Some Say LOI’s Aren’t Worth the Paper They’re Printed On. We Disagree.
Signing a Letter of Intent (LOI) is a major milestone in any business sale transaction. It’s important to understand which elements of a well-constructed LOI are necessary and why, which are binding and non-binding, and which deal points should be negotiated in the LOI phase versus being deferred.
An LOI is more formal and detailed than an Indication of Interest (IOI). The LOI should include all relevant business terms that are part of the deal with enough details to prevent any misunderstandings later in the process. The buyer usually presents the LOI to the seller and it is very important that an experienced M&A attorney review a buyer’s LOI since the LOI is the framework that the attorneys will later use to develop the binding Purchase and Sale Agreement (PSA).
So why not just go straight to the PSA and skip the LOI? Because the LOI has sufficient detail for the parties to decide if there’s a deal to be had, and it also allows the seller to compare offers from multiple buyers before moving on to due diligence and the PSA with just one buyer.
A few trends have developed over the past decade or so on the level of detail included in LOI’s as well as the amount of time spent negotiating the terms included. Today, it is not uncommon for an LOI to go through multiple drafts and include more specific legal and financial provisions, especially those related to seller representations, warranties, and indemnification provisions.
Although an LOI is generally non-binding, there are a few terms that the parties will want to be binding.
Typical binding provisions include:
- Exclusivity (no shop provision)
- Access for due diligence
- Break-up fees
- Allocation of expenses
Typical non-binding provisions include:
- Deal structure (stock vs asset sale)
- Price and terms (type and timing of consideration)
- Plans for key employees post transaction
- Seller’s role post-closing
A well-crafted LOI should be something that both parties’ attorney can easily understand and incorporate into the PSA without too much negotiation. Be cautious if a buyer says, “let’s leave that for now and we’ll refine it in the purchase agreement.” Either they are sloppy, or they just want to get past the LOI stage so they’ll be the only buyer left in the process and have more leverage to negotiate important issues down the road. Negotiating terms in the LOI is often the only time the seller has leverage on key deal points.
If the buyer or their attorney are not accustomed to doing deals, then they may not be aware of all the elements of an effective LOI.
At a minimum insist that the LOI address the following:
- Purchase price and how and when it will be paid and the source of financing
- Stock sale vs asset sale
- Allocation of purchase price for asset sales (depreciation recapture can have a huge impact on the taxes you owe)
- Terms of seller notes or earnout (if any)
- Real estate lease details if seller is leasing facilities to the buyer
- Transition expectations for previous owners – how long, what are their roles, compensation? Working capital (how much is included and how is it defined?); Will receivables be guaranteed? What assets and liabilities are included and excluded?
- Is there excess cash, who gets it and how is it defined?
- Specifics of any non-compete agreements
- Any contingencies – employee interviews, financing, assignment of contracts, Phase 2 environmental assessment, etc.
- Holdbacks or any non-standard representations, warranties or indemnifications
- Due diligence timing and requirements
- Will a quality of earnings report or other level of financial review be required and who will pay for it?
- When will certain sensitive information such as detailed customer lists be shared? Waiting until after the purchase agreement is signed or even after money is in escrow prior to close might make sense
- Expected closing date
- An exclusivity period is common, but make sure it has a time limit (say 90 days) where you can go talk to other buyers if things aren’t working out; remember, a buyer’s failure to meet deadlines should end the exclusivity granted to them in the LOI
- Timing on announcements to employees, suppliers, and customers
This is not a complete list, but covers many of the common terms that should be addressed. The less that both buyer and seller assume the better.
We advise that you consult your M&A advisor, attorney and tax advisor before signing an LOI. By being organized, having experienced advisors, and knowing which aspects of an LOI to focus on, you will be able to:
- Maximize value
- Improve your probability of closing the transaction on your terms
- Reduce the time from signing the LOI to having money in your bank account
LOI’s are certainly worth more than the value of the paper they are printed on, and the color of that paper is green!