What is a Letter of Intent (LOI)?
A Letter of Intent (LOI) is a formal written document that outlines the preliminary agreements between two or more parties before a legal agreement is finalized. It sets the foundation for a future detailed contract.
Why is a Letter of Intent Important?
A Letter of Intent is essential as it provides a structured pathway for negotiations, indicating the seriousness of the parties involved, and minimizing misunderstandings during the negotiation process.
Purpose of a Letter of Intent (LOI)
The main purpose of an LOI is to outline the basic terms of an agreement, clarify key points, and ensure mutual understanding and goodwill between parties.
Major Characteristics of a Letter of Intent
The major characteristics include its non-binding nature, the outline of essential terms, clarity in the relationship between parties, and its temporary nature until a formal contract is signed.
- Non-Binding Nature: Most LOIs are non-binding, with the main goal of agreeing on significant terms like pricing, allowing parties to initiate the due diligence phase. Generally, only aspects such as exclusivity, confidentiality, and no-hire stipulations are binding within the LOI.
- Moral Rather than Legal Obligation: The LOI often serves as a moral commitment rather than a legal one. Consequently, less-than-ethical buyers might manipulate an LOI for their benefit.
- An Initial Agreement: The LOI acts as a precursor to the purchase agreement, enabling the parties to launch due diligence and helping them save on legal costs by averting the need to draft a detailed purchase contract before they’re prepared to commit. It symbolizes an essential phase in the sales process, paving the way for due diligence, with the final purchase agreement content being influenced by the findings during this process.
- Foundation for Negotiations: The LOI sets the groundwork for negotiations and the drafting of the purchase agreement. Any undefined transaction terms in the LOI are typically drafted to favor the buyer in the purchase agreement.
- Exclusivity Clause: Many LOIs include a clause requiring the seller to withdraw the business from the market and stop negotiations with other potential buyers, which may reduce the seller’s bargaining strength.
- Restricted Information: Typically, buyers have access to only limited information about the business prior to due diligence. The transaction’s terms may shift based on what is uncovered during this process, and the price and key conditions may be altered if unexpected issues arise.
- Conditional Nature: The LOI’s effectiveness is often dependent on the buyer successfully completing due diligence. If dissatisfaction occurs with the due diligence results, the buyer has the option to abandon negotiations in most situations.
- Creating Momentum: The LOI serves as a chance for both parties to identify and solve problems early on, before becoming financially or emotionally invested in a specific stance.
- Spotlight on Unresolved Matters: The LOI can also emphasize unresolved elements, such as the conditions of an ongoing employment contract with the seller or the stipulations of an earnout, allowing them to be addressed in the early stages of negotiation.
How Legally Binding Is a Letter of Intent?
Though generally considered non-binding, specific clauses within the LOI may be legally binding, such as confidentiality or exclusivity agreements.
How Courts Interpret Letters of Intent
Courts interpret LOIs based on their language and content, considering factors like whether there was a clear intention to be legally bound.
Why Bother if the Agreement is Non-binding?
Even if non-binding, an LOI provides a roadmap for negotiations, establishes trust, and reflects serious intent between the parties involved.
- Obligation: Parties value the LOI as a moral obligation that sets a framework for major terms before significant expenses in due diligence and agreement negotiation.
- Test Commitment Level: The LOI assesses parties’ commitment, acting like an engagement before marriage, and tests the buyer’s seriousness.
- Morally Commits: The LOI morally binds parties, and misuse can harm a buyer’s reputation.
- Expresses Intentions: The LOI reveals parties’ true intentions and priorities, like payment methods.
- Clarifies Key Terms: The LOI memorializes essential terms, reducing confusion and disagreement later.
- Grants Exclusivity: Ensures commitment from the seller, preventing them from shopping the offer elsewhere.
- Reduces Uncertainty: The LOI defines terms, minimizing disagreements in later stages.
- Defines Contingencies: The LOI outlines pre-transaction conditions or contingencies.
- Enables Financing Pre-Approval: Lenders often require an LOI for underwriting a loan.
- Grants Permissions & Price Agreement: The LOI enables due diligence permissions and price agreement before further commitments.
What is Included in a Letter of Intent?
The LOI primarily outlines key terms, including:
- Purchase Price & Terms: Defining the cost and conditions of the purchase.
- Included Assets & Liabilities: Highlighting essential working capital and what is included.
- Consideration Form: Specifying payment methods like cash, stock, earnout, or notes.
- Legal Structure of Transaction: Detailing whether it’s an asset sale or stock sale.
- Seller’s Role & Compensation: Describing the ongoing responsibilities and payment to the seller.
- Closing Conditions: Identifying any prerequisites, such as financing.
- Due Diligence Process: Outlining the investigation process.
- Exclusivity Clause: Emphasizing a unique agreement between parties.
- Important Deadlines: Setting clear transaction milestones or time frames.
The Letter of Intent Process
The process includes drafting, negotiating, signing the LOI, and then proceeding to a detailed contract negotiation.
The process of negotiating the Letter of Intent (LOI) can be summarized in the following steps:
- Preparation of LOI: Usually drafted by the buyer, but sometimes the seller if in a strong negotiating position. The seller is advised to prepare the LOI if possible.
- Length & Format: LOIs vary in length (1-7 pages) and often blend a formal letter with legal agreement.
- Skipping the LOI: Rarely, parties may skip the LOI stage, happening less than 2% of the time.
- Drafting and Revising: Normally, the buyer prepares the first draft, which may be revised through a process of exchanging red-line versions in Word format. Some negotiations may require a reverse LOI.
- Negotiation Communication: Discussing issues over the phone can facilitate understanding and lead to creative solutions.
- Timeframe to Sign: Usually takes one to three weeks to negotiate an LOI, with the full process taking one to two months after a non-disclosure agreement. The average is influenced by rounds of negotiations and weekends.
- Tactics and Seriousness: Tactics vary between high initial offers to middle-ground approaches. Assessing buyer sincerity and negotiating details is key, with experienced M&A attorneys being helpful.
- Final Considerations: Beware of “final offer” tactics and the avoidance of LOI by public companies due to reporting obligations.
What Happens After a Letter of Intent is Signed?
After signing an LOI, both parties move forward to finalize the formal contract, using the LOI as a guide for detailed negotiations.
What are the Risks of Using a Letter of Intent?
The risks include potential misunderstandings, legal challenges if binding clauses are included, and delays in negotiations if not properly drafted.
What Are Some Differences Between A Term Sheet And An LOI?
Term Sheets vs. LOIs
While both Term Sheets and LOIs outline the terms of an agreement, an LOI is more formal and might include legally binding provisions, whereas a Term Sheet is generally considered a non-binding agreement.