What Middle-Market Sellers Should Expect in a PE Deal Process: LOI to Close

Circular 230 / general information notice. This article is general information only. It is not tax, legal, or accounting advice. Reading it does not create an attorney-client relationship. Tax results depend on your facts and on law that can change. Consult your own attorney and CPA before taking any action. This article was not written to be used, and cannot be used, to avoid tax penalties.

A sale to a private equity buyer moves through a predictable sequence: NDA, indication of interest, letter of intent, confirmatory diligence, definitive agreements, and closing. The sequence is familiar. What surprises sellers is how much of the economics is fixed at the LOI stage, before the lawyers draft a purchase agreement, and how little bargaining power remains once exclusivity starts. This article is a seller's map, with the LOI provisions, the tax structuring math, the Texas-specific closing items, and the points where middle-market deals tend to stall.

The LOI: what binds and what does not

Most LOIs say the economic terms are non-binding and a handful of provisions are binding. A typical binding-provisions clause:

"Except for the provisions of Sections 7 (Exclusivity), 8 (Confidentiality), 9 (Expenses), and 10 (Governing Law), which are intended to be and shall be legally binding, this letter is a non-binding expression of interest and does not create any obligation of either party to negotiate or to enter into any transaction. No such obligation shall arise unless and until a definitive agreement has been executed and delivered by each party."

The last sentence matters under both Texas and Delaware law. In John Wood Group USA, Inc. v. ICO, Inc., 26 S.W.3d 12 (Tex. App. Houston [1st Dist.] 2000), the court held a letter of intent non-binding where it expressly said its sale terms were not binding and contemplated a definitive purchase agreement. Texas courts apply ordinary formation rules, so an LOI that reads like a contract and omits that language can be enforced as one. Delaware adds a different risk. In SIGA Technologies, Inc. v. PharmAthene, Inc., 67 A.3d 330 (Del. 2013), the Delaware Supreme Court held that a party that breaches an express obligation to negotiate in good faith toward a term sheet's terms can owe expectation damages if the parties would have reached agreement absent the bad faith. A seller should not sign an LOI with a binding "good faith negotiation" covenant it does not intend to honor, and a buyer should not sign one unless it is ready to be held to the stated terms.

The exclusivity clause is where the seller gives up bargaining power:

"For a period of 60 days after the date of this letter (the "Exclusivity Period"), the Company and its equityholders shall not, and shall cause their representatives not to, solicit, initiate, knowingly encourage, or engage in discussions or negotiations with any person other than Buyer regarding any sale of the Company or its material assets. The Exclusivity Period shall terminate automatically if Buyer proposes any reduction in the Purchase Price or any material change in the structure or terms described in this letter."

Notes:

1. Sixty days is a negotiated number. Buyers ask for 90 with automatic extensions. Sellers should resist automatic extensions or condition them on the buyer having delivered a full purchase agreement draft and committed financing.

2. The fall-away sentence at the end is the seller's strongest protection. A buyer that retrades price ends its own exclusivity.

3. "Knowingly encourage" keeps the seller from breaching because a banker answered an unsolicited call.

What should be settled in the LOI

At minimum: enterprise value and the definitions it assumes (cash-free, debt-free, a normalized working capital peg), structure (equity or assets, and any tax election), the rollover percentage and its tax treatment, the escrow or R&W insurance approach, the employment or consulting terms for founders, and the exclusivity terms above. Price is not the same as proceeds. A $30,000,000 stock sale and a $30,000,000 asset sale can leave a seller with materially different after-tax cash, depending on entity type, asset mix, depreciation recapture, and whether a corporate-level tax applies. Model both before signing the LOI.

The debt definition deserves a sentence of its own. If the LOI says "debt-free" without listing what counts as debt, expect the purchase agreement draft to include deferred revenue, accrued but unpaid bonuses, unpaid pre-closing income taxes, and deferred rent. Each of those reduces price dollar for dollar. Negotiate the list in the LOI, while the seller still has alternatives.

