Congratulations! You've conquered numerous milestones in establishing and operating your business, and the next step in your entrepreneurial journey may be to consider an exit strategy. Alternatively, perhaps you're considering buying a company. Given the market trends and expansion of eCommerce in recent years, M&A activity abounds.
Execution of a letter of intent (“LOI”) is often viewed as the official kick-off of an M&A transaction. As a practical matter, LOIs are also used in many other types of commercial transaction, such as real estate deals, loan transactions, contract amendments, and more. In this blog post, we explore six important tips for drafting an effective LOI, from the perspective of both buyers and sellers.
The Law Office of Jennifer M. Settles assists clients in strategizing, negotiating and drafting protective and favorable LOIs. Please contact Jennifer M. Settles, Esq. at (602) 617-3938, or through the Contact Form on our website, www.jsettleslaw.com, for more information and a FREE initial consultation.
1. Understanding The LOI
An LOI is a short document (usually about 2-4 pages, but could be longer) executed by each party to the transaction, which lays out the basic terms of the proposed transaction. Although LOIs are typically non-binding (with certain exceptions), LOIs are important in that they effectively demonstrate that the parties see eye to eye on the key terms of the proposed transaction, and that the parties are serious, or at least somewhat serious, about moving forward with next steps.
In some cases, one or both parties may execute an indication of interest (“IOI”), term sheet or memorandum of understanding (“MOU”) in lieu of an LOI. Whether titled as an LOI, IOI, term sheet or MOU, these documents essentially serve the same purpose - namely, to lay out the principal terms of a proposed transaction. For ease of reference, in this blog post we will refer to the document as an LOI.
The LOI provides the framework for the terms and conditions that will be included in the definitive transaction agreements. Generally, the more detailed the LOI, the less difficult it may be to negotiate the definitive transaction agreements later, because the framework for the terms will have already been established in the LOI. Conversely, a less-detailed LOI may generally necessitate a greater amount of negotiation work at a later stage of the transaction. A party can be strategic about how detailed or non-detailed the LOI should be, taking into account such factors as the number of potential bidders at the LOI stage, the speed with which the party desires to finalize the LOI and closing, relative bargaining strength, and other considerations. An experienced business broker or business attorney is a good resource for preparation of the LOI.
2. Terms Included In An LOI
Although the details will vary by transaction, an LOI typically includes some or all of the following terms:
- Identification of the parties to the transaction;
- Description of the subject of the transaction and the assets to be sold in the transaction;
- Purchase price;
- Payment terms, including whether the purchase price will be payable in full in cash at closing or whether a deferred or contingent component such as a promissory note or earnout will be involved;
- Timing or target dates for the completion of due diligence and closing;
- Whether the transaction will be structured as an asset sale, equity sale or merger;
- Whether the seller will be subject to a non-compete obligation upon closing;
- Whether the seller will be required to provide transition assistance upon closing;
- Contingencies to closing;
- Whether an escrow or monetary holdback will be required at closing;
- Legal terms to be included in the definitive agreements, such as representations, warranties, indemnification, survival periods, dispute resolution and choice of law;
- Confidentiality requirements;
- Exclusivity requirements; and
- Other special or atypical terms.
3. Who Prepares The LOI
Typically, the buyer (with assistance of legal counsel) prepares the LOI and sends it to the seller (or seller's legal counsel or broker). Like any legal document, an LOI must always be carefully negotiated, drafted and reviewed by each party before execution. Using a canned LOI from an online source or recycled from a prior deal, or simply signing an LOI without truly negotiating or understanding its terms, could be a significant mistake.
Pro Tip: Although often bypassed at this stage of a transaction, for optimal results, each party should be represented by its own legal counsel in the negotiation, drafting and review of an LOI. Using legal counsel can be extremely valuable, often saving the parties from disagreements, delays or problems at a later stage of the transaction and helping to ensure that the desired favorable terms are captured in the LOI.
4. Non-Binding, With Exceptions
Typically, an LOI expressly provides that it is nonbinding on the parties, with the exception of certain binding aspects (discussed below). This is significant, in that a non-binding LOI does not constitute an enforceable contract (other than with respect to the binding provisions), and therefore either party may terminate the transaction negotiations without liability. Stated alternatively, a non-binding LOI cannot be relied upon to require parties to move forward with the proposed transaction. Of course, as it is often said, “the devil is in the details”. Depending on the terms, LOIs can vary as to their binding or non-binding nature, and a party must always understand the implications of termination of the proposed transaction (including legal, practical and relationship) before opting to terminate. Legal counsel can help parties negotiate and understand these requirements.
