checklist

what your merger letter of intent needs

fontaine

bonus: a 19-point checklist for sellers.

by marc rosenberg
cpa firm mergers: your complete guide

note: this post was written in collaboration with attorney peter fontaine, the founder and managing partner of newgate law, a firm of lawyers that work with cpa firms exclusively. he served as legal counsel at arthur andersen and rsm for more than two decades. he can be reached at pfontaine@newgate.law or (617) 513-2440.

at the onset of the merger process, most sellers contact at least two to three potential buyers. this positions the seller to select one buyer to commence negotiations with, in earnest.

more: buying a solo | 23 questions for mergers of equals | 61 things buyers should explore with sellers | why merging in smaller firms is fabulous | selling your firm? what to expect | thirteen ways to woo potential firm buyers
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after an exchange of financial and operating data and meetings to clarify the information, but before serious negotiations begin, it is customary for the qualified buyers to issue letters of intent (lois).

as the term is used in cpa firm mergers, an loi is a written offer made by the buyer to merge in or acquire the seller. it is a relatively short, simple, nonbinding offer, subject to further negotiations, performance of due diligence and a formal vote by the buyer’s partners.

the custom and process of issuing a letter of intent is a rather curious one for several reasons.

  • the loi is contingent and, for the most part, nonbinding.
  • the offer is commonly made before the parties have begun serious, detailed negotiations and performed due diligence.
  • lois are usually short and sweet, lacking the kind of detail that appears later in the merger agreement.

it has been my experience that buyers often submit lois that fail to address important areas. this unnecessarily prolongs the loi process because the seller needs to ask the buyer to address the areas omitted and perhaps reissue the offer. when we represent sellers in a merger, we advise them to be proactive by giving the buyer a list of issues they would like addressed in the loi. this makes it more likely the buyer will issue a properly written loi.

steps that lead to issuance of an loi

the first step in the merger process is the get-to-know-you meeting. the purpose of this meeting is simply to introduce each firm to the other, give each a chance to kick the tires, get a feel for the personality and style of the other and share some very basic facts. it’s designed to help each firm decide if they wish to go to the next step.

after both firms sign an nda, the next step is the exchange of financial and operating data. i’ve heard of some deals in which financial data is exchanged after the loi is accepted by the seller, toward the end of the merger process as part of due diligence activities. this makes no sense to me. i advocate exchanging financial information as early in the process as possible, certainly before issuance of an loi. the financial data speaks volumes about the nature and operation of a firm. after seeing the other firm’s financial data, one party may decide to break off merger discussions, saving both firms a lot of time.

after the firms review the data, they usually need to convene a meeting to clarify the data and drill a bit deeper into the firms’ operations of the firms. here are some common agenda items for pre-loi-issuance meetings.

  1. both the buyer and the seller ask deeper questions. this gives each firm a more thorough understanding of how the other’s practice is managed, how work gets done, how people work on client projects, and how systems and technology are used. all of this helps both firms gauge the likelihood of the merger’s success and the value of the seller.
  2. the parties exchange general ideas about desired terms. the operative word is “general.” rarely do merger partners try to negotiate deal terms before the buyer issues an loi. but addressing the deal terms in general makes it more likely that the buyer’s offer will be closer to what the seller expects.

most deal terms fall within a range of norms, such as:

    • purchase price between 80% and 110% of revenue
    • payout terms between four and six years
    • down payment between zero and 15%
    • compensation haircuts between zero and 20%

if either firm is adamant on terms that fall outside of these norms, this should be discussed to see if it’s worth continuing discussions. for example, if the seller will accept no less than 150% of fees and the buyer will go no higher than 100%, it may be a waste of time for the buyer to issue an loi.

