Understanding a Letter of Intent in an M&A Transaction
At some point in the negotiations between the potential Buyer and Seller of a business there will be discussion of putting the negotiated terms into writing. The business principals on both sides will want to confirm their discussions and provide a roadmap for the transaction. To accomplish this, the Buyer and Seller will often enter into a Letter of Intent (LOI), also referred to as a Term Sheet or a Memorandum of Understanding (MOU).
Should the Buyer and Seller enter into an LOI?
- In a smaller transaction it may be more pragmatic to move straight to the main deal documents rather than create an additional step with the LOI.
- Often the Buyer and Seller want to set out the main terms of their agreement in the LOI to avoid misunderstandings.
- A more detailed LOI in particular may save time and expense in the document drafting stage because the attorneys have a clearer roadmap.
- Also, a more detailed LOI is often preferred by the Seller. The Seller’s strongest negotiating position is usually before the LOI is signed when other buyers may be competing for the deal. Therefore, the Seller will want to include certain provisions before it agrees to take the deal off the market through an exclusivity provision (see below). Conversely, the Buyer often will often want to defer certain terms until after the LOI has been signed where the Buyer will have more leverage.
Is the LOI Legally Binding?
- The LOI generally states that is not legally binding except for certain provisions.
- Even though the LOI is not legally binding, that does not necessarily mean the parties can simply walk away. A court could find, for example, that there is an implied covenant of good faith and fair dealing that could include an obligation of the Buyer and Seller to negotiate with one another in good faith.
- The LOI will usually have some legally binding provisions, most notably the exclusivity clause and the confidentiality clause. The exclusivity clause (or no-shop clause) provides that for a stated period of time, the Seller will not negotiate a sale with other parties or shop the buyer’s offer. The Seller favors a shorter exclusivity period (e.g. 7 to 14 days) while the Buyer favors a longer exclusivity period (e.g. 30 to 60 days). The confidentiality clause requires the parties to keep the potential transaction and the LOI confidential.
What Terms are Typically Included in an LOI?
- Two important functions of the LOI are to set out the commercial terms of the deal (e.g. purchase price, structure of the transaction etc.) and to allocate risks among the parties (e.g. is the Buyer or Seller responsible for a specified liability that becomes apparent after the closing?). Typical provisions in an LOI include the terms below.
- Structure of the Transaction: The structure of the transaction is heavily influenced by tax considerations. Simplistically, a Seller will often prefer a stock sale that results in only one level of taxation at the shareholder level. A Buyer on the other hand will often prefer to purchase all of the assets of the Seller, which gives the Buyer the benefits of a “stepped-up” basis in the assets, but can result in double taxation to the Seller at the company level and the shareholder level.
- Purchase Price: The LOI should specify whether the purchase price is all cash, cash plus stock, and whether any part of the purchase price is deferred (e.g. through a promissory note) or contingent (e.g. on the future performance of the business through an earn-out).
- Indemnification: This is a highly negotiated term reflecting the parties’ respective responsibilities for certain liabilities that may arise. Often there are hold-backs from the purchase price placed into escrow to cover any potential indemnity obligations. The length of indemnification, deductibles and caps are among the negotiated items.
- Closing Conditions: The LOI will often state that closing is contingent on certain events, including, for example, regulatory approvals.
- Management: Will any employees of the Seller continue to be employed by the Buyer? If so, the terms of employment and any restrictive covenants (e.g. prohibiting the Seller from working for competitors) may be set out in the LOI.
If you require any further information on LOIs in the M&A process, please contact Edward Grenville, Shareholder, Inspire Business Law Group, PC (egrenville@inspirelawgroup.com; +415 279 0779).