Minimum Viable LOI
Big Deal Small Business: Minimum Viable LOI
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Today’s post discusses the Letter of Intent (“LOI”).
As always, no definitive / objective answers here. I am constantly struggling and reworking my approach to LOIs. This post is an attempt to codify my current mindset. I’d love to hear your views on your framework.
We do pre-LOI diligence, but at some point we have to cross the threshold into post-LOI diligence. To cross that threshold, we need visibility into a minimum set of information, which allows us to confidently submit an LOI.
I’m calling that threshold my “Minimum Viable LOI”.
I break up my Minimum Viable LOI into two pieces:
Minimum Terms: What is the level of detail I need covered on deal terms in the LOI?
Minimum Conviction: What are key “gut feeling” questions I need answered before submitting the LOI?
My guiding principle is that when I submit an LOI, I am saying the following to the Seller: “If post-LOI diligence confirms what you have represented to me, I am willing to buy this business at the terms in this LOI.”
Minimum LOI Terms
As a result of that guiding principle, I tend to go heavy on details in an LOI. At a minimum, I want it to include the following:
A single headline price (or very tight range) — a prerequisite being sufficient business & financial analysis to determine valuation
Core deal structure elements (seller note size at a minimum, ideally consulting/transition plan)
An exclusivity period matched with a diligence period
Discussion of working capital to avoid surprises down the road
Any idiosyncratic business issues (such as timing of close in a seasonal business)
It sounds like others in search may opt for lighter LOIs with just a valuation range and exclusivity (and sometimes not even exclusivity).
A core issue for me as a part-time searcher is that time is at a premium. I just don’t have the bandwidth to run multiple deals past the LOI stage.
Further, I start incurring real deal costs post-LOI, which comes out of my personal funds, not the management fees off a fund or search fund capital specifically earmarked for deal costs.
This LOI approach tends to exclude me from competitive processes. I’m okay with that because I wouldn’t have won those processes anyway. I’m optimizing for LOI conversion rate, not # of post-LOI deals.
On the flip side, this approach leads me to kill deals too early where I may have gotten more excited once I got into full diligence.
For a full-time traditional searcher or a PE fund, maximizing LOIs is rational. You have the time & money to pursue deals, so optimizing the # of deals that go deeper in the deal funnel makes sense. They get to turn over more rocks, which can lead to more diamonds in the rough.
On the flip side, I hear a lot of feedback from brokers that are wary of “kick the tires” LOIs, so you might be less credible with the light LOI.
Minimum Conviction Level
Given my guiding principle above, my conviction level on the deal needs to be fairly high to submit an LOI.
There’s the usual industry, business, and financial due diligence. I have to do that regardless.
But setting the core, measurable diligence aside for a moment, there is also a few “gut feeling” tests that I want to feel good about before submitting an LOI.
These include:
Do I actually want to own this business (setting aside price)? Do I want to live & breathe this industry?
Can I picture my life running this business full-time? Do I like that vision?
Can I reasonably replace the owner given enough time & training?
These are not questions that can be definitively answered or analyzed with extensive data requests. These are gut feeling tests, with underlying questions that I’ve fleshed out below.
Do I actually want to own this business? Do I want to live & breathe this industry?
I call this is the “can’t stop thinking about it” test. Do I stay up at night thinking about all the cool ways I can grow the business? Am I endlessly going down blog/YouTube spirals learning about the industry?
While not a predictor of success by any means, it’s an early indicator that I can build a passionate interest in the industry.
Can I picture my life running this business full-time? Do I like that vision?
I call this the “day-to-day” test. When evaluating a new job, people gravitate towards companies that do things they find interesting. But in practice, their day-to-day tasks and their boss will likely have a much larger impact on their happiness.
In a similar vein, I like to picture what life looks like as the operator of the business, setting aside the vision of entrepreneurship.
What time do I wake up? Do I go into an office or into a home study?
Am I spending all day on the phone putting out fires or making sales calls? Am I getting in the car and driving to customers?
Can I reasonably replace the owner given enough time & training?
This is the “can I actually do this” test. Look, I’m underqualified to replace any SMB owner. They have 30+ years of experience running their business. That said, with certain businesses I can develop a level of confidence that I can actually replace the owner.
For example, does the owner have any specific licenses?
Do they personally leverage their experience-driven qualifications to generate sales?
Are they self-managing one key piece of the service process (i.e. estimating/scoping)?
Will I be able to establish credibility with the workforce? What do I need to do establish that credibility?
Conclusion
My Minimum Viable LOI requires detailed terms and conviction on several key gut-feeling tests.
On the spectrum from loose indication to fully-baked PSA, my LOI shades toward the fully-baked PSA end.
To be clear, I’m not sure this is the best or optimal approach, even for my specific situation — I just want to share my current mindset. Hopefully it helps you formulate your own frameworks.
If you’ve got any opinions or want to push back on my mindset, I’m all ears! Hit reply to this email or find me on Twitter.
Thanks,
Guesswork Investing