Structure: why the buyer wants basis, and what it is worth

Buyers prefer an asset purchase, or an equity purchase treated as an asset purchase for tax purposes, because it gives them a cost basis in the target's assets. Goodwill and most other acquired intangibles are amortized over 15 years under Section 197. Since the One Big Beautiful Bill Act, 100% bonus depreciation under Section 168(k) is permanent for qualified property acquired after January 19, 2025, which makes a step-up in tangible equipment more valuable to a buyer than it was during the phase-down.

Put numbers on it. If a step-up creates $10,000,000 of additional basis in goodwill, the buyer deducts about $666,667 per year for 15 years. At a 21% corporate rate, that is roughly $140,000 per year of tax savings, or about $2,100,000 undiscounted. Discounted at 10%, the present value is closer to $1,065,000. That present value is the most a rational buyer should pay for the structure, and it is the number a seller should have in mind when asked to accept a structure that costs the seller tax.

The 338(h)(10) and 336(e) elections

A Section 338(h)(10) election treats a qualified stock purchase as a sale of assets followed by a liquidation. It requires a corporate purchaser that acquires at least 80% of the target's stock by vote and value within 12 months, and the target must be an S corporation or a member of a selling consolidated or affiliated group. For an S corporation target, every shareholder must consent, including any who do not sell. The election is made on Form 8023 by the 15th day of the ninth month beginning after the month that includes the acquisition date.

Many PE buyers acquire through partnerships, which are not corporate purchasers for Section 338 purposes. A Section 336(e) election can work instead for a qualified stock disposition, and the purchaser need not be a corporation. For an S corporation target, the S corporation and all of its shareholders, including non-sellers, must enter into a written, binding agreement to make the election, and the election statement is attached to the S corporation's return for the year that includes the disposition date. A third path for S corporations is the pre-closing F reorganization, which I cover in pre-closing F reorganizations for S corporation targets.

The gross-up, worked

Suppose an S corporation seller agrees to a $20,000,000 equity price, and the buyer later asks for a 336(e) election. The CPA estimates that the deemed asset sale increases the shareholders' combined federal tax by $600,000, mostly from ordinary-income depreciation recapture. If the gross-up payment itself is taxed at an assumed 23.8% combined capital gain rate, a payment of $600,000 leaves the seller $457,200 after tax, which is not enough. A full gross-up solves for X where X minus 23.8% of X equals $600,000. That is $600,000 divided by 0.762, or about $787,402.

A gross-up clause:

"Buyer shall pay to the Sellers an amount (the "Election Gross-Up") equal to the excess of (a) the aggregate U.S. federal income Taxes payable by the Sellers as a result of the Section 336(e) Election, computed using the Assumed Tax Rates and the Allocation Schedule, over (b) the aggregate U.S. federal income Taxes that would have been payable by the Sellers had no such election been made, increased by any Taxes payable on the Election Gross-Up itself; provided that the Election Gross-Up shall not exceed $850,000."

Notes: "Assumed Tax Rates" avoids a fight over each seller's personal return. "Allocation Schedule" ties the gross-up to an agreed Section 1060 allocation. The cap reflects that the buyer's benefit from the step-up has a ceiling too, which is why the present-value math above matters. State taxes are a separate negotiation and should be addressed expressly. Texas has no personal income tax, but sellers who live elsewhere may.

Rollover equity

Most PE buyers ask founders to roll a portion of their equity. If the buyer's holding company is a partnership, the rollover is usually a contribution under Section 721. If it is a corporation, Section 351 requires the transferors as a group to control at least 80% immediately after the exchange, which is hard to meet alongside a sponsor unless the sponsor's cash is contributed as part of the same plan. In a deal with a deemed asset sale, the election can trigger gain on the rolled portion before the rollover is issued, so the structure needs separate modeling. I discuss the terms in rollover equity in private acquisitions.

