Letter of Intent: Lots of Questions

Wow! Last week’s letter of intent post certainly struck a nerve! That post focused on an LOI’s “no-shop” clause because it was an issue that caused significant agita for one of our brokers a while back. But the general topic of letters of intent appears to be one that a lot of brokers – to say nothing of sellers – are not exactly comfortable with. So, this post is intended as a primer. It’s not all-encompassing because letters of intent, though they certainly share certain aspects, can vary widely from deal to deal. But this post will touch on a few of the issues usually covered in most of the LOIs that we’ve seen.

Purpose and Uses

The purpose of a letter of intent is normally to get the most important points – such as purchase price, scope of due diligence, financing terms and closing terms among other things – out of the way before the parties – usually the buyer – starts spending time and money drafting all the legal jargon that the documents needed to acquire a business usually require. An LOI is a document outlining the general understanding between the parties to a transaction and includes statements of intent to formalize that understanding in a legally binding agreement, usually within a certain period of time. When submitting a letter of intent, the buyer usually wants to express its interest in the business in a way that signals a higher level of seriousness on the part of the buyer than the legions of tire kickers that we encounter. But there are other purposes, as well. One is to give the buyer an opportunity to get a “quick look” at the business without fear of another buyer scooping the business up out from under him. This is the purpose of the “no-shop” clause which prohibits the seller from actively marketing the business or entertaining other offers during the “no-shop” period. But there are also potential buyers out there – most notably, private equity groups – that will submit letters of intent to multiple businesses at once thereby tying up the seller of these businesses when their intent is to buy only one.

Content

Letters of Intent in our industry generally include a price to be paid for the purchase of the business as well as any other terms that the buyer considers important. But a letter of intent is a negotiable document. A buyer might submit an LOI for a $4 million business with an offering price of $3 million; or 100% seller financing; or a closing date 12 months away. Our brokers would advise their client, the seller, to counter any terms that are not acceptable with terms more in keeping with what the seller and broker believe to be reasonable. Sellers and brokers have to remember that every item in the LOI is negotiable. As a rule, LOIs are not binding. However, many LOIs contain certain provisions that are binding, such as those governing non-disclosure, governing law, exclusivity or covenants to negotiate in good faith. Some LOIs are very detailed and are envisioned by the parties to include the buyer’s due diligence. Others are more general and assume that the buyer’s due diligence will be addressed in the anticipated purchase agreement. There’s no “correct” way to draft, counter or negotiate an LOI.

Upsides

If carefully negotiated, an LOI can serve to protect both parties to a transaction. For example, the seller of a business may incorporate what is known as a non-solicitation provision, which would prohibit the buyer from poaching an employee or client of the seller’s business should the deal not come to fruition. On the other hand, an LOI might protect the buyer of a business by containing a condition that its obligation to complete the transaction is rescinded if the buyer is unable to secure the necessary financing. And both parties should benefit by a well-drafted confidentiality section whereby even the existence of any negotiations – let alone any identities – are kept under wraps.

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Downsides

The seller – or any business broker working for the seller – must understand that, because an LOI is likely to be non-binding, it is important to pay attention to the restrictive clauses in the LOI, the most notable of which are likely to be the “no-shop” and due diligence clauses. It is imperative to limit the time that the buyer can exclusively tie up the business and keep the seller from entertaining other offers because the seller’s position grows weaker with the passage of time since there is no ability to create any leverage from a little competition. Restricting the seller’s ability to entertain other offers puts the business owner at a distinct disadvantage. It’s our job to reduce that downside. Another critical aspect of this phase is the importance of managing the seller’s expectations. Our experience suggests that once a seller receives a letter of intent to purchase his or her business, the purchase price in the LOI is fixed in the seller’s mind as permanently as the North Star. If you, as a business broker, allow that to happen, you’re almost guaranteed to be in for some unpleasantness as the deal process unfolds. Why? Because after the buyer’s team of accountants, attorneys, and other professionals comb through the business, any flaws that are uncovered will be used to reduce the price. And, once the purchase contract negotiations begin, many of the deal terms might change, as well. The final agreement might not look much like the one outlined in the LOI. The need for time limits and milestones are critical. Precious time can be lost while waiting for one potential buyer to make a decision. The seller’s personal life and strategic business plans are essentially put on hold during this period. To complicate matters, as I mentioned last week, it is not unusual for a buyer to ask for an extension of the “no-shop” (or the due diligence) period, a condition that will only heighten the seller’s anxiety. The toll of this ongoing state of limbo often softens the seller psychologically and enables the buyer to negotiate increasingly more favorable terms. To reduce the chances of a long, drawn-out period of limbo and to mitigate the potential damages of such uncertainty, professional business brokers will advise their clients to consider requiring a non-refundable – and maybe non-applicable – payment; essentially meaning the buyer has to “buy” more time. This has the effect of not only compensating the seller for any foot-dragging on the part of the buyer but also to motivate the buyer to get its act together. Milestones – and penalties for not meeting them – are a potent tool for the business seller. Make sure you advise your clients accordingly.