Why is the Letter of Intent so important?
Because, in the context of a business sale, it marks the critical point where power shifts from the seller to the buyer.
What I mean by this is that an LOI typically includes a term requiring exclusivity. Exclusivity means the seller has to stop engaging with other possible buyers and focus exclusively on negotiating with the counter party to the LOI. Buyers require exclusivity because, subsequent to signing an LOI, they will spend substantial resources to close the transaction and this will include costly third parties such as lawyers and due diligence resources (for example technology auditors, financial auditors, etc.). They wont want to invest in this process if the seller is not committed to the deal.
The seller has power while they have options (i.e. pre LOI), and therefore a letter of intent is a critical document in a sale process.
What is an LOI?
A letter of intent is typically a several page letter outlining a series of agreements between two parties before the agreements are finalized. The final and complete document is the purchase and sale agreement (PSA). The concept of an LOI is similar to a term sheet or memorandum of understanding (MOU).
When is an LOI used?
The first letter that outlines the value and structure of a potential acquisition is called an Indication of Interest (IOI) or Expression of Interest (EOI). This is typically based on limited information and is used as a gating mechanism to asses whether parties should be proceeding in a sale process. An LOI is a much more serious document and forms the basis for a purchase and sale agreement.
What is the purpose of an LOI?
The letter of intent is a bridge between discussions and a binding contract. An LOI can serve to protect both parties to the transaction. For example, an LOI might include a non-solicitation provision, which would restrict the buyer’s ability to hire employees of the seller’s business should the two parties not be able to close the transaction. On the other hand, an LOI will protect the buyer of a business by including conditions such as the transaction being subject to securing acceptable financing. Other purposes of an LOI are:
- To allow parties to agree on fundamental terms quickly before expending substantial resources on negotiating definitive agreements
- To evidence or announce that parties are negotiating a more substantial deal
Is an LOI legally binding?
A letter of intent is typically partially biding and partially non biding. The non binding part would pertain to requiring to complete the transaction on the exact proposed terms, whereas the binding part usually applies to confidentiality, governing law etc. An example of this language is as follows:
“This document is an expression of the intent of the parties only, and nothing herein shall create any legally binding obligation except as to those matters referred to under paragraphs 9, 10 and 11, which provisions shall be binding upon the parties.”
An LOI may sometimes be interpreted by a court of law as binding the parties to it if it too-closely resembles a formal contract and does not contain clear disclaimers.
What should an LOI include?
An LOI will generally contain the following components:
- an introduction and the rationale for the LOI;
- form of consideration, including cash, earn-out, vendor note (i.e. payment over time), hold-back, equity rollover (i.e. accepting buyer shares);
- seller participation (i.e. time frame), compensation and management roles;
- any specific conditions such as subject to more information, seller operating performance, buyer financing etc.
In addition LOIs contain a number of boilerplate terms such as: subject to a definitive agreement, timing – how long the offer is valid for, Due Diligence Requirements, Exclusivity, Access and Cooperation, Confidentiality, who pays what expenses including any applicable fees to brokers, what approvals are required to complete a transaction, the governing law of the offer, etc.
The following are examples of some such clauses:
Exclusivity and Other Negotiations. Seller agrees to an eight (8) week exclusivity period beginning on the date this letter is countersigned by the Seller. From the date of execution of this letter and through the foregoing exclusivity period, it is hereby agreed that neither Seller, nor any shareholder, director, officer or employee thereof, shall, directly or indirectly, engage in or enter into any agreement, discussion, or negotiation with, or provide information to, or solicit, encourage, entertain or consider any inquiries or proposals from, any other corporation, firm or other person or entity with respect to (a) the possible disposition of a material portion of Seller’s business or assets, or (b) any business combination involving Seller, whether by way of merger, consolidation, share exchange or other transaction. From the date of execution of this letter and through the foregoing exclusivity period, it is hereby further agreed that Seller shall run its business in the ordinary course of business.
Seller understands and agrees that Buyer is bearing expense to perform due diligence and both parties are moving forward in good faith to consummate the transaction contemplated herein.
Seller shall notify Buyer in writing immediately if, during the exclusivity period, Seller or any of its affiliates or representatives receives any indication from any third party (including any third party with whom Seller may have previously been having negotiations prior to the date of this letter) that such third party may wish to have discussions with a view to a possible transaction involving all or any part of Seller or its assets or business.
Such exclusivity period shall be terminated in the event that (a), Buyer ceases to complete due diligence or (b), informs Seller of its intent to discontinue negotiations.
Access and Cooperation. Seller will ensure that during the exclusivity period, and for such additional period as the parties may mutually agree, Buyer and its representatives will have full access to Seller, its assets (including any subsidiaries), officers, employees, counsel, auditors, books and records; full opportunity to investigate Seller’s (and its subsidiaries’) properties and assets, technology, business and liabilities; and full opportunity to review Seller’s business plan and sales pipeline with key employees. Such due diligence shall also include discussions with agreed upon customers once Buyer has completed most other due diligence and the definitive agreement has been materially negotiated.
Expenses. Buyer and Seller shall each bear its own costs related to the proposed Acquisition, including the fees and expenses of its financial advisors, lawyers and accountants.
Approvals. It is hereby understood that Buyer will require customary approval from its Board of Directors, its shareholders, and its financing source prior to signing the acquisition agreements.
Definitive Agreement. We anticipate that the acquisition agreement will contain representations and warranties, closing conditions, and other provisions customary for a transaction of this type.
What makes a great LOI?
A great LOI is one that anticipates issues going forward and addresses them ahead of time. Essentially a point form PSA that then makes drafting the PSA a very straightforward process.
Buyers are typically more experienced than sellers in the M&A process. There are many companies and private equity groups that buy many companies but seller usually only sell once. When sellers first see the extent of the reps and warranties they will be asked to represent it can be overwhelming. A good LOI includes the main reps and warranties so that they will not come as a surprise in the PSA. The following is an example reps and warranties summary:
A good LOI prevents stumbles during the final negotiations where “deal fatigue” can result in small items derailing a closing. That is why the LOI is so important.
The following are good resources for free LOI samples:
Recommended Further Reading
For more on other documents used in a sale process, see: Terminology
For more on the Purchase and Sale Agreement, see: The Purchase and Sale Agreement Explained