Why is a Letter of Intent Important?

Business clients sometimes ask why a Letter of Intent is necessary or advisable as part of the M&A process when most provisions are non-binding?  We understand that signing a Letter of Intent does not guarantee that a deal will close however it is an important step in the deal process.

A Letter of Intent is important for several reasons:

• The Letter of Intent includes key deal points. Forcing the parties to summarize the deal terms helps to identify any deal breakers in advance.
• The Letter of Intent provides an outline for the deal and guides counsel on the key terms and documents that need to be prepared.
• The Letter of Intent can set expectations for activities during due diligence and the timing of key milestones in the negotiation process. For example, the seller might commit to upload all material documents to the data room within a specified period of time.  The buyer might commit to produce a first draft of all definitive documents within a noted period. While these timing commitments will not usually be legally binding, setting expectations is an important part of the process.  The parties can develop trust by meeting these, and the deal moves along.
• The Letter of Intent can help to inform regulators, investors, lenders, insurers and other ancillary parties about the key terms of the deal and the level of the parties’ commitment to the deal. If a Letter of Intent for an acquisition requires financing, for example, a prospective lender might require a Letter of Intent to ensure that it has a “real” deal and to identify key issues in the financing (such as the scope of possible collateral).
• The Letter of Intent also helps the parties, especially where the individuals are not experienced in the M&A process, to ensure that they truly understand the process. It is not uncommon for non-lawyers to use terms like “buy- out,” “acquisition” and “merger” as if they were synonymous when, in fact, they all very different legal concepts. By forcing the clients to articulate their intentions in writing, the attorneys have a platform to ensure that their clients have a clear understanding of the proposed transaction.

Drawbacks of a Letter of Intent

It is almost always preferable for parties to have a well-crafted Letter of Intent in place before proceeding with a transaction. However, a badly drafted Letter of Intent can create liabilities.  There are risks inherent in drafting and negotiating a Letter of Intent.

• Drafting and negotiating a Letter of Intent takes time and money.
  • Inexperienced parties and those who cannot distinguish between necessary points and negotiable points, can cause the process to become protracted. Sometimes a deal falls apart at this stage.
  • Some attorneys may be willing to waive their fees assisting with the Letter of Intent to ensure is is properly completed.
• Depending on the circumstances, such as when there is a publicly-traded participant, an Letter of Intent can trigger a public disclosure obligation.
• A seller who pursuing two or more prospective buyers may prefer to keep the bidding process open to maximize its selling process. Halting the process through the “Exclusivity/No-Shop” provisions of an Letter of Intent may run contrary to that goal.
• A defective Letter of Intent may bind the parties in situations that they did not intend, resulting in liability.
• Some courts have find that even a “non-binding” Letter of Intent can obligate a party to “negotiate in good faith,” creating potential liability where the parties did not intend.

Benefits to the Buyer of an Letter of Intent

The buyer in an M&A transaction hopes that the Letter of Intent establishes the key terms of the transactions, commits the seller to a due diligence process, prohibits the seller from shopping the buyer’s terms and empowers the buyer to keep the seller in an exclusive process for as long as possible.

While terms likely are  not legally binding in the LOI, they are a guide to drafting to definitive documents. If the seller later asks for provisions that contradict those in the Letter of Intent, the buyer will have the moral high ground to tell the seller that the question has previously been resolved.

The “Exclusivity/No-Shop” provisions could not only prohibit the seller from discussing a competing transaction with another party, but obligate the seller to notify the buyer if the seller is approved by a third party with an invitation to discuss a competing transaction.

While notice provisions like this are notoriously hard to enforce they plan an important role in regulating the parties’ behavior. If the deal in the LOI is not completed and there is litigation between the parties on some other issue, discovery (particularly of emails or text messages) may reveal whether the seller was true to its no-shop obligations. If the seller was not, that fact might make possible a separate cause or action or create other leverage in the litigation in the buyer’s favor.

The Letter of Intent can set expectations for due diligence, obligating the seller to make its responsive documents and information available in a certain manner and in a certain time.

Benefits to the Seller of the Letter of Intent

Sellers may be reluctant to negotiate the terms in a Letter of Intent for fear that they will “spook” the buyer or perhaps upset the deal they are placed to have reached. This attitude is often a mistake.  The seller often has the most leverage early in the process, when the buyer is pursuing the seller but uncertain that its price and terms will be accepted. Sellers should use the Letter of Intent as an opportunity to nail down key terms and concessions at that early stage when they are best-situated to achieve their demands.

For transactions where the seller is a private business, perhaps being sold by its founder or the founder’s family, the seller may want to exclude certain assets from the sale (such as personal vehicles, office furniture or similar items). Items that might otherwise be swept up as part of the Seller’s business assets should be specifically excluded in the Letter of Intent. The seller will want to ensure that the confidentiality provisions in the Letter of Intent are enforceable.

The seller will want to keep its confidential information secret for at last two reasons. First, if the deal doesn’t close, the seller will need to preserve the value of its confidential information for a different buyer or to continue to run the business. Second, the seller will want to keep the proposed purchase price and other payment terms secret.

The seller will want to preserve the integrity of its work force. Thus, the seller should control the purchaser’s access to its workforce to avoid any temptation on the purchaser’s part to hire-away seller’s key employees. Some Letters of Intent include provisions, controlling access to seller’s employees and even prohibiting the purchaser from offering employment to those employees, except after a closing of the sale transaction.

If any portion of the purchase price involves stock in the purchaser (such as in a merger or in an asset sale where the seller receives purchaser stock as part of the purchase price) the seller will want to conduct some due diligence (sometimes called “reverse diligence”) on the purchaser. The scope and intensity of that diligence will depend in large part on the value of the purchaser securities that seller will be receiving and the proportion that value bears to the total purchase price.

If there are specific liabilities or contingent risks (such as pending litigation or known risks that have the potential to result in litigation) a well-advised seller may require the Letter of Intent to address those risks. Depending on the situation, transaction terms might require (a) the purchase of a post-closing claims-made liability insurance policy (such as a D&O insurance, for example) to cover seller’s legal fees and potential exposure (or the legal fees and exposure of selling shareholders or departing directors or officers) with respect to that litigation or potential litigation, (b) certain post-closing covenants that would bind purchaser to certain actions that are calculated to mitigate the likelihood or impact of litigation, or (c) affirmative obligations to indemnify the seller (or its shareholders, officers  or directors) against specific cases or types of liabilities.

Please reach out to the Goosmann Law Firm if you are the potential buyer or seller of a business working on a Letter of Intent.  It is very important to have counsel involved from the outset to have clear delineation on the binding and non-binding terms.  We are committed to customer service and will consider alternative fee arrangements.

Angela Madathil is a Real Estate, M&A, and Deal Attorney and provides legal assistance to buyers and sellers of businesses, as well as business brokers in Nebraska and Kansas.   This can involve contract review and negotiation, due diligence assistance, and post-sale integration.  The Goosmann Law Firm team advises to buyers and sellers of businesses, as well as business brokers throughout the Midwest and has attorneys licensed in Iowa, Kansas, Minnesota, Missouri, Nebraska, South Dakota, and other states.