“My intentions? Unethical, reprehensible but very practical.”
Quote from the movie, Sabrina (1954)
Once the buyer and seller have reached an agreement in principle, it’s time for the buyer to draft the letter of intent (LOI). This document, written in the format of a formal letter, outlines everything which has been agreed thus far: the structure of the deal, the duration of due diligence, management arrangements and other provisions.
The LOI is not unlike any other contract, with the exception that, as long as it’s outlined at the outset of the letter, the terms outlined therein (with the exception of clauses on confidentiality, exclusivity, expenses and governing law) are not legally binding. For this reason, the seller of the business being acquired can request edits and additions to the LOI proposed by the buyer.
The beginning of the letter sets out in general terms the aim of the LOI, and usually, the context of how the business being acquired fits strategically with your own. The introduction should also set forth that the LOI is non-binding. This is a general understanding of LOIs, but there is some gray area among attorneys on this point, so it’s better to underline this at the beginning.
2. Deal Structure
As the most important part of the LOI, the deal structure directly follows the brief introduction. The wording of this part may require assistance from a legal expert if the structure is more complicated than a straight 100% takeover. Crucially, this section should also include how payment is made and when (for example, in installments, based on revenue, etc.)
An important component of this is the terms around accounts receivable. You’re buying the business partly on the basis of its current assets. In the case of receivables, you’re not sure if they’ll be paid, so you have to make a provision for this in the LOI. The nature of such provisions will depend on the size of the receivables in monetary terms, and to the successful operation of the business in the short-term.
Where the owner(s) of the acquired business will remain in the business, the terms of their employment may also be outlined in this section. This should be clear but non-confrontational. The seller should feel that they stand to benefit from the acquisition and not that they’re being coerced into the new set of arrangements.
As with any other employment contract, this should include some incentives for the management team and outline the difference their contribution will make. This would typically include some equity benefits in the new company and perhaps improved working conditions such as reduced working hours.
3. Indemnification Obligations
The courteous tone of the previous section is especially important, as it’s followed by the seller’s indemnity obligations. This section, arguably the second most important after the deal structure, sets out your recourse in the event of the circumstances of the business suffering a significant deterioration in the aftermath of the deal.
The scope of indemnities are covered well elsewhere, but suffice to say that these are thought of in terms of ‘caps’ and ‘baskets.’ Caps set the limit in dollar terms of what the seller owes the buyer in the event of such a deterioration. Baskets provide the seller with some cover on how much losses are allowed before compensation to the buyer kicks in.
4. Transaction Closing Conditions
The closing conditions are usually composed of regulatory and financial conditions that must be met before the transaction can close. For example, a takeover could be subject to some form of regulatory approval (this would be typical in the case of a foreign buyer looking to acquire a US telecoms company) or the buyer obtaining sufficient financing from their 3rd party lender.
You should now have a document (in letter form) which will serve as a roadmap for the deal. Although it’s technically non-binding, the idea is that it’s written in good faith. To dramatically change anything within it jeopardizes the chances of the deal closing. Once sent over to the seller’s side, it will also serve as the basis for your negotiations.
How to Negotiate a Letter of Intent (LOI)
Assuming there’s been a good deal of discussion leading up to the drafting of the LOI, it may be that only a few tweaks are required by the seller after they have read it over. So, while they will already know the price being offered for their business (do not, under any circumstances, change this in the LOI if it was agreed in advance, as such changes are not taken well on the seller side), it could be that the financing terms are a concern for them.
This is the point at which the seller looks to dilute some of the clauses you’ve set out for them (a non-compete clause if they’re leaving, terms around receivables, exclusivity, the cap indemnity, etc.) and massage upward some of the benefits they’re gaining from the transaction (their equity share in the new business, their incentives, the basket indemnity, etc.).
While there are many parts of the acquisition process that can be conducted without advisors, negotiation of the LOI is best conducted using your legal team. Why? Well, at the very least, because the other side of the transaction is sure to have their legal team providing advice. The last thing you want to do is to go up against the cavalry on your own.
Free Download Sample Letter of Intent
Form of LOI - Equity Acquisition
Form of LOI - Asset Acquisition