Exclusivity, Definition of Revenue, and Buyer Guarantees
There are numerous components within an LOI (Letter of Intent) in an accounting practice acquisition. This article will discuss three areas that can cause headaches, if not deal breakers when it comes time to negotiate the final definitive agreement and close.
Exclusivity, definition of revenue, and buyer guarantees all have the potential to kill deals or delay retirement if not fully negotiated in a Letter of Intent. Both buyers and sellers are anxious to sign an LOI after a meeting or two that goes well.
Buyers are anxious to secure a deal for their “growth through acquisition strategy,” sellers are tired, ready for help in the firm, and overdue for their exit. When negotiating the LOI, be sure that these three issues have the level of clarity and detail up front to give your deal the highest probability of closing.
Exclusivity within an LOI
An LOI (Letter of Intent) is usually a non-binding offer negotiated in the early phases of an acquisition or merger. Buyers often want a couple of provisions within the LOI to be binding.
One of these areas is the exclusivity the seller provides to the buyer during the due diligence, contract negotiation, and financing phases before closing. Buyers put binding language in many of the LOIs we see, which forces the sellers to stop marketing to other buyers, stop all negotiations with other buyers, and provide the buyer with the exclusive right to purchase for some period.
Exclusivity Details
The selling season for accounting firms is noticeably short, usually May-January, which creates difficulties for exclusivity on the selling side of the equation. Depending on when the deal begins during this period, it could have serious implications for exit. If the deal goes south, and if the exclusivity expires late in the season, it may cause the seller to keep working, impacting retirement and all the subsequent issues around their exit.
On the other side of the equation, buyers need some level of comfort that the time and money they spend investigating due diligence, obtaining financing, and preparing a definitive agreement are not wasted if the seller chooses another buyer while completing these steps. Both issues have real validity and need to be negotiated.
Negotiating the Exclusivity with an LOI
Because both sides have merit, we want to suggest some viable solutions. We have found common ground in all requests for exclusivity as we advise our clients on this. First, if the exclusivity period is short and the deal is being negotiated early in the season, we rarely see issues from the seller in exclusivity.
However, if the exclusivity period is long or late in the season, we find it easier to negotiate the exclusivity in tranches. We use three primary segments within the exclusivity period, and when taken together, we give the buyer comfort and the seller the right to get out of exclusivity.
We typically address the due diligence period, the definitive contract negotiation, and financing. Suppose the seller agrees to provide exclusivity during the due diligence period and is willing to extend exclusivity depending on the due diligence results. In that case, the parties seem to be satisfied. If the buyer finds issues they do not like and wants to slow down the deal, the seller should have a right to exit.
If the buyer needs to change the price and terms based on their due diligence, the seller has the right to move on to other buyers that may be interested. If due diligence is satisfied, and there are no changes to the terms, sellers will give another segment of exclusivity to the buyer.
Similar strategies can be made with the time it takes to get a definitive purchase agreement presented and negotiated and the financing contingency. By keeping the exclusive period short and by using tranches the deal flows smoother, quicker, and all parties have their needs met.
The Definition of Revenue and How it Causes Issues During Final Negotiations
Most practice sales have an earnout within them. The seller receives a cash out at close, but there is also a holdback, or earnout, that ensures that the buyer is protected if clients leave during the transition period.
This protection is usually based on the revenue the buying firm earns in the year or two after the sale. Sellers only receive full price if the revenue earned after sale is equivalent to the revenue promised to the buyer contractually.
Cash Basis or Accrual Basis Revenue
One of the first issues is that revenue must be defined in accrual or cash basis accounting. Most deals use a cash basis, but for several reasons, sometimes the accrual method gets selected. If a cash basis is selected, there would need to be a collection period following the retentive period that allows clients to pay after the services have been billed.
What if the work is completed and billed during the retentive period, but the client pays after the retentive period is over? Additionally, how will the contract handle work in process, where some work has been done but not finished and billed until after the retentive period?
Other Revenue Definitions Detail to Consider
Detailing what is included in the revenue is also important. Several variables should be discussed and agreed to. Below, you will find questions that will prompt you to think about what is and is not included in revenue.
- Is the definition confined to only the clients being sold, or is there a more expansive definition that includes new business from an existing website?
- What about the current sales pipeline of new clients the company has lined up to join the firm?
- How much revenue does the buying company bring from new products?
- What about client referrals, staff referrals or referrals directly from the selling principal?
Mitigating Risk of Deal Collapse Due to Revenue Definition Issues
This can be tedious discussion and many of these issues might appear to be small but combined there is a substantial risk that revenue will not be measured in the same way it is expected to be measured if not defined within the initial LOI.
Take the time to work through these questions yourself and find a definition that suits your needs and negotiate and document the full definition within the LOI.
Guarantees Must Be Finalized Within the LOI to Avoid Disruption in the Final Negotiation
Sometimes, sellers are so excited to get an offer, they fail to think through what happens if things go south. Attorneys will help buyers and sellers think through these issues during the contract phase but if irreconcilable differences arise in the guarantee portion of the contract it can die quickly regardless of the amount of time already spent.
Mitigating Risk by Defining Guarantees
Again, thinking through different variations of what is included in the guarantee will be helpful for you. Most buyers want to keep guarantees to a minimum and most sellers want maximum guarantees so understanding the variations is important as you negotiate this up front.
Personal Guarantees
Personal Guarantees allow the seller to pierce the corporate veil and come after the buying principal’s personal assets if the contract is breached.
In Arizona, the spouse of the principal or those providing guarantees must also sign. These should be considered when the buying entity is small and does not have the liquid resources to pay up or when a shell entity is used to purchase that is not associated with the parent entity.
Corporate Guarantees
If the company purchasing the practice is large and financials statements detail significant assets and liquidity there may be comfort in allowing corporate guarantees in lieu of a personal guarantee or both. Buyers are much more comfortable providing corporate guarantees.
Sometimes, however, a buyer may form an entity to keep everything separate and trackable. If this entity is separate from the parent company, it has little in terms of assets to repay.
Mitigate Risk for Buyer and Seller by Negotiating Three Items Up Front
If buyers and sellers take a little extra time to negotiate and document these three issues, the LOI has a much better probability to make it to closing. Waiting to negotiate these three issues, until the definitive agreement brings risk to the decisive moments before close. It is in these decisive moments when the parties get cold feet, and everyone is tired.
Both buyers and sellers will waste less time, improve their closing probability and experience less deal fatigue if these items can be addressed at the beginning vs the end of the transaction.
These are just a few of the items that can derail a mutually agreeable LOI when attorneys write definitive contracts. Berkshire Business Sales & Acquisitions is aware of these issues and many more. They have the experience of hundreds of negotiated LOIs and successful closings and transitions to help you navigate exit.
If you would like help in finding the right buyer when selling your accounting or CPA firm in Arizona, and getting your deal to the finish line, call Ryan Gipple at 602-614-3583.
