The Letter of Intent also known as LOI is a contract that can be binding or non-binding. Oftentimes, it begins the acquisition process. Here are five important considerations when it comes to the LOI.
In commercial acquisitions of less complexity, a buyer may submit a purchase and sale agreement without the interim use of a letter of intent. However, there are many scenarios in which tremendous details involved in the deal require fairly sophisticated businesses to reach definitive common grounds before a binding purchase and sale agreement is drawn.
The reason is that negotiations on all the wide range of details may be time consuming, necessitate the involvement of transactional attorneys and CPAs and hence become costly. The buyer faces the risk that parties do not reach a consensus on all grounds and the deal does not materialize. To make things even more complicated, once a purchase and sale agreement is reached, the deal may fall through in the due diligence phase.
To avoid unnecessary sunk costs, it is customary for sophisticated businesses to utilize a LOI and then begin due diligence and draft the purchase and sale agreement. If parties are on the same page and reach an agreement on the LOI, then it’s cost-effective to move forward with the process.
Components of the LOI
There are various building blocks to a LOI. The purchase price, escrow agent, methodology of disbursement, amount of earnest money, whether earnest money will be refundable, whether account receivables are included, duration of due diligence, the information & documents seller shall disclose, warranties and representations, whether there are any commissions to be paid, whether there is a real estate component and many more. Typically, the binding provisions in a LOI are exclusivity in negotiations, confidentiality, and termination penalties if any.
Buyers may also have an incentive to ensure the inclusion of restrictive covenants in the LOI. This may include but is not limited to non-solicitation, non-compete, and trade secret clauses.
Deal Structuring impacts future liability in more ways than explainable in one short article. It is crucial for a buyer to think creatively and understand how structuring the deal impacts liability. Generally, a buyer will have the option of purchasing the stocks of a business or alternatively, the assets of a business. The main consideration is limiting the pre-closing liabilities of the business for future owners as well as ease of maintaining account receivables post closings. While an asset purchase limits liabilities, it is crucial in such structuring to be clear on what assets are transacted and the impact on account receivables.
Negotiating a LOI or a purchase and sale agreement is a mixture of art and science. Businesses are generally evaluated based on three accepted approaches of 1) income approach, 2) market approach and 3) asset approach. The key variables in each approach is different so it is important to have familiarity with them. The LOI is the best time to dictate the favorable methodology which ultimately impacts the purchase price.
There are many details to a well developed LOI. The process of acquisition of a business is complex and may not always be a win-win. To avoid unpleasant surprises, consult with your team of experts to ensure you set yourself up for success.