In a business sale, the letter of intent is a vital document, and sellers need to thoroughly understand its purpose and scope.
While his trucking company was always his first love, Howard had a variety of business interests, including farms in Missouri, a heavy equipment dealership in Kansas, and a gypsum mine in Utah. As is true of many entrepreneurs, he was a big-picture guy who knew how to build up and turn around a business but had little tolerance for details.
Howard’s aversion to the minutiae of business ownership reared its head after he decided to sell his mining operation. After letting a few people know that it might be available, he took a call from a potential buyer in California. Their conversation was brief, and Howard didn’t give it much more thought.
A few days later, Howard got a call from his son, who was Howard’s CFO at their office in Colorado Springs.
“Pop, we just got what looks like a letter of intent from a guy in Fresno who wants to buy the mine for $19 million cash. The tail goes with the hide” – mimicking his dad’s favorite term for a clean business sale – “and he wants to close in 90 days. I’m going to fax this to you and Larry” (their corporate attorney).
“Keep the damn lawyers out of it,” Howard grumbled. “Sign it and send it back to him, and I’ll look at it in a few days. Oh, and you’ll need to start putting together some financial information and a list of assets. Leave out the condo and King Air.”
A week later, Howard received a call from another potential buyer, who said over the phone that he would pay $22 million. Howard called his son and told him they had a better deal and to break it off with the Fresno buyer, who promptly sued to enforce the letter of intent and to bar any sale to another buyer.
After six months, lots of attorneys’ fees, and the loss of the sale to the second buyer, the judge dismissed the first buyer’s lawsuit, ruling that, despite the fact that the letter of intent stated that it was legally binding (an important detail), it left out some of the contractual elements that would have been part of the ultimate sales agreement, and thus Howard was not bound by it.
He dodged a bullet. Had the language of the letter of intent been just a little different, or if the lawsuit had caught a different judge, Howard could have been stuck with the lower price.
That he eventually sold his mine to a third buyer, for a good price, with the help of IBG Business, is not the point of this tale. The moral is this: In a business sale, the letter of intent is a very important document, and both parties need to understand its purpose and scope and take it seriously.
About Letters of Intent
As we discuss in our article, “How Long Does It Take to Sell a Business?”, receiving a letter of intent typically occurs in the fourth of six stages of an IBG-managed sale:
- Information Gathering
- Management Meetings
- Letters of Intent and Negotiation
- Due Diligence
The preceding steps include our preparation of the Confidential Information Memorandum (CIM), marketing the business, and fielding inquiries from potential buyers concerning the nature of the business and its revenue, assets, earnings, etc., without the buyers being able to identify the company.
If a buyer is truly interested and survives our vetting, we execute a non-disclosure agreement that allows them to receive the seller’s CIM and, for the first time, see detailed information about the business. The next step is for the buyer to present the seller with a letter of intent.
(Everything up to this point fits within our “running the process,” described in our article, “Selling Your Business, a ‘Trip to Tahiti,’ and the Perils of a One-Buyer Deal.” In the sale process, we sometimes call for at least an indication of interest, which is effectively a non-binding LOI that further qualifies the buyer and allows for more vetting on both sides. In some cases, active and informed buyers are willing to jump directly into a partially binding LOI.)
Here are seven common questions about a letter of intent and its place in an M&A deal.
- What is a “letter of intent”? In a business sale, a letter of intent (LOI) is a buyer-originated document through which the buyer expresses its intent to buy the subject business. When signed by the buyer and seller, it should provide:
- a written expression of the parties’ intent to enter into a deal;
- an outline of an agreement in principle for the buyer to purchase the seller’s business at an offered price or range and under certain terms;
- confidentiality protection for the seller;
- an outline of the buyer’s financing;
- a timeline for due diligence and closing; and, in most cases,
- the buyer’s exclusive right to purchase the company during a specified time period.
- What is an LOI’s purpose? In the M&A context, the LOI’s fundamental purpose is to formally acknowledge the parties’ (a) intent to enter into a business purchase or merger and (b) good-faith desire to proceed in negotiations.
It bridges the temporary gap between a verbal expression of interest and a definitive purchase agreement. It can be viewed as a roadmap and a timeline for the parties to follow through the due-diligence process to the final closing.
While the LOI provides the basic terms and conditions of the eventual contract, it should acknowledge that negotiations are still in progress. In most cases, some of the contractual elements are omitted (a) to prevent the document from becoming a binding legal document (more below), and (b) because of the impracticality of including every detail in a preliminary document.
