Why is the Letter of Intent (LOI) so Important?

LOI

Why is the Letter of Intent (LOI) so important? Because, in the context of a sale process, 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 requires the seller 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 a document 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).

What is the purpose of an LOI?

The letter of intent is a bridge between discussions and a binding contract.  If carefully negotiated, an LOI can serve to protect both parties to the transaction.  The LOI might be seen as the second step in pursuing a transaction, the first one being the NDA.  Beyond keeping discussions confidential, an NDA can include a non-solicitation provision, which would restrict the buyer’s ability to hire an employee 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 a condition that the transaction is subject to securing acceptable financing for the transaction.

A party that has signed a letter of intent may be legally bound to it depending on how the letter is drafted. In a business-to-business transaction, a letter of intent normally contains a provision stating the letter is non-binding.  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.[2]
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 and Due Diligence Requirements, Exclusivity, Access and Cooperation, Confidentiality, Expenses, Approvals, Governing Law, etc.

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:
“All representations and warranties shall survive the closing for one year, subject to customary exceptions for taxes, fundamental corporate matters and intellectual property, which shall survive longer. Indemnification will be limited to 25% of the Purchase Price except for (a) issues related to taxes payable and IP ownership which will not be limited and (b) issues related to capitalization, authorization, organization, and subsidiaries which will be limited to Purchase Price. Indemnification will be limited in time to twelve months except for (a) taxes which will be limited to the statute of limitations plus 60 days, and (b) IP which will be indefinite. There shall be an aggregate basket of $100,000 for all claims going back to first dollar if breached.”

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.

LOI Sample

The following are good resources for free LOI samples:

Law Depot Free Sample

How to Write a Letter of Intent

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

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