Most merger and acquisition deals (M&A) start with a letter of intent, with one party (usually the buyer) submitting its proposal to the other, to lie down the foundation of the transaction. Letters of intent are generally short and informal, and, accordingly, often are drafted and negotiated directly by the principals to the transaction. However, parties would be well-served to consult their lawyers prior to executing the letter.
“All too often, clients give up significant negotiating leverage by signing a letter of intent without running it by their lawyer,” says Julio C. Esquivel, a partner at Shumaker, Loop & Kendrick LLP.
“These miscalculations can often complicate and prolong negotiations and sometimes lead to the failure of the transaction or even to litigation.”
Smart Business talked to Esquivel about the importance of the letter of intent and how it can most effectively be used in M&A transactions.
What is the purpose of the letter of intent?
The letter of intent memorializes the preliminary agreement of the principals and in that fashion allows them to take their negotiations to the next level. It does so by not only summarizing the parameters of the proposed transaction, such as price and closing conditions, but also by setting forth certain safeguards that promote continued dialogue such as nondisclosure and no-shop provisions.
Additionally, letters of intent may allow the parties to begin the process of obtaining governmental and other third-party approvals necessary to close the transaction.
What is the most common mistake that parties make when it comes to the letter of intent?
Often, having reached a handshake agreement, the parties want to maintain the momentum of their negotiations, so they rush to sign the letter of intent. This is especially true when one of the parties is eager to publicly announce the agreement. But even though the letter may be meant to be preliminary, the words in that letter can have a profound impact on the subsequent negotiations, providing one party with a psychological if not legal advantage over the other.
For example, sellers often sign letters of intent that contemplate an asset sale without fully appreciating the tax implications of such a structure. Later, having conceded that point in the letter of intent, it becomes very difficult to convince the buyer to restructure the deal.
Are letters of intent generally nonbinding?
They can be drafted to be either binding or nonbinding, but most commonly are a combination of the two, with some provisions being purely a reflection of the parties’ preliminary intentions and others having the weight of contract. It is critical that the letter specify which provisions are intended to be binding and which are not; otherwise, the parties may find themselves litigating this issue.
Which provisions are typically binding?
Typical binding provisions include confidentiality and other limitations on a party’s ability to publicly disclose the negotiations, as well as the standstill or no-shop provision, which is a provision that limits the seller’s ability to solicit or accept competing offers for a certain period of time. This allows the buyer time to complete its due diligence and to negotiate the definitive documentation without fear that the seller may simultaneously be negotiating with others.
What about the purchase price?
The purchase price in the letter of intent is typically nonbinding. Yet, for the reasons already mentioned, and because it is usually the key term to the deal, particular attention should be paid when drafting this provision.
In an all-cash deal, drafting the purchase price should be straightforward. However, when the circumstances merit it for example, when the purchase price is complicated by the existence of an earnout, holdback or equity kicker the parties should carefully consider how much additional detail should be included so as to avoid later disputes. Should the letter include the strike price, vesting schedule and termination date for any warrants to be paid at closing? Additionally, should the parties specify whether the earnout will be calculated before or after interest and taxes or based on generally accepted accounting principles (GAAP)?
Legal counsel can assist clients in identifying these and other significant issues that may need to be addressed in the letter of intent and can ensure that the letter meets the client's objectives. For these reasons, parties should discuss their objectives with their counsel prior to signing a letter of intent.
JULIO C. ESQUIVEL is a partner at Shumaker, Loop & Kendrick LLP in Tampa. Reach him at firstname.lastname@example.org or (813) 227-2325.