• 083 03/03/2019
    This post references an example LOI template, which is available for download. The company described in the LOI is fictional.
    A Letter of Intent (LOI) is a largely non-binding document entered into by the potential sellers and buyers of a company. This document helps serve as a guide for the documentation required to consummate the transaction (the “definitive agreements”). The primary objectives of the LOI are twofold:
    1. Establish a Value: The LOI will describe the total consideration offered to acquire the common stock or assets of the business. In the example LOI available for download you will see that the offer is made on a cash-free and debt-free basis. There is also generally an escrow (see below) and an adjustment for working capital. 
    2. Secure Exclusivity: Once a buyer enters into a LOI, it is their responsibility to engage third party counsel to work towards a close. This is an expensive and time-consuming process. To give the buyer the confidence to proceed with this due diligence, the seller will grant exclusivity for a period of time (“exclusivity period”). During the exclusivity period the company is prohibited from discussing a potential transaction with other parties and is required to conduct its business in the ordinary course consistent with previous practices.
    Beyond these two objectives, a LOI will also typically address the following:
    Capital Structure
    The LOI will state how the buyer intends to fund the transaction. More precisely, it will detail the amount of leverage the buyer intend to secure. This is more relevant if the sellers intend to remain with the company, and even more so if they intend to remain shareholders. More debt raises the risk profile of the business, which should make any shareholder uncomfortable. 
    A portion of the total consideration (Enterprise Value) will sometimes be placed in an escrow account. The funds placed in escrow are held by a third party for a negotiated duration. If at the conclusion of this time period there are no material findings, the funds are released to the seller.
    Employment Agreements
    Employment agreements for key members of the management team will be detailed in the LOI on a very superficial basis. This can range from language including actual figures for salary and bonus to a mutual understanding that both buyer and seller will work towards terms that are acceptable to both parties.
    A buyer will typically want to secure a non-compete in an effort to prevent talented operators from competing with the business when their employment agreements terminate. 
    Conditions to Closing
    A thorough understanding of what the buyer expects prior to close can facilitate the process and eliminate the potential for any surprises. For example, if the business requires a highly specialized facility, the buyer might want to include that they require a long-term lease prior to closing.
    A major priority in any transaction is to reduce exposure to potential for loss. For this reason the buyer will want to detail how they expect to be indemnified by the seller for damages related to certain items. This is accomplished via representations and warranties made in the definitive agreements. 
    Management Fee
    Any fees that the buyer intends to charge either on an ongoing basis or at close are typically described in the LOI.
    PDF of Example LOI: Letter of Intent



  • 082 03/03/2019

    Document available for download at the bottom of this post.

    I once worked on a transaction where every item had been negotiated and all documentation was drafted and in final format, but a single number in the Subordination and Intercreditor Agreement nearly caused the entire transaction to fall apart.

    A disagreement between the Subordinated Creditor and the Senior Creditor on the appropriate number of days for the Standstill Provision threatened to ruin months of work, which would have left all parties with hundreds of thousands of dollars of dead deal costs.

    Up to that moment I had spent little time thinking about this document, but since that episode I always try to make sure the lenders financing a transaction are on the same page long before we are days from funding a transaction.

    The purpose of this post is to briefly explain how the Subordination and Intercreditor Agreement governs the rights of the Senior Creditor and the Subordinated Creditor. There is a downloadable PDF file that includes examples of language that you might see in this document to help provide greater context. In summary, the variables to look for in this document are as follows:


    There will be no negotiation surrounding subordination. The Senior Creditor will require that the Subordinated Creditor’s claims on the business are junior to the Senior Creditor until the Senior Creditor has been repaid in full.

    Standstill Provision:

    The Subordinated Creditor will be prohibited from taking any action to enforce payments on the subordinated capital in the event that the Senior Creditor has provided a notice of default. As an example, in the event of a Senior Covenant Default, the Subordinated Creditor might have to wait 120 days before they can act (i.e. exercise remedies available in the Subordinated Note Purchase Agreement).

    Blockage Period:

    The Blockage Period allows the Senior Creditor to prohibit otherwise permitted payments to the Subordinated Creditor for a defined period of time. Items to take into consideration as it relates to the Blockage Period:

    1. The reason for the Blockage Period should be well defined. Is this allowed in the event of a Senior Covenant Default or only in the event of a Senior Payment Default?

