If you have ever discussed the process of selling a business with an owner who has been through it, he or she likely mentioned the term “letter of intent” or “LOI” at some point during your conversation. The LOI is a key document that denotes a major transition in the sale process. Essentially, it’s a legal document that attempts to provide both buyer and seller with enough comfort and certainty to move forward into due diligence and negotiation of a transaction.
A poorly thought out LOI can result in disputes between the parties, “re-trading” whereby the buyer (after conducting some measure of due diligence) attempts to drive down the purchase price it previously proposed in the LOI, or in the worst case scenario, a termination of the parties’ dealings after months of painstaking due diligence and negotiations. Unfortunately, this is often a well formed strategy for buyers who are dealing with inexperienced sellers. It’s like putting a contract on a house and then beating up the buyer after an inspection with repairs and concessions. The LOI is a critical step; it documents the transition from a broad market auction or the ability to run a broad market auction (wherein the seller typically has more leverage because it’s being pursued by or has the ability to market to multiple buyers) to the exclusive due diligence period which inherently shifts leverage to the chosen suitor. However, the buyer’s leverage can be limited to a large extent through a strategically drafted LOI that protects the business owner and maintains leverage in the transaction.
So what is an LOI? It is a legal document that is signed by the buyer and seller to a proposed transaction. The LOI provides a preliminary statement of basic deal terms upon which the parties wish to enter into binding, definitive agreements following due diligence. An LOI typically contains both binding and non-binding provisions.
The parties to a transaction will sign a LOI for a number of different reasons, the most common of which are: to clarify the essential terms and time frame of the transaction; demonstrate the parties’ commitment to consummating a transaction; increase efficiency in the transaction process; incentivize the buyer to devote more resources to the transaction by providing exclusivity; create preliminary documentation to lenders so that the buyer can arrange financing; and, if necessary, “start the clock” on the 30-day waiting period for Hart-Scott-Rodino antitrust approval.
There are no required terms in a LOI. At a minimum, most LOI’s include the following:
- a description of the transaction (e.g., asset or stock purchase);
- principal deal terms (e.g., structure, consideration and purchase price);
- binding terms regarding the negotiation process (e.g., confidentiality, exclusivity, non-solicitation of key employees, customers and suppliers, etc.);
- provisions that will survive the LOI’s termination or expiration;
- requirements and scope of due diligence;
- requirements concerning cooperation by the parties;
- final deadline for execution of the definitive purchase agreements;
- allocations for payment of the parties’ expenses;
- governing law; and
- conditions precedent for consummating the proposed transaction (including any corporate, governmental and other required approvals or consents).
In a typical letter of intent, the substantive deal terms (e.g., price, transaction structure, and form(s) of consideration) are non-binding. However, the rules governing the process for the negotiation period are normally binding. Such rules include: buyer access to seller’s information; cooperation by the parties; seller’s exclusivity obligations; seller’s obligation to conduct its business in the ordinary course; LOI termination or expiration; confidentiality; allocation of the parties’ expenses; and governing law. These process-related terms will dramatically impact a business owner’s bargaining position in the post-LOI due diligence phase, and an experienced M&A advisor will be proficient at negotiating the terms in a way that maximizes the seller’s post-LOI leverage and minimizes the risk of a failed transaction.
It is rare that the parties will make an entire LOI binding, but this will sometimes occur in a highly competitive transaction. If the parties decide they want a binding LOI, the seller should be sure to include as many key terms as possible that are crucial to its decision to sell, as there is a substantial likelihood that full definitive agreements are never reached and the parties will need to rely on the term sheet.
In addition to the binding provisions of an LOI, the parties will sometimes feel a “moral obligation” to comply with the key deal terms stated, such as purchase price, form of consideration, and acquisition structure. Without some type of justification – e.g., material negative information discovered about the seller during the due diligence process – parties are often reluctant to break their commitment and revise key terms, although they are not legally bound to honor them. For example, M&A advisors often negotiate to have a specific purchase price stated in the buyer’s LOI, which provides the seller a built-in “high ground” to resist any buyer attempt to re-trade based on its due diligence findings.
