Letters of Intent
A Solidified Handshake
One of the first steps in the M&A process is negotiating and signing a Letter of Intent (“LOI”). Letters of Intent are non-binding statements of understanding between a seller and buyer that set forth the key terms upon which they intend to enter into an agreement. The LOI will typically be no more than 10 pages long and touch upon key deal points, leaving the finer deal points to be negotiated in the Purchase Agreement.
Even though most provisions in an LOI are non-binding, the signing of an LOI, much like an engagement ring in marriage, signals that the parties are serious about wanting to transact with one another. It is important to involve your attorney in the process from the beginning because if a key term isn’t negotiated in your favor or is otherwise left out of the LOI, it will be very difficult to renegotiate for its inclusion in the definitive Purchase Agreement. Also, the attorney will make sure to include specific language in the LOI to preserve its non-binding nature.
Some of the typical terms negotiated in an LOI include:
- Purchase Price – How much is the buyer paying? Will the buyer pay cash upfront or will a portion be paid over time in the form of debt? Will the debt be seller financed; for example, via a promissory note? Will a portion be paid in stock or equity of the acquirer? If so, what security will be offered? Will there be an earn out (i.e. part of the purchase price is based on the future performance of the company)? What purchase price adjustment mechanisms (such as a working capital adjustment) will come into play?
- Deal Structure – Will the deal be an asset sale or a stock/equity sale? There are significant legal and tax consequences to each structure to consider so involve your attorney and accountant in this process. For example, in general, a stock purchase will be more tax advantageous to a seller and an asset purchase will be more tax advantageous to a buyer.
- Escrow and holdbacks – Often times a portion of the purchase price will be held back or placed in escrow to cover future payments for past liabilities.
- Closing Date and Conditions – When will the deal close and under what conditions? What tasks, approvals and consents need to be in place on or before closing?
- Due Diligence – How will due diligence be conducted and for how long?
- Exclusivity – Due to the time and money put into completing the due diligence process plus drafting and negotiating the purchase agreement, a buyer will typically require the seller to stop entertaining offers from other buyers during a set exclusivity period. This typically runs anywhere from 30-90 days, or longer, depending on the complexity of the deal.
- Representations and Warranties – A large portion of the Purchase Agreement will be dedicated the Representations and Warranties of the seller (“Reps and Warranties”). The Reps and Warranties will determine risk allocation between the parties after closing. If the seller Reps and Warranties turn out to be incorrect, the seller may have to indemnify (reimburse) the buyer for future damages incurred, or the buyer may be entitled to set off a portion of the purchase price from a note payment, holdback or escrow amount. While standard Reps and Warranties probably won’t be listed in the LOI, if the buyer wants something that isn’t standard it may be included.
- Post-Closing Employment Offers – Will key members of the management team (or other employees) stay on post-closing? Under what terms? Will they be subject to a Non-Compete?
- Governing Law – Don’t assume all jurisdictions are the same.
- Confidentiality– This is one of the few clauses that is generally binding in an LOI. Due to the sensitivity of the information that will be disclosed during the due diligence process, it is paramount that such information be kept confidential, particularly when the buyer and seller are competitors.
After an LOI is signed, the due diligence process begins.
While from a legal perspective, LOIs are vital documents, they are not mandatory. As a result, inexperienced parties looking to save money might skip over this process and go straight to drafting a Purchase Agreement. This is particularly true in smaller deals where buyers are not relying on the LOI to provide preliminary documentation for lender or board approval.
However, the well-known proverb, “A stitch in time saves nine,” applies here. LOIs minimize wastes of time and money by setting the expectations and timelines for the parties and ensuring there is a common consensus before the parties invest significant time, money and energy into the acquisition process. Having an LOI in place will maximize the probability that the transaction will close and will minimize the probability of misunderstandings and renegotiations between the parties at a later date. Ultimately time is one of the top killers of deals and a lack of clarity of key terms at the LOI stage will ultimately slow the acquisition process and increase the likelihood that the deal will fall apart.