- Why is an LOI important? Negotiating the purchase and sale of a business is expensive and time-consuming for both parties, and an LOI can give both parties some assurance that the associated costs and risks are justifiable.
An experienced buyer will not commit time and money to due diligence, analysis, and legal, tax and accounting services unless they believe they have an earnest seller and will have an exclusive right, expressed by a “no shop” clause, to buy the company.
Meanwhile, a prudent seller will not subject its business to the disruption and exposure of the due-diligence process unless the buyer is committed to the deal.
The simplicity and structure of an LOI allow the parties to move forward with an agreed understanding of what they are trying to accomplish, within certain guidelines.
As North Carolina attorney Amy E. Risseeuw explains in her article, “The Basics of an M&A Letter of Intent,” an LOI:
“allows the parties to determine very early in the process whether there is a basic agreement on key terms and confirm that there are no ‘deal-breaker’ issues before either party has devoted substantial time and resources. In addition, an LOI helps to facilitate the preparation and negotiation of the definitive documents for the transaction by serving as an outline of the key provisions.”
- Is it legally binding? By its language and content, an LOI can be either binding or non-binding. Given the uncertainty of how a deal will progress, in most cases neither buyer nor seller wants to be ultimately bound by the LOI and will state in the LOI that it is non-binding. In that circumstance, either party should be able to walk away from the deal without legal liability.
However, courts have ruled that an LOI is a binding contract and can be enforced by the party that wants to move forward, if it contains all the material terms of an agreement and, as one judge wrote, “is complete, clear and unambiguous on its face.”
Also, while the majority of LOI’s have some provisions that are non-binding (e.g., the buyer must buy the company), other provisions are binding, such as the exclusivity period, confidentiality protection, etc.
- What should a seller look (and look out) for? Be on the lookout for “poison pills” that some buyers might try to sneak past an unwary seller. Language stating that the parties have agreed to anything should raise a red flag. Also, sellers should be alert to unintended presumptions or default events, such as, “Unless we hear from you to the contrary …”
In addition to vigilance against unwanted language, sellers should expect to see provisions that are common to most well-structured LOIs. In addition to identifying the company or assets to be purchased, the parties and their contact information, and the deal’s price and terms, an LOI might address such issues as:
- whether it is legally binding or non-binding (discussed above)
- the structure of the transaction
- confidentiality and non-disclosure protection
- guidelines for negotiations
- scope and guidelines for due diligence
- timelines for due diligence and closing
- conditions for closing
- governing law
- What if I want to make changes before I sign it? An LOI is not a one-way proposition to be dictated by the buyer and is subject to negotiation.
Matt Frye, a partner in the Oklahoma office of IBG Business, points out that “the LOI is an agreement between the buyer and seller. It is intended to protect both parties, and the seller has the right to negotiate its terms.”
“An experienced M&A broker can help facilitate this process,” Frye continued, “through their knowledge of standard provisions and terms. More important, we always request that our client have all documents vetted, if not drafted, by their legal counsel.”
- What happens after the letter of intent is signed? The signing of an LOI typically triggers the due-diligence period, during which negotiations occur, the purchase agreement is drafted, and the buyer’s requests for company information are satisfied (see our article, “Preparing for Due Diligence in a Business Sale.”
Also, a signed LOI usually marks the start of material expenditures by both sides, which could include a quality of earnings review, equipment valuations, inventory assessments, site surveys, etc.
“Once the parties reach the point where the buyer feels comfortable and the seller has portrayed the business and assets as advertised, the parties will then initiate the bulk of the definitive documents via legal counsel,” said Bob Latham, IBG’s Texas partner. “Prior to that point, only the major topics have been outlined and discussed. The ‘papering’ phase includes a significant amount of negotiation on the finer details, such as seller transition or employment agreements, facility lease terms, purchase price allocations and, importantly, working capital pegs, just to name a few.”
Keeping It Simple
In contrast to the final purchase agreement, which, even without addendums, can easily expand to hundreds of pages, a letter of intent should be relatively brief, focusing mostly on the major issues that will help the buyer and seller reach common ground and justify the risk and expense of pursuing the deal.
In her aforementioned article, attorney Amy Risseeuw writes, “While it is important to include [in an LOI] the key terms proposed for the potential transaction, the details and finer drafting should be deferred until the definitive deal documents are prepared. Including non-material issues at the LOI stage can unnecessarily lengthen the time to complete this first step, potentially causing lost deal momentum, frustration, and a longer overall transaction timeline.”
For assistance in evaluating a letter of intent for the purchase of your business, contact an IBG Business M&A advisor near you.