The first significant, substantive document in most business sales or any merger & acquisition transactions is generally the letter of intent. This may also be called a memorandum of understanding, expression of interest, indication of interest, or term sheet, but for purposes of this article, all of these terms will collectively be referred to as a letter of intent.
A letter of intent sets forth in abbreviated form the basic understanding of the key transaction terms between the buyer/acquirer and the seller/target. The letter of intent is not intended to be the final understanding between the parties, and subject to the discussion on exclusivity below, as well as certain other provisions, is not intended to be binding. That said, parties will usually find that terms which are provided for in the letter of intent are very difficult to reverse in a definitive agreement.
The most important terms in the letter of intent are the form of transaction, what is being purchased, its price, method of payment and any adjustments which may be made to the price. The letter of intent will also set out what the seller is to receive for the sale, whether stock of the buyer or cash, and if the latter, how it will be paid. If the buyer is not going to pay the full purchase price in a set amount of cash at the closing, the letter should specify how much of the purchase price will be in a note (and if so, the terms of the note and perhaps whether or not the note will be secured, convertible or have other features) or via an earn-out, what amount will be escrowed and the timing and conditions for its release, and whether there may be an adjustment to the purchase price based on a closing value, which is often a combination of equipment, inventory and accounts receivable less debts of the seller.
Perhaps next most important, the letter of intent also often specifies key closing conditions for the parties, most often, the seller. These may include any combination of the buyer being able to arrange financing to complete the transaction, certain of seller’s employees entering into employment agreements and/or covenants not to compete with the buyer, the ability to assign or otherwise transfer key contract rights, lack of material adverse change in seller’s business and obtaining regulatory approvals necessary for the transaction to close. These provisions must be considered carefully, even more so in the definitive agreement than the letter of intent, because they allocate risk between the parties and will likely give the party not subject to the condition an “out”, which is to say, a unilateral option not to close the transaction if such condition is not satisfied.
Numerous and varied other non-binding terms often appear in letters of intent. These may include the timetable for the transaction and the choice of law and forum for resolving disputes, which is particularly important when the parties are located in different jurisdictions, especially if they are in different countries. Among the important non-binding terms, there is one key term which is binding, at least on the seller: exclusivity. This provision, which may also be known as a no shop or a standstill, requires, at the least, a seller not to enter into negotiations with another party for sale of what the buyer proposes purchasing for a specified period, almost always not less than 30 nor more than 90 days. At its most stringent, it may require a seller to report any contact, even if not initiated by seller, to the buyer, and may even require a payment (a “break-up fee”) in the event the seller does not complete the transaction. In light of the typical lack of reciprocity of break-up fee provisions, as well as the number of matters out of the seller’s hands, these provisions should be vigorously resisted in almost all instances by sellers.
Finally, sellers may wonder if a letter of intent is typically about 5 pages and a definitive purchase agreement closer to 50, what constitutes the vast amount of provisions which are in the latter but not the former? The lengthiest and most substantive provisions which are in definitive purchase agreements which typically are not included (other than to say that the definitive agreement will have customary provisions along these lines, which will be true and correct at the closing) relate to the representations and warranties the seller is giving about the business being sold and the accompanying indemnifications it is providing to the buyer if any of these statements are untrue and cause the buyer to incur liability or losses. These provisions relate to a seller’s assets, liabilities, employees, contracts and intellectual property, among other things, the circumstances under which the seller will be required to indemnify the buyer and the procedure to be followed. While these matters often generate among the most animated negotiations in preparing the definitive agreement, they rarely arise at the letter of intent stage. Although indemnification provisions are usually not covered, if the content of such provisions will be critical for the seller in determining whether to enter into the transaction, the seller may well wish to include a couple of sentences on the duration of the representations and warranties and seller’s maximum liability for a breach thereof.
Negotiations at the letter of intent stage need to be handled carefully in tone and in substance as they will be critical in determining what goes into final, binding agreements. It is important for sellers to engage an experienced corporate attorney prior to this stage of the transaction to ensure transaction terms which are as favorable as possible.
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Peter Feinberg has more than 25 years’ experience representing primarily middle market companies in all aspects and many sectors of merger and acquisition transactions. Mr. Feinberg has successfully closed well over 100 merger and acquisition transactions, representing buyers and sellers, public and privately held companies, multinational firms, family owned businesses and private equity firms. He…
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