The Art of M&A® / Integration: Negotiating the Letter of Intent
An excerpt from The Art of M&A, Fifth Edition: A Merger, Acquisition, and Buyout Guide by Alexandra Reed Lajoux
What is a letter of intent?
A letter of intent, or LOI (also known as a memorandum of understanding) is a written instrument that defines the respective preliminary understandings of the parties about to engage in contractual negotiations. In most cases, such a letter is not intended to be binding except with respect to certain limited provisions—for example, provisions ensuring confidentiality, assigning expenses, or banning negotiations with other parties (an exclusivity or no-shop provision). The terms of a typical letter of intent are set forth in Appendix 7A at the end of this chapter. Every transaction is different, so the scope of letters of intent varies. This said, however, Appendix 7A can serve as a checklist of items that usually appear in letters of intent.
What is the purpose of the letter of intent?
The letter of intent memorializes in writing the basic terms of the transaction, which up to that point have been the subject of discussions and early negotiations between the parties. The letter typically will set forth the proposed structure of the transaction; the price and how it will be paid (cash, notes, stock); the terms of notes or stock to be conveyed as part of the price; and other important, but general, features of the transaction such as proposed timing, scope of the representations and warranties, and termination provisions.
The letter of intent also sets forth the conditions for consummating the transaction including, among others, the need for regulatory approvals, collateral agreements, legal opinions, and, most important, the completion of due diligence and the execution of mutually satisfactory definitive documentation.
Does the letter of intent create a binding legal obligation?
Not necessarily. Most letters of intent specifically state that the letter does not create a binding obligation to close the transaction. But simply declaring that the letter is nonbinding in a given area may not be enough to make it nonbinding. The legal test for the binding character of an agreement is the intent of the parties as determined from the circumstances. Some courts have held that a party to an otherwise nonbinding letter of intent has a duty of good faith to negotiate definitive agreements with the other side, even where no such duty is specified in the letter.
In addition, in cases where the parties have agreed on most substantive issues and do not anticipate many closing contingencies, they may consider entering into a fully binding letter of intent—although legal counsel will often advise against this. Also, even with respect to nonbinding letters, the parties typically seek to create binding obligations with respect to the provisions governing such things as confidentiality and the bearing of expenses, and such things as no-shop provisions (see discussion that follows).
If the letter of intent is not binding, is it really needed? Why not proceed directly to the contract itself?
Except in rare cases, use of a letter of intent is recommended.
First, sometimes the parties are not ready for a formal contract—for example, if an acquirer is waiting for financing, a letter of intent can secure the option of a deal.
Second, it can keep the deal from going to a third party. Because the parties have agreed in principle on basic deal terms at this stage, they have an incentive to protect the time and expense they have invested in the transaction, and certain binding provisions of a letter of intent afford them the opportunity to do so. For example, experienced buyers do not want to serve as a stalking horse while the seller shops an offer around to other potential buyers. Thus, the buyer may wish to obtain a no-shop agreement from the seller, as mentioned earlier. This is accomplished through a provision requiring the seller to refrain from negotiating with other parties for a specified period of time in order to give the buyer a proper chance to negotiate a binding agreement.
Third, it can prevent misunderstanding down the line. The parties will have to expend a considerable amount of time and money to complete due diligence and negotiate and draft a contract. A letter of intent agreement enables them to agree on basic terms before incurring the expense of negotiating definitive documentation. Later on in the process, a carefully drafted letter can often be used by a party in the negotiation of a definitive agreement to establish initial positions and to rebuff the opposing party’s efforts to retake lost ground. The document discourages attempts to “re-trade” long-settled terms, which can lead to ill will between the parties even before they come to the closing table.
Finally, it can help to seal the deal. Although the letter of intent is not typically a binding agreement, its execution often has the effect of creating a moral commitment to use good-faith best efforts to consummate the transaction in accordance with the outlined terms. After investing the energy to negotiate a letter of intent, neither party wants to be the one to walk without a very good reason.
The nonbinding nature of a letter of intent can have some drawbacks, though. Because the document is not intended to be binding, some parties will gloss over the details or rush the document to preclude another party from snatching away the opportunity. If one side is hasty, it may overlook details that it did not realize were in the document. When these details resurface subsequently in definitive documentation, it can be viewed as a sign of bad faith if one were to retrade the deal from the LOI. In this way, the old saw is true: haste makes waste.
Is it ever a good idea to skip the letter of intent?
In some rare situations, yes. If having a letter of agreement will complicate or slow things down unnecessarily, or if there is some risk of a leak to target employees, it can be best to go straight to a formal agreement. Also, if either of the parties is a public company, the signing of a letter of intent may be considered material and require a public announcement—a scenario that might not be appealing to one or both parties until the deal is finalized.
When should the letter of intent be executed?
In most circumstances, the parties execute the letter after the acquirer has completed its basic financial due diligence but before it embarks on the other aspect of due diligence (management and operations, legal and compliance, and transactional). This timing reduces the likelihood of incurring substantial expenses before the parties have reached an agreement in principle as to basic business terms. Nevertheless, there are some industries in which the buyer realistically cannot take a sharp pencil to the financial terms without more comprehensive due diligence. These might include services-related industries where the key assets are people-related and thus intangible, or where there exists a substantial amount of uncertainty or contingencies around the business.
Lajoux, Alexandra Reed with Capital Expert Services. The Art of M&A, Fifth Edition: A Merger, Acquisition, and Buyout Guide. United States of America: McGraw Hill, 2019. Pp. 560-563. Print.