Diligence and the Texas-specific items

Legal diligence usually surfaces the same categories: assignment and change-of-control clauses, gaps in equity paperwork, contractor IP assignments, customer concentration, and related-party arrangements. Tax diligence focuses on payroll and worker classification, sales tax nexus, and for S corporations, the validity of the S election. A broken S election can make a planned 338(h)(10) or 336(e) structure unavailable.

For Texas targets, three items come up repeatedly in asset deals.

First, successor liability for state taxes. Under Texas Tax Code Section 111.020, a purchaser of a business or its stock of goods must withhold enough of the purchase price to cover the seller's unpaid Texas taxes until the seller produces a Comptroller receipt or a certificate that no tax is due. A purchaser that fails to withhold is liable to the extent of the purchase price. The Comptroller's current process requires the seller and purchaser to jointly submit Form 86-114, and the certificate protects only the purchaser. Request it early, because the statute gives the Comptroller up to 60 days, and in some cases up to 90 days, to respond.

Second, sales tax on the asset transfer. Texas Tax Code Section 151.304 exempts an occasional sale of the entire operating assets of a business, or of a separately identifiable segment, to a single purchaser. A sale split among multiple buyers can lose the exemption, and inventory is handled separately under the resale rules.

Third, franchise tax. Texas franchise tax reports and the seller's final report status affect the Certificate of No Tax Due and the seller's ability to wind up a selling entity cleanly. Have the CPA confirm the entity's franchise tax status before the LOI is signed.

Definitive agreements

The purchase agreement, disclosure schedules, escrow agreement, employment or consulting agreements, restrictive covenant agreements, and a transition services agreement if needed. The negotiation centers on price adjustments, indemnity, reps, tax covenants, and closing conditions. If a tax election is part of the deal, the agreement should include a cooperation covenant, the gross-up formula, an allocation schedule consistent with Section 1060 and Treas. Reg. § 1.338-6, and a dispute procedure for allocation disagreements. I cover the price mechanics in working capital true-ups, earnouts, sandbagging, and RWI.

Restrictive covenants on founders are usually part of the price. Texas enforces a non-compete ancillary to the sale of a business under Business and Commerce Code Section 15.50 if it is reasonable in time, geography, and scope of activity, and the sale-of-goodwill context generally supports broader terms than an employment covenant. In an asset deal, an amount allocated to a seller's covenant not to compete is a Section 197 intangible to the buyer and ordinary income to the seller, so the allocation deserves negotiation rather than a default.

Closing and after

Closing is a funds flow memo, payoff letters, lien releases, consents, equity transfer documents or bills of sale, officer certificates, and the escrow. Model net proceeds after debt, transaction expenses, escrow, the working capital true-up risk, and taxes. After closing, calendar the true-up deadlines, any earnout measurement dates, the election due date, and the Form 8594 or Form 8883 filings.

Where deals stall

In my experience, the stalls tend to come from four places: a debt definition that was never settled, a buyer request for a tax structure that was not in the LOI, consents that were not mapped early, and disclosure schedules started too late. Each is cheaper to fix before exclusivity starts than after.

How I can help

I advise sellers and buyers on middle-market PE processes from the NDA through closing, and I coordinate with the client's CPA on the structuring and tax model. Office: 1921 Greenville Avenue, Suite 200, Dallas, TX 75206. See also private equity and M&A.

Next step

For a consult on your facts, email info@robertsandwillie.com or call (469) 910-4017. Sending a message does not create an attorney-client relationship.

Disclaimer. This article is for general information only and is not tax, legal, or accounting advice. It does not create an attorney-client relationship. Tax law changes and depends on your specific facts. Do not act on this article without consulting your own attorney and CPA. This article is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or other applicable law. Attorney Advertising. Roberts & Willie, PLLC, Dallas, Texas; Trenton Roberts, responsible attorney.