Everything you Need to Know about Drafting or Reviewing an LOI
The most common way to get the ball rolling in a business acquisition, after the acquirer has had the chance to conduct some basic inquiry (oftentimes called “pre-diligence”) is for the potential acquirer to provide the seller with a Letter of Intent or LOI.
Whether you’re in the acquisition game or are looking to sell your business, it is important to know what this important document means, what it should contain, and some common pitfalls to avoid.
What is the Purpose and How Should You Write the Letter?
The LOI is the first stage of negotiation between a potential acquirer and the seller of a business. It is an indication that the acquirer is “getting serious.” While the deal terms contained in a LOI should be non-binding (though other parts of the LOI may be, including no-shop or confidentiality clauses – more on this later), it is very important to make sure that the final product that is signed by both parties actually does represent the general intention of buyer and seller.
This means that if you’re the seller and an acquirer’s LOI has terms you can’t live with, or are missing certain key terms you require, don’t just sign it and hope to negotiate more later. Conversely, as a potential acquirer, if you discover things about a target business that cause you to want to change key deal terms in any way, it is always best to amend the signed LOI to reflect these changes instead of waiting until later. Why? Even though an LOI is technically non-binding as to deal terms, in my experience everyone still looks to it throughout the deal as the mutually agreed “blueprint” for the deal, especially when there are important details that need to be worked out (like seller financing, earn-outs, contingencies, and the like). Deals where the “agreed” terms are substantially different than what is on a signed LOI tend to drag out longer, create more conflict, and are actually much more likely to fail altogether.
What Kinds of Information Do I Need to Include in the Letter of Intent
There are nine main points to include in a letter of intent.
Identification of the acquirer and target. This might be kind of obvious but is important to point out since you’d be surprised how often it’s missed. Sometimes the person doing the negotiating actually represents an investor group or private equity firm. Or, the seller has a number of different subsidiaries or a complicated ownership structure. Be clear who is doing the buying, and exactly what is to be purchased.
Deal structure – equity purchase vs. asset purchase. The two most common ways to acquire a business are through an equity purchase (or stock sale) or an asset purchase. In an equity purchase, the acquirer purchases either a controlling stake or the entirety of the equity interest (either stock if a corporation or membership interest if an LLC) of the target. In an asset purchase, the acquirer purchases some or all of the operating assets of the target. These two types of transactions are as different as night and day and have completely different approaches, strategies, documentation, and tax implications. Therefore it is absolutely critical to clearly identify, in the LOI, which type of deal structure is intended.
Exactly what is being purchased. It is very important for the LOI to clearly identify what the acquirer is interested in purchasing. In an equity purchase deal, the LOI should specify whether the intent is to purchase a controlling stake (like 51%) or the entirety of the equity. For asset purchase deals, it’s even more important that the LOI clearly identify what assets are being purchased (and whether anything is being excluded). For example, it is common for asset purchase deals to specify that all of the operating assets are being purchased but no liabilities, except for ongoing business liabilities for such things as subscriptions, lease payments, etc.
The purchase price. The LOI should clearly state the purchase price. It should elaborate on the terms of the purchase price as well, but it should clearly state the purchase price first.
The purchase price terms. In addition to the clearly stated purchase price, the LOI should also specify how the acquirer intends to pay, including any sort of a down payment or earnest money agreement (or both). Purchase prices can be paid in an almost infinite number of ways (or combinations) including bank or SBA financing, seller financing, cash in a lump sum, cash in installments, cryptocurrency, other valuable assets, services provided, etc. The LOI should clearly state what the acquirer intends here so that there are no surprises when it comes time to draft deal docs.
Earn-out provisions. One of the biggest sticking points I see in deals that I am involved with are earn-out provisions. Earn-outs refer to a portion of the purchase price that is held back (it can range from 10% to 50% or more) and paid to the seller over time usually contingent on the seller assisting the acquirer with operating the business and achieving some business metric (often revenue or profit goals). While even a rudimentary discussion of this topic is beyond the scope of this article, suffice it to say that if an acquirer intends to require an earn-out, it should be clearly stated in the LOI. “Springing” an earn-out on a seller deep into negotiations is a great way to create a great deal of animosity that can serious damage a deal or even kill it altogether.