Advantages and Disadvantages of Signing a Letter of Intent
There are both advantages and disadvantages to signing an LOI, which a seller must strategically evaluate. On the plus side, the LOI identifies what each party perceives as material deal terms (and deal breakers) at an early stage of the process. The LOI can therefore confirm the parties’ alignment and provide greater certainty of close. On the other hand, the LOI negotiation process may cause the parties to realize they cannot reach an agreement on key deal terms, and importantly, understand this fact early before wasting significant time and resources in due diligence.
Other advantages of an LOI include: reduction of time and cost to negotiate definitive agreements; establishing milestones with a timeline to move the process forward; providing documentation for the buyer to secure financing; signaling the parties’ commitment to consummate a transaction; establishing consistent expectations about the due diligence process; and facilitation of regulatory compliance.
Disadvantages of an LOI include: increased expense by adding another layer of negotiation and legal drafting into the process; loss of seller’s leverage by entering into an exclusive LOI; danger to buyer of agreeing upon detailed terms prior to conducting due diligence; and ambiguous drafting, which can result in the inadvertent creation of binding commitments, or an unintended duty to negotiate in good faith.
Another major disadvantage to be aware of is that an LOI can sometimes limit the parties’ future negotiating positions. Thus, it is important for the parties to include in the LOI all of their conditions precedent, “must haves,” milestone dates, etc., so that they clearly document their positions and “deal-breakers.”
Impact on Leverage and Negotiating Strategy
Due to the substantial implications of entering into an LOI, some key questions to consider prior to doing so are: Which party currently has the leverage, and will that change after signing an LOI? How do I structure the LOI terms to maintain my leverage or reduce the other party’s bargaining position? Would it be advantageous for me to have a more or less detailed LOI?
From a seller’s perspective, signing a poorly-negotiated LOI can cause a significant leverage reduction because most LOI’s require exclusivity obligations toward the buyer. As a result, by signing an LOI the seller has eliminated, at least during the exclusivity period, the competitive nature of the market process. However, the seller can mitigate the potential loss of bargaining power through a well-negotiated LOI. For example, skilled sell-side advisors can use the information asymmetry between the parties to include more specific terms (e.g., purchase price and deal structure) and lock these terms into place. The seller may also reduce the loss of a competitive auction by including terms that will maintain its flexibility while locking in the buyer. Specifically, the seller can insist on termination rights if the buyer proposes changes to key deal terms, or fails to meet deadlines for completing due diligence or delivering drafts of definitive agreements. The LOI can also be negotiated to have a short exclusivity period, impose financial penalties (e.g., break-up fees) that are reasonable under industry standards, and prohibit solicitation of key employees, customers or suppliers.
From a buyer’s perspective, and in light of the likely information asymmetry, buyers will often prefer a less specific LOI to allow for key term adjustments depending on the outcome of due diligence. Buyers will also push for a longer exclusivity period to enable more thorough due diligence and reduce interest from other potential buyers. Buyer-friendly provisions include caveating key deal terms through seller representations, warranties, covenants and indemnification, which provide the buyer with the ability to revise the terms as a result of due diligence findings. In addition, buyers often like to hedge their proposed purchase price in the LOI by including a range rather than a specific amount, or through escrows, holdbacks or earn-outs that will preemptively avoid later arguments about drafting such protections into the definitive agreements.
Ultimately, the unique facts of each deal will dictate whether an LOI should be the initial step in documenting a transaction. In deciding whether to enter into an LOI, major factors to consider include the deal’s complexity, time frame for completion and likelihood that an LOI will speed up the process, cost constraints, and necessity of an LOI to ensure that definitive agreements can be reached. An experienced M&A advisor provides a great deal of value to business owners in the LOI negotiation process by maintaining seller leverage, maximizing the certainty of close, and minimizing the risk of buyer “shenanigans” such as re-trading or demanding contingent or deferred payment of the purchase price.
About Founders Investment Banking
Founders Investment Banking (Founders) is a merger, acquisition & strategic advisory firm serving middle-market companies. Founders’ focus is on oil and gas, SaaS/software, industrials, internet, digital media and healthcare companies located nationwide, as well as companies based in the Southeast across a variety of industries. Founders’ skilled professionals, proven expertise and process-based solutions help companies access growth capital, make acquisitions, and/or prepare for and execute liquidity events to achieve specific financial goals. In order to assist Founders Investment Banking with securities related transactions certain Principals are registered investment banking agents of M&A Securities Group, Inc., member FINRA/SiPC. M&A Securities Group and Founders are not affiliated entities. For more information, visit www.foundersib.com.