    2. The Blockage Period should be limited to a number of days (180 days, for example).

    3. The total number of Blockage Periods should be limited.

    Purchase Option:

    This provides the Subordinated Creditor with the option to purchase the Senior Loan.

    PDF File: Subordination and Intercreditor Agreement Summary


  • 081 10/28/2018
    The purpose of this post is to translate the language surrounding purchase accounting into a financial template with instructions that cover the balance sheet adjustments for most control transactions.
    The template available for download reflects the elimination of cash under Target Company Adjustments below and all of the Purchase Price Adjustments. These are items that will be required in almost every transaction. The remaining items listed under Target Company Adjustments may or may not be required.
    Note: This post does not contemplate situations where the purchase price is not a premium to the net identifiable assets (i.e. negative goodwill).
    This post is divided into two parts:
    1. Target Company Adjustments: Adjustments made to prepare the target company’s balance sheet for the transaction.
    2. Purchase Price Adjustments: Adjustments made to record the acquisition of the target company.


    The list that follows is not comprehensive, but instead focuses on the most common adjustments that might be required to prepare the target company’s balance sheet for a transaction. 
    Eliminate Cash for a Cash-Free Transaction: Most transactions are contemplated on a cash-free basis, which is to say that the sellers intend to keep the cash. To reflect this change eliminate cash on the balance sheet and reduce retained earnings by the same amount.
    Debit: Retained Earnings
    Credit: Cash
    Eliminate Old Goodwill: The purchase price is allocated to the net identifiable assets of the company. Goodwill, which is not an identifiable asset, is eliminated to facilitate the calculation of net identifiable assets. To reflect this change eliminate goodwill on the balance sheet and reduce retained earnings by the same amount.
    Debit: Retained Earnings 
    Credit: Goodwill
    Move Current Portion of Long-Term Assets and Liabilities to Long-Term Balance: The most common example relates to long-term debt. If a target company shows a senior debt balance under liabilities it is likely that the amount of principal amortization due that year will appear under Current Portion of Senior Debt as a current liability. To reflect this change eliminate the current portion and add it to the long-term balance. 
    Debit: Current Portion of Senior Debt
    Credit: Senior Debt
    Adjusting Assets and Liabilities to Fair value: This can apply to nearly any asset or liability on the balance sheet, but in this post we are only going to focus on Accounts Receivable and Inventory.
    Accounts Receivable: If you believe the AR balances might not be collected an adjustment may be required.
    Debit: Retained Earnings
    Credit: Accounts Receivable
    Inventory: If the business has been poorly managed it is possible that the inventory balance will not be accurate. If it is overstated it should be written down. 
    Debit: Retained Earnings
    Credit: Inventory
    If inventory is understated and needs to be written up the tax consequences need to be considered. 
    Debit: Inventory
    Credit: Deferred Tax Liability (Amount Written Up x Tax Rate)
    Credit: Retained Earnings (Amount Written Up x (1 – Tax Rate))
    By accurately adjusting the Target Company balance sheet for the items described the calculations for the purchase price adjustment are made simple. The first objective should be to identify the sources of capital used to make the acquisition. Once you have these figures totaled you can subtract all uses to arrive at Seller Proceeds. For example:
    Sources and Uses Table
    This makes the goodwill calculation pretty straightforward. Goodwill is equal to Seller Proceeds less the net identifiable assets of the target company. Net identifiable assets is equal to identifiable assets less liabilities, which per the accounting equation is equal to shareholders’ equity.
    Goodwill Calculation
    With these values calculated we can make the required balance sheet adjustments. To provide context, I think it is helpful to think about this in the following steps (download the template to work through the list):
    1. Eliminate OldCo Equity Accounts
    2. Eliminate OldCo Debt Balances
    3. Add NewCo Equity Accounts
    4. Add NewCo Debt Balances
    5. Expense Transaction Expenses
    6. Adjust for Financing Fees* (see note at bottom of post)
    7. Add Goodwill Calculation
    8. Add Cash at Close

    Pro Forma Balance Sheet Adjustments


    Full Balance Sheet Adjustments Image (click on the image for fullscreen view):


    LBO Balance Sheet Adjustments



    1. Under GAAP the financing fee is no longer on the asset side of the balance sheet. A recent accounting update requires that this sum be subtracted from the corresponding debt line item. I prefer to see the total principal balance outstanding on the balance sheet and continue to use the old approach for this reason. You can find a video covering the update here (subscriber content).




Models are:
A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above



*Answers a, b, c, d, e, f and g are all correct.