What is a Letter of Intent, and why do I need one?
The age-old question when it comes to buying and selling a business. A letter of intent, or LOI, has significant advantages for both parties in a business acquisition transaction. What does one look like, and do you need one?
First, a business acquisition letter of intent is a document that outlines specific aspects of a purchase deal that have not yet been agreed upon and grants the buyer exclusive rights to purchase the business if no other offer is made.
The reason for this is that it is often essential and desirable for both parties to hash out at least some key terms before they invest significant time, effort, and resources, including legal expenses, to pursue an acquisition. If the parties cannot agree to terms during the LOI phase, it is unlikely they will do so later in the negotiation process.
Types of Letters of Intent.
First, there are two types of letters of intent. One is a short form, the other is a long form. In most instances, a buyer prefers a short-form letter of intent with a long period of exclusivity, which gives them time to conduct due diligence and perform other tasks. Typically, they can obtain this if they have significant leverage in the negotiation process.
The short-form letter of intent also takes less time to draft and obtain approval from both parties. It only covers the purchase price and a few key issues. However, the drawback is that this type of letter of intent leaves many key issues to be negotiated later on.
The long-form letter of intent is usually more desirable to the seller. The more terms spelled out in the LOI, the less likely it is that a deal will fall through due to a debate over specific details. An LOI offers them some sense of security before they agree not to solicit other buyers for their business.
The type of letter of intent will depend primarily on the parties involved and the nature of the deal they are pursuing.
The Parts of a Letter of Intent.
The letter of intent, or LOI, typically comprises several key components. Most are listed here, provided it is a long-form LOI. Short forms may have only some of the items listed below.
- Price/Consideration: How will the deal be structured? All or part stock, earn-out, or promissory note?
- Adjustments to the purchase price: Will it be a cash-free/debt-free deal? Or will the deal be structured another way?
- Transaction structure: Will it be an asset purchase, a merger, or some other kind of purchase?
- Expected timeline: How long will it take to complete due diligence and finalize the deal? What happens if someone misses a deadline or there is a delay?
- Escrow or No Escrow: Will there be an escrow on the part of the seller? How long will it last?
- Exclusivity: How long will it last, how can it be terminated, and what are the consequences if it is terminated early?
- Access: What can the buyer access, including employees, books, and records?
- Key representations and warranties of the seller.
- Employees: How seller employee options and equity held by employees will be treated, and whether these are in addition to the purchase price or subtracted from it.
- Activities: Things prohibited by the seller until final closing
- Third-party consents.
- Confidentiality: The NDA and any other obligations of the parties concerning the transaction
- Conditions for closing.
- Non-Compete: Whether the seller can engage in a similar business and solicit clients, or whether they must sign a non-compete/
- Termination: How and when the acquisition agreement can be terminated
- Disputes (if any): How disputes will be handled and in what jurisdiction
There are other parts as well. You can see from this list how quickly an LOI can become complicated. This is why you need a business broker and an attorney to review the details when selling a business.
Binding vs. Non-binding Terms.
Of course, both the buyer and the seller would love for specific terms to be binding even before final acquisition negotiations begin. However, that is often not the case. The reason is that although both the buyer and the seller want the other party to be bound to specific terms, they don’t want to be bound to complete a transaction at this point.
There are, however, specific terms that are binding for the protection of both parties.
- Confidentiality: Both the buyer and seller may have reasons to keep specific details of the deal secret, and this is often part of the non-disclosure agreement as well.
- Exclusivity: One of the primary reasons the buyer wants an LOI is so that the business is not sold out from under them when they have spent time and money on the acquisition process. These terms are almost always binding.
- Conduct of the Business: The seller doesn’t want any surprises, so they prefer to stipulate that there are certain things the business cannot do during the purchasing process.
- Dispute Resolution: How disputes will be resolved and where they are often binding terms of the LOI.
This is where the LOI must be completely clear, so there is no misunderstanding between the buyer and the seller.
Price and Timeline.
The price of the business and the timeline for exclusivity, due diligence, and other factors are also typically significant, especially to the seller. They don’t want the deal to be exclusive for too long, and then have it not go through. Even though it is common knowledge that many businesses put up for sale never sell, they don’t want their business to be one of those.
Both of these things must be reasonable, but also negotiable in case something unforeseen happens. While typically not binding, the closer both the buyer and the seller are to agreement on these points, the more likely the deal will proceed on time.
Employees.
Besides time and price, employees are also one of the top considerations when selling a business. What will happen to key employees? Will compensation stay the same? What about benefits?
These should not only be part of the LOI, especially if it is a long-form letter, but also be important considerations for both parties. In some cases, if key personnel left in protest over the sale or the deal, there may be a negative impact on the business.
Do you need a letter of intent?
An LOI, while not legally mandatory, is a good idea for the protection of both parties. It increases the likelihood that the deal will close on acceptable terms promptly. That is beneficial for everyone, including both the buyer and the seller, as well as any other stakeholders.
Ready to sell a business and need help understanding an LOI and how to create one? A business broker can ensure the LOI covers all necessary items. Contact us here at Rogerson Business Services to learn more.