  1. the firms evaluate one another’s culture and personality fit. except for the sale of a retirement-minded solo or very small firm, the most important factor that will determine the merger’s success – more than financial terms – is culture and personality fit. throughout the merger process, partners from the two firms should meet as often as possible, in business as well as social settings, to enable the firms to get to know each other and gauge whether or not the two cultures will work well together.

suggestions for preparing the loi

lois should be drafted carefully and include all critical terms. this avoids potentially fatal misunderstandings or disagreements around key terms later in the process.

an loi is too often seen as a not-so-serious, nonbinding jumping-off point, with no real consequences. this is unfortunate. for starters, attempts to change a material term in the loi in the latter stages of merger negotiations can be characterized by a potential partner as an act of bad faith or a breach of trust.

in addition, a number of court cases have decided that promising to negotiate in good faith is a legally binding duty and attempts to change the loi in bad faith can result in the seller being able to sue for damages. so a word to the wise: avoid promising to “negotiate in good faith” if you don’t intend to do so.

include generous protective language in the loi. even though this may appear to signal something less than a full commitment to the deal, it is preferable to a suboptimal transaction or exposure to damages for pulling out.

lois should do the following:

  • allow the parties to discontinue negotiations/discussions at any time, for any reason or no reason at all
  • make any item in the loi subject to modification or elimination
  • eliminate any and all liabilities for a transaction that is never completed or that is not completed consistently with the initially proposed terms
  • permit the parties to subsequently negotiate a similar transaction with any other party, including a competitor, if the present proposed transaction fails

what the loi should include

there is no such thing as a standard loi. some firms like it to be comprehensive, while others prefer extreme brevity. this list is a resource of potential items to include in the loi. no loi that we’ve ever seen addresses anywhere near all of these items. (if it did, it would be 20 pages long!) pick and choose wisely.

  1. effective date of merger/sale
  2. a one-stage or two-stage merger?
  3. purchase price/buyout terms
    • purchase price of the seller, often stated as a percentage of the seller’s revenue
    • will the purchase price be based on billings or collections?
    • will the annual payments vary each year or will the number be locked in after a period of years?
    • in a true merger, it is common for the ratio of the two firms’ revenue to be a factor in deciding each firm’s ownership in the new firm, compensation and partner buyout. in such cases, the loi should specify the revenue amount that the seller will be given credit for. also, there should be language that describes what happens if the seller’s actual revenue is higher or lower than the projected level.
    • is there a minimum number of years that the seller’s owners’ will be required to work, full-time or part-time?
    • how will the seller’s wip and a/r be handled by the buyer? when the seller’s wip and a/r are collected after the merger, how will it be determined which balances the collections are applied against first: seller’s wip and a/r or the wip and a/r incurred after the merger?
    • what the down payment will be, if any, as well as how it will be calculated and how it will be amortized
    • payout term of the purchase payments, including the frequency of payments
    • price, if any, that the buyer is willing to pay the seller for its fixed assets
    • tax treatment of the payments to the seller
  1. as the seller generates new revenue, directly or indirectly (cross-selling to existing clients and bringing in new business, for example), how will the seller be compensated for it?
  2. seller’s personnel and their compensation
    • to what extent will some or all of the seller’s owners be equity or non-equity partners in the new firm?
    • what will be the title of all the seller’s equity and non-equity partners at the buyer?
    • to whom will the seller’s owners report?
    • how will the seller’s owners, both full- and part-time, be compensated both for full-time and part-time work? this includes basic compensation as well as commissions for bringing in new clients. will there be any compensation guarantees? for how long?
    • specify the extent, if any, to which some or all of the seller’s personnel will become employed by the buyer, and any liability for severance benefits.
    • how will perks and benefits be handled, especially those that the seller previously enjoyed and that may be eliminated at the new firm?
    • how will benefit plans be transitioned?
    • will employees be required to sign new employment and non-solicitation agreements?
  1. retirement
    • partners at small firms almost always want to work longer than mandatory retirement provisions at larger firms. the loi should specify:
      1. how long will the buyer allow the seller to work?
      2. what authority will the buyer have to decide how long the seller works?
      3. will buyers’ mandatory retirement provisions be waived for sellers wishing to work longer?
    • if the seller works for the buyer after retirement, either full- or part-time, who determines the details of the work arrangement? compensation? hours worked? clients ser-viced? services provided? full-time vs. part-time? title?
    • if the seller becomes an equity partner in the buyer and participates in the buyer’s retirement/buyout plan, how will the seller’s buyout be computed? how much vesting credit will be given to the seller?
  1. extent that seller’s owners become equity partners at the buyer
    • what will be the title and role of the seller’s partners at the buyer firm?
    • what capital contribution of sellers will be required?
    • what ownership percentage will be awarded to each seller?
    • how will voting work?
  1. billing rates of seller’s personnel, especially the partners
    • it’s common that the buyer’s billing rates will be higher than the seller’s. all sellers fear that the buyer will dramatically increase their billing rates and jeopardize the retention of their clients. the loi should specify how billing-rate increases, if any, will be decided, including the seller’s input into these decisions.
    • the section on billing rates should take into account this nuance: it’s also common at small firms for the partners to perform a large amount of staff-level work. this explains why their billing rates are low; they’re a blend of partner-level and staff billing rates. but at the buyer, the seller’s partners will be expected to do less staff-level work, so their new, higher billing rates will be justified.
  1. clients, billings, hours
    • will the buyer be required to make best reasonable efforts to retain all of the seller’s clients? if the buyer deems that certain clients of the seller are not a good fit, does the seller have any influence over these decisions?
    • what are specific targets for billable hours for the seller’s partners? special work hour targets should be specified. this can be critical; partners at small firms often work 20-30 percent more billable hours than their counterparts at larger firms.
    • conversely, when buyers cite a compensation level for the seller’s partners, they often like to link this amount to the partners working a minimum number of billable hours.
    • does the buyer expect sellers’ partners to change how they practice? generalists vs. specialists. audit vs. tax.
  1. management and administration
    • what will the buyer be obligated to do regarding taking over management of the seller and providing management and staff support to the seller?
    • to what extent will the sellers have a say in the management of the buyer? directly via seats on an executive committee? indirectly? not at all?
    • are there any software conversion issues, including when the conversion is to take place?
  1. what are office lease issues? where will the seller be located?
  2. prior acts
    • neither firm will be liable for acts of the other prior to the merger’s effective date.
    • i have seen a few mergers in which the seller had a significant pending malpractice case. this often causes the buyer to reject the seller. but if the buyer wishes to proceed, the handling of these cases should be specified in the loi.
    • will tail insurance for the seller need to be purchased? if so, who pays? (more commonly, the seller.)
    • if the seller did not carry malpractice insurance, how will insurance for the seller’s acts prior to the merger be handled?
  1. role and compensation of consultant: commitments to pay the consultant a success fee at closing should be spelled out.
  2. contingencies

