The Process of Buying or Selling a Business: M&A Letters of Intent

This article focuses on the memorialization of purchase offers in a letter of intent (“LOI”) in merger and acquisition (“M&A”) transactions.

Overview

An LOI is a document that is typically used in an M&A transaction. It is one of the most important documents in the transaction and serves as a preliminary agreement between the buyer and seller.

LOIs are typically entered into after discussions regarding a potential business acquisition have reached a threshold stage where both the prospective buyer and seller wish to memorialize the high-level terms of the proposed transaction. In most cases, the first draft of an LOI will be used by the buyer to present its formal offer; however, in some cases, the seller will initially present the terms it is willing to accept. Generally,  an LOI will not be drafted until the buyer has conducted enough preliminary due diligence to give it a high degree of confidence that it wants to pursue the transaction.

The LOI sets out the key business terms that the parties agree will be included in the definitive transaction documents, such as the transaction structure, purchase price, payment of the purchase price, working capital adjustment provisions, the role of the seller after closing, etc. This portion of the LOI is non-binding, meaning it’s only an expression of intent, and neither party is obligated to move forward with the transaction. However, notwithstanding that the LOI is non-binding on these terms, the parties may feel morally bound to abide by these during later stages of contract negotiation, so the “non-binding” nature can be a little bit misleading. Additionally, the LOI may contain terms regarding the conduct of the deal process itself, for example, obligations of confidentiality and exclusive dealing, which are often binding (as discussed further below).

Entering into an LOI has several benefits, including (1) identifying key issues for each party early in the process, (2) limiting the scope of items up for negotiation once the parties reach the stage of memorializing the transaction in definitive documentation, (3) if applicable, introducing certain binding requirements (such as exclusivity) which enhances the parties’ ability to commit to the deal process, and (4) providing key terms that may be shared with internal stakeholders (such as equity holders, management, and key employees) or external parties (such as lenders) whose participation in and understanding of the deal at an early stage will help facilitate a smoother and more efficient deal negotiation and closing.

Parties should be aware, however, that LOIs may present risks to the parties if not properly thought through and managed, including potentially (1) limiting the parties’ ability to walk away from the deal due to an implied duty to negotiate in good faith which courts may impose, (2) limiting a party’s ability to change its mind on terms, as the other party will often insist a stated term in the LOI (even if not legally binding) should not be altered unless new facts or circumstances arise, and (3) increasing deal costs and timelines, particularly if the terms of the LOI become complex and heavily negotiated by principals, attorneys and financial advisors.

LOI Provisions

The provisions contained in an LOI can vary, but they often include some combination of the following terms, not all of which will be applicable depending on the particular transaction:

1. Principal Business Terms (i.e. deal structure, purchase price, form of consideration);
2. Material Signing and Closing Conditions (i.e. approvals, financing, tax clearances, diligence);
3. Summary of Representations and Warranties to be included;
4. Summary of Indemnification (i.e. caps, baskets, survival periods);
5. Any Necessary Ancillary Items (i.e. employment arrangements, transition services);
6. Exclusivity Obligations;
7. Confidentiality Obligations;
8. Non-Solicitation Requirements;
9. Tax Treatment;
10. Public Announcements;
11. Allocation of Expenses of the Parties;
12. Termination Rights; and
13. Binding or Non-Binding Provisions.

Binding vs. Non-Binding; Good Faith

Typically, the majority of provisions in an LOI are non-binding, as the parties wish to impose a moral obligation to progress negotiations on terms agreed in principle without creating legally binding arrangements until a definitive agreement has been executed. However, exclusivity, confidentiality, expenses, and non-solicit provisions often are binding, as these terms are understood to be of significant importance to the process of negotiation itself, and the failure of a party to abide by these obligations prior to signing the purchase agreement could result in material damages to the other party.

• Exclusivity: Before committing time, money, and other resources, a buyer wants reassurance that a seller will not pursue competing transactions or simply use the buyer’s bid as a means of attracting more interest.
• Confidentiality: During and following the LOI stage, before a definitive agreement is signed, the parties will almost always be sharing sensitive information with one another that would be harmful if disclosed to competitors or the public. The parties also usually wish to keep the fact that a potential transaction is being negotiated a secret.
• Non-Solicitation: Both the buyer and seller may want enforceable legal protection against the other party recruiting and hiring their personnel, as each party will typically have access to key employees during negotiations.
• Expenses: Allocation of expenses incurred during deal negotiations may be binding so that neither party has uncertainty about the ability of the other party to make unanticipated claims regarding those responsibilities.

It is important that the parties clearly and specifically state which provisions, if any, are legally binding and which are not. For binding provisions, the terms must be sufficiently certain, and there must be consideration in order to satisfy the elements of a valid contract. Non-binding terms likewise should be clearly identified; otherwise, a court may analyze factors to determine the intent of the parties, and this could result in a finding that a party’s failure to abide by a provision was a breach of a legally enforceable contract.

Even if an LOI is generally non-binding, the buyer and seller may be obligated to negotiate in good faith if the agreement is silent on this point. This means a party who signs an LOI intending to negotiate a deal and then simply pulls out or otherwise fails to go through with negotiations could be liable for failing to negotiate in good faith. Therefore, the parties should expressly disclaim good faith if they do not want that obligation to be imposed as an implied term.

Summary

In summary, if properly considered and drafted, the LOI is an effective and highly useful tool for buyers and sellers to progress an M&A transaction. Deal principles and advisors should pay close attention to (1) clearly stating binding vs. non-binding provisions, (2) limiting the LOI’s content to key terms rather than exhaustively covering every item that will be in the definitive agreement, (3) if more information is necessary for a party to commit to a deal point (even if non-binding), deferring agreement on that provision or qualifying it with stated assumptions, and (4) identifying the timeline and the conditions necessary to reach final agreement of the definitive transaction document.

We see that clients who understand the deal process are more confident, less overwhelmed, and get better terms. Having skilled advisors on your team can help you run a successful deal. The mergers and acquisitions practice group at Riggs Davie PLC counsels clients through deals on the buy-side and sell-side in a wide range of industries, including technology, health care, health tech, fintech, professional services, financial services, real estate, business services, manufacturing, and distribution. For more information about our services, please visit www.riggsdavie.com or contact our practice group by email at dealteam@riggsdavie.com.

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This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.