What Is a Letter of Intent and Why Do You Need One?
A letter of intent is a key document that an entrepreneur must obtain prior to selling a company. Learn what information is included in this document and why it is important to get one.
In mergers & acquisitions, a letter of intent (LOI) is a vital document because, when it is signed, it spells out the preliminary agreement between a buyer and a seller. Simply stated, an LOI is a non-binding document that outlines the key business terms the parties have agreed to, which will later become the basis for and part of the Definitive Purchase Agreement and other agreements and documents that memorialize a business sale. Letters of intent (sometimes also called a term sheet) vary in length and specificity. They should spell out the major deal points, deliverables, timeliness and contingencies that become the basis for the legally binding agreements.
An LOI serves many purposes, besides documenting the business deal, including the following:
- It is a record of the progress of the initial negotiations;
- Identifies items that need resolution in order to reach a preliminary agreement prior to due diligence;
- Defines (often) a no shop provision or standstill period during which the seller is precluded from negotiating with other parties;
- Minimizes the waste of time and money by both parties because if they cannot reach agreement on the key terms and conditions of the transaction in the letter, there is almost zero probability of negotiating the other definitive documents;
- Acts as the basis for the buyer to obtain financing from a lender; and
- Defines time frames and deadlines so that the transaction can move towards a closing in a predictable manner (even though delays and extensions are common in merger and acquisition transactions due to the need for third-party consents, renegotiation of terms, the magnitude of work involved in gathering due diligence materials, supporting schedule information for the definitive agreement and other reasons).
At a minimum, an LOI should address the following three items so that there is no misunderstanding between the buyer and seller at a later date:
The Parties to and the Type of Transaction
These should be spelled out clearly. Some key elements to consider include:
- Who is the buyer?
- Who is the seller?
- What is the form of purchase (asset, stock, recapitalization, merger, etc.)?
- What is being purchased and what is being excluded (are all assets, liabilities and debts part of the purchase, or are only specific assets, liabilities and debts part of the purchase?)?
- How are these assets, liabilities and debts defined (cash, accounts receivable, inventory, furniture, machinery, customer and employee lists, seller's right, title and interest in the office lease and other contracts, trade names and trademarks, accounts payable, accrued payroll and payroll taxes, capital lease obligations, etc.)?
- Which party is responsible for paying off bank loans?
- What is the total purchase price?
- How much will be paid at closing?
- What is the method of payment (cash, buyer’s stock, note, stock options, earnout)?
- If other than cash or stock payable at closing, when and how will the other payments be made?
- Will part of the purchase price be retained by the buyer to secure representations, warranties and indemnifications?
- If so, how much and for how long?
- If the purchase price is adjustable based on finalized earnings or balance sheet deliverables (e.g., working capital peg), how will any adjustment be calculated?
Some key considerations regarding employment include:
- What is the employment agreement between the parties and how long will the seller be employed by the buyer?
- What will be the initial salary, bonus, benefits, vacation days, etc.?
- If there is to be a bonus, how will it be determined?
- Will the salary be guaranteed?
- Are there termination obligations as far as salary continuation and benefits?
- What are the terms of the non-compete agreement?
Transaction Contingencies and Conditions
There are many potential transaction contingencies and conditions. Some of the key ones to watch out for are:
- Does the seller need to meet any thresholds to receive the purchase price?
- Is the transaction subject to the satisfactory completion of due diligence?
- How will due diligence be scheduled?
- Is there an "adverse change in the business condition" clause?
- What is the outside date for execution of the purchase agreement and closing?
- What information is to be considered confidential?
- Is the transaction subject to board of directors or lender approval?
- Is approval required by a legislative body?
- Is there an exclusivity period?
- If there is to be a press release, when will it be issued and will the content be be subject to mutual agreement?
- Who will be responsible for the various costs of completing the transaction, including any audit, brokerage or consulting fees?
- How will the purchase price be allocated so that each party can understand the tax ramifications of the transaction?
- Can the LOI be extended if deadlines are not met?
It is important to address all the above-mentioned issues so that there is a true understanding between the parties prior to the initiation of due diligence and the drafting of the definitive agreements. Following this process will ensure the maximum probability for the transaction being successfully completed and the minimum probability of misunderstandings and renegotiations between the parties. It is usually when misunderstandings occur due to the lack of clarity of key items in the LOI that deals have a tendency to fall apart.
Written by Terry Stidham
Terry Stidham is a M&A Industry Expert that has served as the head of entrepreneurial organizations as well as Fortune 500 companies. His experience includes industry sectors from service and manufacturing to technical and professional firms.