Mergers and Acquisitions

For many business owners, executing a Letter of Intent (LOI) feels like the end of the process. The headline valuation looks strong, key terms are set, and the deal seems on track.

In lower-middle-market transactions, however, an LOI is where the real work of defending that valuation begins.

Between signing a term sheet and releasing the final post-closing funds, substantial value can be lost. This rarely happens because a buyer loses interest; more often, it occurs because unaddressed financial, operational, or legal issues come to light during due diligence and contract negotiations.

To ensure the agreed-upon price translates into actual proceeds, sellers should recognize and address key transaction risks early.

1. Accounting Surprises and Disputed Add-Backs

Valuations in private business sales are almost always based on a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA). As a result, every dollar removed from adjusted EBITDA during accounting due diligence lowers the purchase price by that multiple.

The Risk

Sellers often rely on standard tax returns or internal bookkeeping, adding back personal or non-recurring expenses (such as owner perks, one-off legal fees, or discretionary travel). A buyer’s accounting team will scrutinize every line item. If they reject certain add-backs, find deferred revenue issues, or identify unrecorded operating expenses, the earnings figure drops—and the purchase price is reduced accordingly.

Mitigation

• Get an Independent Financial Review Early: Work with a transaction accountant to review historical earnings 6 to 12 months before going to market.
• Document Every Add-Back: Keep clear, auditable records for any non-operational or one-time costs to defend their removal from ongoing earnings.
• Standardize Accounting Methods: Ensure revenue and expense recognition match standard accounting practices to avoid timing disputes.

2. Working Capital Benchmark Disagreements

Working capital adjustments are among the most common sources of post-closing conflict.

The Risk

Most transactions are structured on a “cash-free, debt-free” basis, meaning the seller keeps the cash and pays off debt, but must leave enough working capital (accounts receivable, inventory, less accounts payable) for normal operations. If the target level of working capital—often called the “peg”—is set incorrectly or fails to account for seasonality and customer deposits, the seller may have to forfeit cash at closing or write a check back to the buyer post-close.

Mitigation

• Define the Working Capital Formula in the LOI: Do not leave the calculation details for the final purchase agreement. Outline which accounts are included and what historical timeframe sets the benchmark directly in the initial term sheet.
• Account for Seasonality: Base the target on historical operational reality rather than a single point in time.

3. Customer and Supplier Concentration

Buyers price risk based on stability and predictability.

The Risk

If a single customer accounts for more than 15% to 20% of total revenue, or a handful of accounts generate most of the profit, buyers see significant downside risk. Any sign of customer attrition, margin pressure, or contract renegotiation during the deal process can lead to price cuts, larger escrow demands, or requests to shift guaranteed cash into earnouts.

Mitigation

• Formalize Long-Term Contracts: Secure written agreements that clearly transfer with the business or do not require customer consent during an ownership change.
• Broaden Account Relationships: Introduce other team members to key clients so relationships are tied to the company rather than the owner personally.
• Highlight Account Retention: Document the historical longevity and low churn rate of major accounts.

4. Over-Reliance on the Owner

A company that cannot run smoothly without its founder is harder to transition—and carries more risk for an incoming owner.

The Risk

When key customer relationships, vendor terms, and technical know-how live only in the founder’s head, buyers will discount the business or demand extended transition periods. If there is no capable second-tier management team with incentives to stay, buyer confidence drops quickly.

Mitigation

• Delegate Daily Operations: Gradually hand over key responsibilities and client management to senior staff well before an exit.
• Put Retention Plans in Place: Use simple retention bonuses or stay agreements to keep critical personnel committed through the transition.

5. Over-Reliance on Earnouts and Seller Financing

How the purchase price is paid matters just as much as the total number.

The Risk

When there is a gap between what the seller wants and what the buyer is willing to pay in cash, the difference is often bridged with earnouts (contingent future payments) or seller notes (promissory notes where the seller acts as the lender). Poorly structured earnouts often lead to post-closing tension because the seller no longer controls the operations required to hit performance targets.

Mitigation

• Use Simple, Measurable Targets: If an earnout is necessary, base it on top-line revenue rather than net income, which can be easily skewed by how the buyer allocates overhead costs.
• Protect the Business Operations: Include covenants in the agreement requiring the buyer to adequately fund and support the business during the earnout period.
• Secure Seller Notes: Ensure promissory notes include clear interest terms, fixed payment schedules, and appropriate security or guarantees.

6. Unplanned Tax Consequences

Sellers often focus on the headline sale price and overlook how taxes will affect actual take-home proceeds.

The Risk

In an asset sale—or an equity sale structured for tax purposes as an asset sale—the way the purchase price is allocated across assets (such as equipment, inventory, and goodwill) dictates whether proceeds are taxed as ordinary income or capital gains. Unexpected depreciation recapture, state income taxes, or corporate double taxation can significantly reduce net proceeds.

Mitigation

• Calculate Net Proceeds Before Signing the LOI: Model the after-tax outcome under various deal structures before agreeing to exclusivity.
• Agree on Price Allocation Early: Include basic tax allocation principles in the preliminary term sheet to avoid negotiating against the buyer later in the process.
• Review Corporate Entity Status: Evaluate historical tax filings and entity classifications early to fix any potential compliance issues.

7. Broad Warranties and Post-Closing Liabilities

The risk of losing deal value does not end on the closing date.

The Risk

Purchase agreements contain representations and warranties where the seller makes specific promises about the state of the business. If these terms are too broad, or if the disclosure process is rushed, undisclosed issues (such as past employee misclassifications or uncollected sales tax) can trigger indemnity claims, forcing the seller to return funds held in escrow.

Mitigation

• Treat Disclosure Schedules Carefully: Thoroughly document and disclose all known exceptions, minor disputes, and historical issues. What is properly disclosed generally cannot form the basis of a later claim.
• Negotiate Clear Caps and Thresholds: Set reasonable liability limits, minimum claim thresholds (baskets), and time limits on how long representations survive post-closing.
• Consider Representation and Warranty Insurance: In mid-sized transactions, third-party deal insurance can replace large escrow holdbacks, allowing sellers to access more cash immediately at closing.

Planning Ahead

Protecting deal value is a practical process that works best when started well before negotiations begin.

• 12 to 24 Months Out: Review financial records, address customer concentration, and empower key managers to run day-to-day operations.
• Term Sheet (LOI) Stage: Clarify working capital mechanics, tax allocations, and earnout terms before granting exclusivity.
• Closing Stage: Complete thorough disclosure schedules and set clear contractual limits on post-closing liabilities.

By identifying potential issues early and setting clear terms from the outset, business owners can reduce transaction tension and ensure the agreed-upon value is fully realized at closing.