We recently negotiated the execution of a Letter of Intent (LOI) for the acquisition of our client’s company. It is a crucial milestone on the way to a sale, but it isn’t a time for celebration. There are still too many things to keep focused on and too many things that can still go wrong for that. This is what the LOI really means:
First, the LOI is non-binding in terms of a deal. There are typically a couple of binding clauses in an LOI, most notably the agreement between parties that they will keep everything confidential (“non-disclosure clause”) and the agreement by the seller that they will break off talks with all other parties (“no-shop” or “stand-still” clause) for a period to allow the buyer time to conduct due diligence.
But for the most part the LOI is non-binding and either party can back out for any reason. It is rare for that to happen because at this point both buyer and seller have spent significant time and money in the courtship phase leading up to the LOI. But it happens, and it can go both ways. The last time it happened to me was the seller (actually the seller’s wife) deciding at the last minute not to sell. It was a personal decision relating to a family matter, but very frustrating nonetheless. I had to call the buyer, who at that point had spent tens of thousands of dollars on due diligence and was ready to close.
The LOI is really there to define what a deal may look like, and then allows both parties (but mainly the buyer) some time to perform due-diligence in order to verify the information presented. It is also used as a roadmap for the attorneys when they craft the final purchase agreement and other closing documents. It is important for an LOI to have enough detail so there isn’t a lot of negotiating left. There is always going to be some negotiating, but you really don’t want to have to deal with something so major that it impacts the overall value of a deal.
The obvious items, price and structure, are pretty hard to leave out, but we’ve seen some other basic items overlooked.
For example, here are some common items that are contained in the LOI that should be have some detail:
- If there is a seller note, the LOI should contain what the terms of the note are and what, if any, security is on the note. If it isn’t a straight note (for example, balloons, partial payments, etc.) then a payment schedule as an exhibit can be helpful. (Eg. Was that 2013 balloon payment at the beginning or end of 2013?)
- If there is an earnout (future performance based compensation), then there should be detail on how that is actually earned. If there is any confusion at all, examples can be included to show how any formulas would actually work.
- Unless the seller is going away immediately, which is very rare, there should be detail on future compensation for the seller.
- The status of the AR, payables, cash, etc. and any net working capital requirement should be very clear.
- Often we do deals that include continued ownership for the seller and the structure to make that happen (stock buy back agreements, etc.) can be complex, and in that case it should be clear what the new ownership is. A new ownership table (“cap table”) as an exhibit can be helpful to include in the LOI.
Each LOI is different, and is based on the concerns of both buyer and seller. For example, if we have a seller that says, “I’m concerned the buyer will mess with the compensation structure of my top sales person during my earnout period”. Then we might go to the buyer and ask that a clause be added that states the buyer will provide an employment agreement to this employee that sets the compensation. You can do this after an LOI and before close, but it is usually easier to get in the LOI.
While due diligence is going on, attorneys will take boilerplate purchase agreements, promissory notes, etc., and modify them to include terms in the LOI. A 2-4 page LOI can’t possibly include all details of an acquisition or investment, so there are still points and issues to resolve, and these usually are resolved quickly and amicably. There are usually a few that are a little more challenging, but at that point buyer and seller are committed to a deal and able to compromise on a solution.
Once due diligence is complete, and the purchase agreement and other documents are done, there is really only one thing left: Close.