The Importance of a Letter of Intent in Mergers and Acquisitions: Reach an Understanding Before Committing Time and Resources
This is the second installment in our four-part series, “Key Stages in Buying and Selling Businesses.” In this series, we explore critical stages in the mergers and acquisitions (M&A) process that both buyers and sellers should consider.
Once a confidentiality agreement is in place for a business deal, focus shifts toward preliminary negotiations. Typically, negotiations are complicated, expensive, and time-consuming for both parties. For that reason, a Letter of Intent (LOI) is an important tool to help ensure the investment is worthwhile. The LOI, sometimes referred to as a Memorandum of Understanding, documents key terms and the structure of the contemplated transaction before committing the resources necessary to negotiate finer points and to draft a definitive agreement. It also allows the parties to determine the viability of a deal early in the process, and to confirm that there are no unexpected deal-breakers or glaring issues that could potentially derail a deal further down the road.
Usually, at the time of negotiating an LOI, the parties only have limited information about each other and have not committed the time and resources to an in-depth due diligence analysis. Therefore, many of the proposed terms in the LOI (structure, purchase price, indemnification, closing conditions) are generally intended to be non-binding. This gives both parties freedom to come to an understanding about major aspects of the deal without being committed to them should something adverse regarding the other party arise in due diligence. The LOI usually also includes certain binding terms (exclusivity, confidentiality, governing law, expenses) to give the parties some assurance and protection as they proceed further with negotiations.
Advantages of a well-written LOI
There are distinct advantages to memorializing common understandings in the form of an LOI. First and foremost, it documents the fundamental business terms of the proposed transaction that, barring unforeseen discoveries during due diligence, outline the parties’ mutual understanding. The LOI helps avoid misinterpretations, discourages re-negotiation of key points, and aids negotiation of definitive agreements by identifying areas requiring greater dialogue. Secondly, the binding exclusivity gives a potential buyer assurance during negotiations that the seller won’t use the offer as leverage to negotiate or sell the business to another buyer. Thirdly, the LOI often sets concrete timelines for exclusivity, due diligence, and the signing of definitive agreements, which provide a framework for the deal and help both parties plan accordingly for the future. Finally, the LOI can serve to memorialize the contemplated transaction for third parties, such as lenders and governmental agencies.
In smaller-scale acquisitions, it may be more efficient to proceed without an LOI and address the major points of contention through negotiation of the definitive agreement. The more complicated the acquisition, the more likely an LOI will be beneficial. In all instances, negotiating buyers and sellers must be mindful of their duty to negotiate in good faith.
Clarity is key
While an LOI can be extremely helpful to aid a smooth negotiation, a poorly drafted LOI may not only fail to achieve the potential benefits, but worse, may create animosity or distrust between the parties. If terms are ambiguous or incomplete, either or both parties may proceed to due diligence or negotiating definitive agreements believing an agreement in principle has been reached when, in fact, key terms may have never been discussed. Under such circumstances, the parties are likely to be less open to good faith negotiations, opening the door to lawsuits and the imposition of court-sanctioned damages for breach of contract or for failure to negotiate in good faith.
If you are considering buying or selling a business, contact Kathy Granbois to discuss how Saxton & Stump’s M&A team can help ensure that your interests are adequately represented at the LOI stage and throughout the acquisition or sale process.
Series: Key Stages in Buying and Selling Businesses
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