Special note: This excerpt is used with permission from: Mergers and Acquisitions from A to Z Kindle Edition, by Andrew J. Sherman.
There are many different styles of drafting a letter of intent (LOI), which vary from law firm to law firm and from business lawyer to business lawyer. These styles usually fall into one of three categories:
In general, the type to be selected will depend upon:
- The timing and the scope of the information to be released publicly concerning the transaction (if any).
- The degree to which negotiations have been definitive and the necessary information has been gathered.
- The cost to the buyer and the seller of proceeding with the transaction prior to the making of binding commitments.
- The rapidity with which the parties estimate that a final agreement can be signed.
- The valuation ranges for the seller’s company that have been discussed to date.
- The degree to which the buyer needs or wants a period of exclusivity (and the degree to which the seller is willing to grant an exclusivity period.
- The relative status of the parties and leverage that both the buyer and seller have.
- The degree of confidence each party has in the good faith of the other party and the absence (or presence) of still other parties that are competing for the transaction.
In most cases, the hybrid format, which contains both binding and non-binding terms, is the most effective format to protect the interests of both parties and to level the playing field from a negotiations perspective.
Although it is formally executed by the buyer and the seller, a letter of intent is often considered to be an agreement in principle. As a result, the parties should be very clear as to whether the letter of intent is a binding preliminary contract or merely a memorandum from which a more definitive legal document may be drafted upon completion of due diligence.
Regardless of the legal implications involved, however, by executing a letter of intent, the parties make a psychological commitment to the transaction and provide a road map for expediting more formal negotiations.
In addition, a well-drafted letter of intent will provide an overview of matters that require further discussion and consideration, such as the exact purchase price. Although an exact and final purchase price cannot realistically be established until due diligence has been completed, the seller may hesitate to proceed without a price commitment.
Instead of creating a fixed price, however, the letter of intent will typically incorporate a price range that is qualified by a clause or provision setting forth all of the factors that will influence and affect the calculation of a final fixed price, such as balance sheet adjustments, due diligence surprises or problems, a change in the health of the company, or overall market conditions during the transaction period, and sometimes even an “upside surprise” in favor of the seller when a significant positive development occurs during the transaction period (e.g., the settlement of litigation, the award of important intellectual property rights, or a big new contract or customer commitment) that had not been included when the valuation range was established.
The purchase price may also be affected by the tax implications of the transaction, which is generally a key factor in determining whether the transaction is structured as an asset purchase or stock purchase. The LOI also sets the framework for ancillary agreements to be negotiated later, such as licensing agreements, employment and shareholder agreements, management agreements, and non-competition agreements.
The first section of the LOI addresses certain key deal terms, such as price and method of payment. These terms are usually nonbinding so that the parties have an opportunity to complete the due diligence and analysis and have room for further negotiation, depending on the specific problems uncovered during the investigative process.
[Letters of intent] also includes certain binding terms that will not be subject to further negotiation. These are certain issues that at least one side, and usually both sides, will want to ensure are binding, regardless of whether the deal is actually consummated.
Legal ability of the seller to consummate the transaction
Before wasting too much time or money, the buyer will want to know that the seller has the power and the authority to close the deal.
Protection of confidential information
The seller in particular, and both parties in general, will want to ensure that all information provided in the initial presentation and during due diligence remains confidential.
Access to books and records
The buyer will want to ensure that the seller and its advisors will fully cooperate in the due diligence process.
Breakup or walkaway fees
The buyer may want to include a clause in the letter of intent to attempt to recoup some of its expenses if the seller tries to walk away from the deal, either because of a change in circumstances or because of the desire to accept a more attractive offer from a different potential buyer. The seller may want a reciprocal clause to cover its own expenses if the buyer walks away or defaults on a preliminary obligation or condition to closing, such as an inability to raise acquisition capital.