state what the deal is contingent on, such as performance of due diligence, the parties obtaining approval from their respective shareholders and the execution of mutually acceptable merger agreement(s).

  1. confidentiality
    • neither firm shall solicit, enter into or pursue any merger discussions or negotiations with any other party until ___ days after the date of the letter of intent.
    • each firm agrees not to disclose the existence of the proposed transaction, the terms of the loi or any confidential information provided in connection with the proposed transaction for any reason other than to employees, consultants and professional representatives reasonably required by either firm for the sole purpose of evaluating the proposed merger. each firm further agrees that its consultants and representatives are bound by this confidentiality agreement and that any breach by them shall be deemed a breach by the firm they are assisting.

if the negotiations terminate without a transaction, these personal representatives shall not, acting for themselves or on behalf of any other person or entity, be permitted to use the confidential information. each firm shall advise their respective professional representatives of these terms.

    • if sale or merger discussions terminate, both the seller and the buyer agree not to disclose any confidential information about the other for three years after negotiations are terminated.
    • neither firm nor its professional representatives will make any public announcements or release any confidential or nonpublic information to trade publications or the press without the prior consent of the other firm.
  1. miscellaneous
    • how long will the loi be valid?
    • how will legal expenses incurred by the buyer and seller be shared or not shared (if at all)?
    • sellers’ owners will be required to sign the buyer’s partner agreement, which will include a nonsolicitation clause.
    • i once worked on a merger where due diligence revealed that the seller was lax at keeping its state cpa licenses current. the seller claimed he was unaware of this, but who knows? the point: the loi should specify basic claims that the seller must sign off on.

loi comparison checklist

(for sellers)

provision firm a firm b firm c
1. deal terms: purchase price
2. deal terms: compensation for full-time work
3. deal terms: compensation for part-time work
4. deal terms: perks and benefits
5. deal terms: other
6. compensation to seller if new business is brought in, from either existing or new clients
7. sellers to be equity partners?
8. comp guarantees for sellers’ partners
9. buyers’ policies for partners working part-time
10. how long buyer will let seller work
11. will buyer employ sellers’ staff?
12. capital contribution required
13. ownership awarded
14. how voting works
15. how billing rate disparities will be handled
16. billable hour expectations of seller
17. management of the new firm
18. software adopted and conversion timetable
19. office lease issues