5. Binding Provisions
Often, an LOI contains binding provisions with respect to confidentiality and exclusivity. This means that if the LOI is terminated, the binding provisions will nonetheless continue to exist and be binding upon the parties. As a result, buyers and sellers must be especially careful in negotiation and drafting of the binding provisions, and must be prepared to comply with their requirements.
- Confidentiality. A confidentiality provision ensures that the proposed buyer will keep the seller's business and proprietary information confidential. A confidentiality clause may also require both parties to keep the fact that they are in discussions with one another, and the terms of such negotiations (i.e. deal pricing), confidential. Both parties must carefully negotiate and draft any confidentiality provisions in an LOI, and must ensure that their respective representatives (i.e., the members of their respective deal teams, including employees, consultants and other agents) understand and comply with the confidentiality obligations, as applicable. Breach of confidentiality can be embarrassing, harmful to the relationship, and can even result in legal liability. In lieu of including a confidentiality provision in an LOI, it is perfectly acceptable for the parties to enter into a confidentiality or nondisclosure agreement (NDA) as a separate agreement.
- Exclusivity. An exclusivity provision (sometimes called a “no-shop” or “lock up” clause) restricts the seller and its principals from negotiating a transaction for the sale of the business (i.e., “shopping” the business) with anyone other than the buyer, for a specified period of time. From the buyer's perspective, exclusivity is important because the buyer will be spending time and resources performing due diligence and therefore needs a level of certainty that the seller will not simply grant the deal to someone else at an early stage. From seller's perspective, the exclusivity period serves to “lock-up” seller, prohibiting negotiating with other parties. Accordingly, sellers typically seek a short exclusivity period, to ensure that they are not precluded from shopping the deal to other potential buyers for an unnecessarily long period of time. A short exclusivity period will also serve to keep the pressure on the buyer to proceed swiftly through due diligence and closing.
6. Establishment of Deal Terms
While it is true that an LOI is typically non-binding (other than the binding provisions, which are discussed above), an LOI must nonetheless be carefully negotiated and drafted before execution. The LOI lays out the basic deal terms for the pending transaction. As a practical matter, once an LOI is signed, deviating from its terms when negotiating the definitive transaction agreements can be difficult. A party seeking to modify terms that were agreed upon in an LOI may be viewed as engaging in “bait and switch”, re-trading terms, or otherwise acting in bad faith. Thus, unless there is a good reason for doing so (such as adverse findings during due diligence), seeking to change material terms of an LOI should generally be avoided. Seeking to re-trade terms can be frustrating for the counterparty and can lead to distrust . . . which is never a good way to start a negotiation process.
Moreover, including well thought-out terms in an LOI will give a party the upper hand when it comes time to negotiate and finalize the definitive transaction agreements. For example, if the buyer wants a portion of the purchase price to remain in escrow post-closing as security for seller's indemnification obligations, the buyer will have a much easier time negotiating for that concept in the definitive agreement if the concept was already addressed in the LOI. Similarly, from seller's perspective, if the seller wants a seller-friendly term to be included in the definitive agreement (a one-year survival period for seller's representations and warranties, as opposed to a five year survival period, for example) it could behoove the seller to negotiate for this at the front end of negotiations, in the LOI.
Pro Tip: Simply stated, even though LOIs are largely non-binding, it is generally easier to secure more favorable final deal terms to the extent those terms have been negotiated and set forth in the LOI. Taking the time to negotiate a strong and favorable LOI is often well worth the effort.
Carefully crafting an LOI is an important early step in M&A and other commercial contract transactions and is well worth the time and effort. By having a reasonably robust LOI in place, buyers and sellers can proceed confidently to the next steps of the transaction, focusing their efforts on due diligence and preparation of the definitive agreements that protect their interests. The Law Office of Jennifer M. Settles is available to assist clients in negotiating and drafting protective and favorable LOIs. Contact Jennifer Settles today at (602) 617-3938, or though the Contact Form on our webpage, www.jsettleslaw.com, for more information and a FREE initial consultation.
Jennifer M. Settles, Esq. is a corporate lawyer at the Law Office of Jennifer M. Settles. She advises clients on M&A transactions, commercial contracts, real estate matters, financing transactions and corporate law. To schedule a free consultation with Jennifer, please call 602-617-3938, or connect through the Contact Form on the website.
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