A letter of intent (LOI) can serve a variety of purposes in any business transaction.
However, they can contain pitfalls for the unwary. Too often, businesspeople enter into LOIs with the attitude that they are not binding. Before signing an LOI in your haste to lock in a deal, beware of all consequences — legal and practical.
An LOI can facilitate progress in a deal by identifying key substantive issues and terms and providing the ground rules for reaching a definitive agreement and consummating the deal. Along these lines, LOI provisions are typically categorized into deal process terms that are binding and enforceable, and substantive terms that are not.
The LOI will typically state that it does not constitute a binding agreement, except for certain specific terms that are intended to be “legally binding and enforceable.” Nonetheless, whether a term is binding or not, you need to anticipate and understand its impact on the outcome of a deal.
Nonbinding topics in an LOI for a business acquisition may include descriptions of the basic transaction (what’s being sold, for what price, what the organizational structure is), payment terms, side agreements and other closing conditions, representations and warranties, and indemnification provisions.
The LOI typically provides that proposed terms will be addressed in the final negotiated agreement. Terms are uncertain at this stage because due diligence often has not yet started, much less been completed.
The extent to which you address any of the substantive topics depends on your position in the deal. In an acquisition deal, a buyer may want to defer negotiations on specific deal points until it has more knowledge of the target assets through due diligence. A seller may want to resolve important issues (such as setting limits on representations and warranties, and indemnification) while it has greater bargaining power prior to entering into an LOI.
Do not psychologically commit yourself to a position. If you do incorporate any of these terms into the LOI, consider that they may be viewed by the other side as being cast in stone in the context of contract negotiations.
Tax considerations are often overlooked at the LOI stage. If you intend to have a tax-free business reorganization, make sure the proposed structure qualifies as such. If it turns out the transaction contemplated in the LOI does not qualify, this could fundamentally affect the economic terms of the deal and compromise your negotiating position.
The binding parts of the LOI typically include provisions regarding exclusive dealing, break-up fees, access for due diligence, confidentiality of deal terms and disclosed information, allocation of transaction costs, conduct of the business prior to closing and termination of the LOI. Avoid binding provisions that require “best efforts,” “every reasonable effort” or “good faith” negotiations to finalize and execute a definitive agreement containing the terms set forth in the LOI.
Courts could construe these as agreements to reach an agreement, and could find a party liable for the reliance costs of the other party if a definitive agreement is not reached. Some courts have held that even though the particular terms of an LOI are not enforceable, parties can create duties to bargain in good faith by entering into an LOI.
A primary goal of entering into an LOI is to get assurance the other side is serious about doing a deal with you. This is more important to the buyer of a business than a seller, who may want flexibility to shop the business around. An LOI provision prohibiting the other side from soliciting or entertaining offers from or negotiating with third parties for a certain period of time will provide some comfort that you are not wasting resources pursuing the deal.
Additionally, mostly in deals involving public companies or bankruptcy sales, an LOI could provide the payment of a break-up or topping fee if the exclusivity provisions are breached and, within a certain period of time, the other party consummates a similar deal with a third party.
Depending on the complexity of a proposed deal, a variety of issues can arise in negotiating an LOI. The above are just a few of the common ones.
The more complex the deal, the more careful you have to be. It is prudent to seek counsel, ideally from a professional you would ultimately use to negotiate and implement the deal. David Lu ([email protected]) is an attorney at Arter & Hadden LLP and is a member of the firm’s E-Group and Growth Group. The Growth Group is a multidisciplinary group of attorneys that focuses its practice on entrepreneurs and emerging growth companies. He can be reached at (216) 696-5590. For more information about the E-Group and to read SBN “Matter of Law” reprints, visit www.arterhadden.com/egroup.