Letters Of Intent: The Purpose & The Pitfalls
A business acquisition normally starts with a conversation between business people. Eventually, both parties will want to spell out the major terms of the deal term. This document is frequently referred to as a “letter of intent (LOI),” “term sheet,” or “memorandum of understanding (MOU).” Regardless of the name, the purpose is the same: summarize the major deal terms and move toward the consummation of a deal. Like any other legal document, the parties must carefully negotiate the LOI.
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The “intent” in a letter of intent
The purpose of an LOI or term sheet is to describe the business deal of the parties. By doing so, the parties will settle differences about key issues such as the sales structure, price, management, post-closing and financing of the transaction.
A letter of intent also allows the parties to avoid spending substantial amounts of time, energy and money preparing definitive agreements and conducting due diligence. And, both parties can determine the level of interest the other party really has.
Binding or nonbinding
Because the buyer and seller have differing objectives, one party may want the LOI to be binding and the other party many not. For example the buyer may want to have further conversation and conduct due diligence on the seller. Alternatively, the seller may want to lock the buyer into a purchase price or retain the ability to walk away from the deal without incurring substantial expense.
Letters of intent usually include both binding and nonbinding provisions. It is important that the nonbinding and binding provisions are clearly separated to avoid confusion. For example, the buyer will typically want the price term non-binding while the confidentiality provision is binding. On the other hand, the buyer may determine that the price is advantageous and seek a binding commitment from the seller.
Typical matters handled in a letter of intent:
- The structure of the proposed transaction (merger, asset purchase or stock purchase
- Assumed liabilities
- Purchase price, payment terms, earnouts, form of payment, etc.
- A statement of conditions that must be satisfied
- A statement concerning representations and warranties
- Bust up or breakup fees
- No shop provision
- Provisions for deal termination
- Payment of fees if the deal is not completed for various reasons
Indications that you intended to be bound
Careful parties know that the wording in the LOI itself is an important factor if one parties tries to enforce the LOI as a binding document.
Courts will also look to the behavior of the parties as well to determine if the parties intended to be bound. Examples include:
- Words like “we have a deal!”
- Joint proposals
- Combining of, or being in the process of, combining systems such as accounting systems
- Press releases
- Combining management teams
- standardizing invoices
- Size and complexity of the transaction
- How specific or nonspecific are the terms in the letter of intent
- Requirements of approval or lack thereof
How you set up the deal is a very important part of any purchase or sale. Asset purchases, stock purchases or mergers can have serious tax consequences. The letter of intent can outline how the deal will be structured before substantial time and money is spent.
Some of the considerations when determining the structure include:
- Acquiring the assets to avoid liabilities of the seller
- Depreciation schedules
- Favorable tax consequences to the seller by buying stock
- The requirements for consents
- Determining the number of title transfers of real and personal property that must occur. If numerous are needed, it may add substantial cost to the sale.
A very important factor is the strategy involved in who drafts the letter of intent. The drafter can establish the how the deal will be laid out, how the terms will be binding and nonbinding, and allows the other party to refer to the LOI during future negotiations.
A business lawyer’s role
Your business attorney will help draft the LOI and ensure the following:
- That you do not inadvertently create contract terms that the other party can enforce when those terms were intended to be nonbonding.
- That issues are not intensified in the terms of formation that may cause the entire deal to have to be reworked at a later date, causing a change in the contract price.
There may be circumstances where it is best for the seller and buyer to engage directly in negotiating the letter of intent without their attorneys present. Even in these cases, you should ensure your lawyer prepares you for the meeting and reviews the letter of intent before it is signed.
Who should prepare the letter of intent?
Buyers generally prepare the letter of intent. Generally, however, the party that prepares the letter of intent has the upper hand.
He or she can decide:
- What matters will be addressed in the letter of intent
- How specific will the letter be
- What provisions should be binding on the parties
In all cases, both parties (buyer and seller) should sign the letter of intent. This process typically takes two or more revisions before the parties will agree to sign.
If you have any questions regarding letters of intent, or are considering buying or selling a business, please call our attorneys for an assessment. You can reach our business attorneys at 303-688-0944.