees. Lenders and investors view key person risk as a credit issue, so a clear transition plan supports financing as well as operations. If the seller will stay on for a transition period, the letter should state its length, the role and how compensation is paid, so those costs can be reflected in the buyer's model and the lender's cash flow analysis rather than appearing as a surprise in the final weeks.

Which terms are binding and which are not?

Most of a letter of intent is expressly nonbinding, meaning neither party is obligated to complete the transaction on those terms. Certain provisions, however, are typically binding: exclusivity or no shop restrictions on the seller, confidentiality, allocation of expenses, governing law and sometimes a requirement to negotiate in good faith. The letter should say explicitly which sections are binding. Courts have occasionally found that loosely drafted letters created binding obligations, so precise language protects both sides. Ambiguous good faith language is particularly risky and should be either clearly binding or clearly excluded.

Exclusivity periods should be long enough for the buyer to finish diligence and financing but not so long that the seller loses its alternatives. Sellers often negotiate a shorter initial period with an extension tied to progress milestones, such as delivery of a financing commitment or a first draft of the purchase agreement. Buyers may ask for expense reimbursement if the seller breaches exclusivity. Both parties should also agree on how the letter terminates, including an outside date after which either side may walk away without liability if a definitive agreement has not been signed.

What do underwriters look for when reviewing a letter of intent?

An underwriter reading a letter of intent is testing whether the deal can be financed as described. Key questions include whether the purchase price is consistent with normalized earnings, whether the equity contribution is real cash, whether seller notes are subordinated and on standstill terms that a senior lender can accept, and whether earnouts are structured so they do not drain cash needed for debt service. The underwriter also checks that working capital and debt definitions will produce a closing balance sheet that supports the business plan. Inconsistencies between the letter, the quality of earnings report and the lender's model are a leading cause of last minute retrades and closing delays.

From headline price to cash wired at closing

1. The letter of intent sets enterprise value at $30,000,000 on a cash free, debt free basis with a working capital peg of $4,000,000.
2. At closing the company has funded debt of $6,000,000, cash of $1,000,000 and net working capital of $3,600,000, a shortfall of $4,000,000 - $3,600,000 = $400,000.
3. Equity purchase price = $30,000,000 - $6,000,000 + $1,000,000 - $400,000 = $24,600,000.
4. Consideration includes a $2,000,000 seller note, so cash due at closing = $24,600,000 - $2,000,000 = $22,600,000. An earnout of up to $3,000,000 is contingent and not paid at closing.
5. An indemnity escrow of $1,500,000 is withheld from the cash, so the seller receives $22,600,000 - $1,500,000 = $21,100,000 at closing, plus repayment of its $6,000,000 debt from the purchase price.

How underwriters apply this

• Reconcile the letter's price to normalized EBITDA from the quality of earnings report.
• Confirm the definitions of debt, debt like items and working capital before modeling sources and uses.
• Verify that seller notes can be subordinated with standstill terms acceptable to senior lenders.
• Check that earnout payments are capped and cannot impair required debt service.
• Confirm the equity contribution is cash rather than rollover or deferred consideration.
• Flag any key person dependency not addressed by employment or transition terms.

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Educational content written by practitioners. Not investment, accounting, legal or tax advice.