The buyer may want a period of exclusivity during which it can be confident that the seller is not entertaining any other offers. The seller will want to place a limit or “outside date” on this provision in order to allow it to begin entertaining other offers if the buyer is unduly dragging its feet.
Good-faith deposit—refundable versus nonrefundable
In some cases, the seller will request a deposit or option fee, and the parties must determine to what extent, if at all, this deposit will be refundable and under what conditions. There are often timing problems with this provision that can be difficult to resolve. For example, the buyer will want the deposit to remain 100 percent refundable if the seller is being uncooperative, or at least until the buyer and its team complete the initial round of due diligence to ensure that there are no major problems discovered that might cause the buyer to walk away from the deal.
The seller will want to set a limit on the due diligence and review period, after which point the buyer forfeits all or a part of its deposit. The end result is often a progressive downward scale of refundability as the due diligence and the overall deal reach various checkpoints toward closing. In the event that the buyer forfeits some or all of the deposit and the deal never closes, the buyer may want to negotiate an eventual full or partial refund if the seller finds an alternative buyer within a certain period of time, such as 180 days.
Impact on employees
Perhaps one of the most challenging issues faced by sellers is the decision as to who within the company is told what, when, and why. Sellers will typically want to “play their cards close to the vest,” whereas buyers, as part of their due diligence perspective, may want access to key executives and employees who are not yet in the loop.
From a human capital management perspective, if team members are told too soon, then it may be hard to keep them from running out the door (because of their uncertainty), and if they are told too late, it may lead to resentment and frustration.
If the communication of the possible sale is mishandled, then the employees may get the message that their jobs are unimportant or in jeopardy, or both. Supervisory personnel should be briefed first, and all of their questions should be answered so that they can inform their subordinates.
After the closing, it is imperative that the top management of the acquiring company meet with the employees of the target company to discuss their post-closing roles, compensation, and benefits. If there will be job cuts, discuss the methods by which this will be determined and whether any training, instruction on résumé- writing skills, or outplacement services will be offered.
Key terms for the definitive documents
The letter of intent will often provide that it is subject to the definitive documents, such as the purchase agreement, and that those definitive documents will address certain key matters or include certain key sections, such as covenants, indemnification, representations and warranties, and key conditions for closing.
Conditions to closing
Both parties will want to articulate a set of conditions or circumstances such that they will not be bound to proceed with the transaction if certain contingencies are not met or if certain events happen after the execution of the letter of intent, such as third-party approvals, regulatory permissions, or related potential barriers to closing.
Be sure to articulate these conditions clearly so that there are no surprises down the road.
Conduct of the business prior to closing
The buyer usually wants some guarantee that the general state of the company that it sees today will be there tomorrow. Thus, the seller will be obligated to operate its business in the ordinary course, so that assets, customers, and employees will not start disappearing from the premises; equipment will not be left in disrepair; the company will not fail to pursue new customers; bonuses will not be magically declared; personal expenses will not be paid the night before; and other steps that will deplete the value of the company prior to closing will not be taken.
If these things do occur, then the parties should provide a mechanism for adjusting the price based on the relative valuation of the lost contracts, relationships, or human resources.
These “negative covenants” help protect the buyer against unpleasant surprises at, or after, closing.
Limitations on publicity and press releases
The parties may want to place certain restrictions on the content and timing of any press releases or public announcements of the transaction, and in some cases may need to follow Securities and Exchange Commission (SEC) guidelines. If either or both of the parties to the transaction are publicly traded, then the general rule is that once the essential terms of the transaction are agreed to in principle, such as through the execution of the letter of intent, there must be a public announcement.
The timing and content of this announcement must be weighed carefully by the parties, including an analysis of how the announcement will affect the price of the stock. The announcement should not be made too early, or it may be viewed by the SEC as an attempt to influence the price of the stock.
The parties should identify, where applicable, who shall bear responsibility for investment bankers’ fees, finders’ fees, legal expenses, and other costs pertaining to the transaction.