Key dates for timeframe. I always recommend that LOIs have an expiration date. This helps set the tone for the negotiation – that the acquirer is serious, probably looking at other deals, and that time is of the essence in moving forward. Additionally, I recommend setting rough estimates of key timeframes and dates. This should include an estimate of the amount of time that due diligence should take (usually 60-90 days providing that the seller is cooperative) and an intended closing date. While these should be expressed as flexible dates “subject to change by agreement of the parties” having them in the LOI is useful, again because the LOI will often be looked to as the document governing the key terms of the deal including the timing.
No Shop Clause. I always recommend, both for sellers and acquirers, to include a “no shop clause” in LOIs. This clause states that the seller will not, for a set period of time while in serious negotiations with the potential acquirer, entertain other acquisition offers. For acquirers, this is an important clause to protect one of their most important assets as the start investing seriously in moving the deal forward: their time. For sellers, having this clause is also important since it can be coupled with an earnest money provision (requiring that the potential acquirer post a certain amount of money that can be held in escrow and can be forfeited if they back out of the deal under certain circumstances) to also protect their time investment.
Confidentiality Clause. Finally, I recommend that LOIs detail what is expected as to confidentiality. At a minimum, I recommend a clause requiring that the seller not broach the potential sale to employees outside of executive management until such time as both parties agree on how to announce. Premature announcement of deals can be extremely stressful to employees who are concerned for their future and can result in key employees leaving or being less productive, ultimately hurting the performance or even value of the target company. Additionally, if unwanted publicity might be a concern, for example if either party is a large or high profile business, the LOI should restrict the ability of either party to publicize the details of the deal, again until the parties agree on how and when to publicize.
Common LOI pitfalls.
Just as it is important to make sure your LOI contains the most important key points as detailed earlier in this article, it is important to avoid the most common pitfalls. Here are some common pitfalls that I have seen while representing buyers or sellers in acquisition deals.
Letting the seller’s broker or attorney draft the LOI (or asking them to). This is not technically a pitfall per se, but is more like a red flag. LOIs should ALWAYS be written by the potential acquirer. They are the one who is offering to buy and should therefore be the one who is putting together the LOI (which can be thought of as an offer to buy). When I represent an acquirer, I always think of it as a red flag when the seller’s broker or attorney offers to provide either a stock or drafted LOI. I’ve never seen one that hasn’t been either poorly drafted or extremely and unfairly favorable to the seller. On the other hand, when I represent a seller, I think it is poor form (and I’ve seen this) for a potential acquirer to ask the seller or seller’s attorney to draft the LOI. Again, the acquirer is the one who is making the offer so they should be writing the LOI!
Confusing stock purchase vs asset purchase terminology. Sometimes I will see LOIs that intertwine language from a stock purchase transaction with those from an asset purchase. LOIs need to be crystal clear as to which type of a transaction is being proposed and not use confusing language thereafter. For example, a deal structured as a stock purchase should make no mention of transferring assets or trying to disclaim or leave any specific asset items or even debt. With a stock purchase, the acquirer is purchasing the company as a whole. They must take it all – assets, debt, everything!
Terms that suggest the deal terms are binding. While some portions of the LOI can be binding (such as dispute resolution, allocation of costs, or the no-shop clause), the deal terms should clearly be described as being non-binding. Anything that states otherwise, including punitive penalty fees if the deal doesn’t go through as descried in the LOI, should be avoided.
Conclusion: A well drafted LOI that is actually a fair summary of the agreed deal terms is an important foundational document for a smooth deal.
Need help either structuring an LOI to make an offer for a prospective acquisition or reviewing an LOI offered to you by a potential acquirer? I am available to assist for a flat fee of $500. Additionally, if you end up hiring me to advise and represent you for the deal after the LOI is accepted, I will credit you with the entire $500 toward my flat fee for deal representation.
Do you use business positions in your small business? If not, will you be doing so after reading this article? What has your experience been with business positions and management teams? I want to hear from you! Please comment below or hit me up on LinkedIn.