When the time comes, the determined buyer will need to draft a letter of intent (LOI) or an offer to purchase addressed to the shareholders of the target company. This signed document marks their first mutual commitment in the transfer process.

Although a letter of intent is often described as legally non-binding, it can include penalties that the buyer must pay in certain failure cases. For example, if they demonstrably fail to make their best efforts to meet the deadline. This compensation indemnifies the seller, who has often granted exclusivity for negotiations, invested time, and incurred potential costs in the process.

One of the main topics of discussion in the LOI is the price that the buyer commits to offering, subject to conditions. How should this price be formulated? A fixed amount? A formula? If so, which one?

The Perils of a Fixed Price

While the benefit of a fixed amount is its clarity, its limits must be considered. A company does not stop operating just because its shares are changing hands.

Accounting presents the company’s financial situation at regular intervals, at least annually, but always retrospectively. Information is only available once all the data has been collected, encoded, and approved. Therefore, negotiations between the seller and the buyer inevitably take place based on past accounts. And this isn’t the only issue! There’s also the period between the date of the last approved accounts and the signing of the LOI, which can stretch into many months. This period, where the company’s results are unknown, introduces a substantial risk for the buyer, who is essentially betting on the stability or growth of the company’s value.

The Imperfect Adjustment Variable

A company’s value is a combination of tangible assets (real estate, machinery, stock, receivables, net cash, etc.) and intangible assets (human capital, reputation, business model, client base, etc.).

Savvy buyers often structure their price offers by partially or fully isolating tangible assets from intangible ones. The offer typically includes a fixed portion (valuation of the intangible assets) and a variable portion (valuation of the tangible assets). Examples:

• Sale Price = Enterprise Value (fixed) + net cash position (variable)
• Sale Price = Adjusted equity (variable) + Goodwill (fixed)

It’s not uncommon to break down the “Enterprise Value,” which incorporates some tangible elements along with the intangible ones, to better frame the offer. However, this first formula, as written, allows for the optimization of the situation at the time of sale, often to the detriment of healthy business management. For example, pressuring clients to pay their debts ahead of schedule or delaying payments to suppliers to inflate the net cash position on the day of the sale. The second formula, however, avoids such maneuvers, which can be particularly sour for the newly acquired business owner.

By using an adjustment variable, the buyer protects themselves from a more difficult economic situation. However, this also means they forgo benefiting from any substantial performance improvements during the negotiation and finalization periods.

The Full Formula: Secure but Unpalatable

What happens if the long period of uncertainty results in substantially different figures?

An SME can undergo many changes in a short time. While an adjustment variable can help during temporary fluctuations, it won’t be enough to absorb a major and lasting downturn in the company’s performance.

The intangible assets of a company are generally valued based on the structural profitability of its business. In the event of a major crisis affecting the company, its sector, or the economy, adjusting the sale price based on the company’s cash position or equity might not be enough to soften a significant drop. To cover this possibility and to motivate the seller to remain fully engaged until the end of their tenure, you might encounter this kind of pricing formula in an LOI:

Sale Price = Enterprise Value (variable) + net cash position (variable)
Enterprise Value = Adjusted EBITDA (variable) * 5.5 – Normalized working capital requirement + Working capital requirement (variable)

While this formula reduces the buyer’s risk even further, it also prevents them from benefiting from any growth in the company’s results during the blind period. In practice, this type of pricing formula is rare. The seller may find it overly complicated and prefer a more straightforward offer.

Tailor-Made for Every Deal

Other mechanisms exist to further reduce the buyer’s risk, such as the use of an Earn-Out clause.

Many deals fall through due to a plethora of unresolved issues that were not addressed earlier in the process, particularly in the drafting of a smart and adapted LOI. Each case is unique, and so are the solutions. The key is to analyze the situation carefully, approach it with perspective, identify the major components of value, and focus the debate on what truly matters.