Letter of Intent: The First Step Toward Purchase

What Is the Purpose of an LOI?

The letter of intent (LOI) is generally the first significant, substantive document in most business sales or in any merger and acquisition transaction. The LOI may also be called a memorandum of understanding, expression of interest, indication of interest, or term sheet. However, for the purposes of this article, we refer to it as a letter of intent.

What is a Letter of Intent?

A letter of intent sets forth, in abbreviated form, a basic understanding of transaction terms between the buyer/acquirer and seller/target. The letter of intent is not meant to be the final understanding between parties. It is not intended to be binding. That said, parties will usually find terms in the letter of intent difficult to reverse in a definitive agreement.

What is Specified in the Letter of Intent?

The most important terms in the letter of intent are:

• The type of transaction
• What is purchased
• Price
• Method of payment
• Any price adjustments

The letter of intent should also set out what the seller receives for the sale – whether stock or cash. If the latter, it should also define the method of payment. The buyer may not always pay full purchase price in a set amount of cash at closing. In that case, the letter also specifies how much of the purchase price will be in a note. It describes the terms of the note and whether it is secured, convertible, or via an earn-out.

The letter describes the escrow amount, timing, and conditions for its release. It specifies whether the purchase price may be adjusted based on closing value. A closing value is often a combination of equipment, inventory, and accounts receivable – minus debts of the seller.

Most importantly, the letter of intent specifies key closing conditions for the parties, especially for the seller. Conditions may include any combination of the following:

• Can the buyer arrange financing to complete the transaction? (ensuring that seller’s employees enter non-competing employment agreements or covenants)
• The ability to assign or otherwise transfer key contract rights
• The lack of material adverse change in the seller’s business
• Regulatory approvals necessary for the transaction to close

Consider these provisions carefully, even more in the definitive agreement than in the LOI, because they allocate risk between parties. Additionally, they will likely give the party not subject to the condition an “out.” That is, a unilateral option not to close the transaction if such condition is not satisfied.

Non-Binding Terms

Other non-binding terms may appear in letters of intent. These could include a timetable for the transaction or the choice of law and forum for resolving disputes. This is particularly important when parties are located in different jurisdictions or different countries.

There is one binding key term, at least on the seller — exclusivity. This provision is also known as a “no-shop” or a “standstill.” It prohibits a seller from entering negotiations with another party for the sale over a specified period. The period is typically between 30 and 90 days.

The no-shop may require a seller to report any contact — even if not initiated by the seller — to the buyer. It may even require a payment, or “break-up fee”, if the seller does not complete the transaction. Sellers should almost always vigorously resist such provisions. The lack of break-up fee reciprocity and matters taken out of the seller’s hands are not advantageous.

The Letter of Intent vs the Definitive Purchase Agreement

An LOI is typically about 5 pages in length while a definitive purchase agreement is usually closer to 50 pages. What is in those extra pages?

Those lengthy and substantive provisions in definitive purchase agreements relate to:

• Representations and warranties the seller is giving about the business being sold and
• Accompanying indemnifications it provides to the buyer if statements are untrue and the buyer incurs liability or losses

These provisions relate to a seller’s assets, liabilities, employees, contracts, and intellectual property, among other things. They discuss the circumstances under which the seller is required to indemnify the buyer and the procedure to be followed in such cases. While these matters generate the most animated negotiations toward the definitive agreement, they rarely arise at the LOI stage.

Maximum Liability for a Breach

Indemnification provisions are usually not covered in an LOI, but the content of such provisions may be critical for the seller to decide whether or not to enter into the transaction. The seller may wish to include a couple of sentences on duration of representations and warranties. That limits the seller’s maximum liability for a breach.

Negotiations at the letter of intent stage need to be handled carefully in tone and in substance. They will be critical in determining what goes into the final binding agreement. Sellers should engage an experienced corporate attorney prior to this stage to ensure favorable transaction terms.

Read more:

• When Should a Seller Sign a Letter of Intent?

•  Strategic vs. Financial Buyers: Distinctive Ways of Acquiring Businesses

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

• The M&A Process: Understanding the Lifecycle of a Deal & Basic Deal Documents
• Structuring and Planning the M&A Transaction
• Roadmap to Selling a Business or Taking on Outside Investors

This is an updated version of an article originally published on April 3, 2015 and previously updated July 16, 2019. It was recently edited by Maryan Pelland.]

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