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If you’re considering the sale of your business, or possibly the acquisition of another competing business, it’s important to understand the selling/buying process.
An often overlooked and important first step during the process of buying or selling a business involves the negotiation of certain terms the buyer and seller will ultimately agree to at the closing table once the due diligence phase of the process is completed.
If either party ignores the importance of the initial terms’ negotiations, they can often end up with a bad deal or no deal at all.
This article is intended to help both business sellers and buyers understand the importance of the initial negotiation phase and how a well-drafted Letter of Intent, also known as an LOI, is vital to the deal process.
In this article, you will learn the answers to these questions:
- What is an LOI or Term Sheet?
- What’s included in an LOI for a business acquisition?
- Should I use an LOI when I am buying or selling my business?
- Is a Letter of Intent legally binding?
- What is a Letter of Interest vs. a Letter of Intent?
- What happens after the LOI is signed?
Before we cover these topics, it’s important to make the point that a Letter of Intent is not something you should create yourself, without legal counsel. There are numerous ways a buyer could go wrong if he or she drafts the LOI without proper legal advice. A good attorney will want to understand the matters that are unique to the potential business deal and any nuances around the business being acquired before drafting the Letter of Intent.
This article is only intended to educate the business buyer (and the seller) so he or she is well-prepared to discuss a Letter of Intent with their attorney.
As for the business seller who has received an LOI from a buyer, this article is intended to help you to understand why certain matters may be addressed in the document. Again, whether you’re the buyer or seller, your M&A Attorney is best-suited to assist in the drafting, editing, and negotiating of a Letter of Intent.
What is an LOI or Term Sheet?
A Letter of Intent is a legal document that is proposed by the business buyer and ultimately signed by the seller.
The LOI is drafted in the form of a business letter which includes a space on the last page of the document where the business seller would acknowledge their acceptance.
It’s not unusual for an LOI to be drafted by the buyer and then its terms be negotiated and changed by the business seller prior to their signature. Of course, both parties must agree to any edits to the LOI in order for the LOI to be valid.
In my practice, I have found it to be the best use of everyone’s time to verbally negotiate between the seller and buyer the major deal terms before drafting a LOI. Otherwise, there can be too many LOI drafts going back and forth which will slow down the deal process. Those back-and-forth activities can be very costly as well.
The verbal negotiations regarding important deal matters typically include the purchase price, deal structure (asset or stock sale), financing terms if any, contingencies, and whether the business seller continues to remain on the staff or as a consultant. Such deal terms are typically clarified before the LOI is drafted by presenting them to the business owner verbally. There may also be other terms that are important to the buyer that are negotiated before the LOI. It really depends on the buyer and seller’s circumstances.
Once a verbal understanding between the two parties is established, typically the buyer drafts the Letter of Intent for the seller’s review.
It’s important to understand that an LOI imposes significant obligations on both the buyer and the seller so, this step in the selling process should not be taken lightly. We will cover that aspect of the LOI later in this article.
Many business owners ask “Is there such a thing as a Letter of Intent template?”
Unfortunately, the answer is no. And that’s because every deal is different. Very different. That said, there are certain basic matters that most LOIs include.
What’s Included in an LOI for a Business Acquisition?
In addition to the purchase price (which may be fixed or a range), a well drafted LOI may include language related to the deal’s structure, financing terms, the ongoing relationship with the business’ seller post-closing, and any other known deal terms that may be important to the buyer and the seller.
Other important deal terms most LOIs include cover:
- Conditions to closing — For example, the seller may not materially change the way in which the business operates prior to closing, the buyer’s right to conduct due diligence, the buyer’s satisfaction with due diligence in every respect,etc.
- Allocation of professional fees and other deal-related expenses
- Anticipated time-frame for the due diligence process
- Confidentiality regarding the sale and due diligence process
- Non-solicitation so the buyer is prevented from soliciting the seller’s employees or customers if the deal does not close
- Targeted closing date
- Exclusive negotiating period — often called the No Shop Clause. This prevents the seller from continuing his negotiations with other prospective buyers for a specific period of time.
- Indemnification terms
- Governing law or venue
- Definition of the Binding and Non-binding LOI provisions
- Termination date for the LOI
Should I use an LOI When I am Buying or Selling my Business?
There are several reasons for using a Letter of Intent when acquiring a business.
For most buyers, their time is important to them. Time is money. There is no better way to expedite the decision process whether to proceed or not to proceed with a potential deal than to negotiate the LOI.
Negotiating the terms included in a Letter of Intent can help the parties identify key terms in the deal as well as the deal breakers. Why not determine as many of these possible matters sooner than later?
Similarly, for the business seller, time is of the essence. Having a business on the market for a prolonged period of time is never good for the business owner. Selling a business takes an enormous amount of time and financial resources and can be very distracting to the business owner. For this reason alone, anything that can be done to expedite the selling process should be considered carefully.
If considered thoughtfully, drafted well, and negotiated carefully, an LOI can offer both the buyer and the seller important protections.
While there are many good reasons to negotiate a Letter of Intent when buying or selling a business, there are a few reasons you may want to consider skipping the LOI:
- The LOI drafting and negotiations have a financial cost for both parties in the deal.
- If a deal term is negotiated in the LOI and later one party wants to renegotiate it, their position to do so is weakened. They will need compelling reasons to do so.
- A Letter of Intent can create a duty to negotiate in good faith for both parties. This makes it difficult for either party to simply change their minds and walk away.
- An improperly drafted LOI may create unintended obligations to negotiate and close the deal.
Is a Letter of Intent Legally Binding?
While a LOI is a legal agreement between two parties, it is not typically a binding agreement. However, within the LOI document, typically you will find certain terms that are binding for both parties. This is an important point to understand and worth further exploration.
Most LOIs will include intentionally binding provisions such as the exclusivity period for negotiations of the final purchase agreements, confidentiality and non-solicitation, expense allocation, targeted closing date, and the governing law or venue.
Such intentionally binding provisions in the LOI should be specifically identified as binding provisions. If this is not done, an unintended binding obligation in the LOI may be created.
Given the enormous amount of investors with capital ready to invest in businesses for sale in recent years, I’ve observed a number of buyers taking a lax approach to drafting and presenting Letters of Intent to sellers.
This always causes me to step back and pause a bit. I wonder if the buyer truly understands the importance of a well-thought out LOI, or is he simply so eager to get the deal done that he’s willing to hasten the business acquisition process.
Hastening the process by drafting a LOI without due care can have disastrous consequences.
LOI Duty to Negotiate in Good Faith
While the Letter of Intent to acquire a business may not be binding, there are several terms in the LOI which will be legally binding for the parties and the parties have a duty to negotiate in good faith.
According to Katherine Shonk, of Harvard Law School, “to negotiate in good faith means to deal honestly and fairly with one another so that each party will receive the benefits of your negotiated contract.”
Examples of negotiating in bad faith may include:
- Negotiating with the seller while having no intention to close the deal. Instead, the seller is simply seeking information that will be made available through the due diligence process.
- Changing a major term to your favor without a discovery resulting in a compelling reason to do so. This act of bad faith usually appears towards the end of negotiations or at the last minute.
- Disregard for the due diligence process by either party.
While courts view the duty to negotiate in good faith differently, it’s generally understood that under this obligation neither party to a Letter of Intent should take advantage of the other for its own benefit.
What is an Expression of Interest (EOI) vs. a Letter of Intent (LOI)?
Over the past few years, there has been a rise in the number of business owners receiving official-looking letters referred to as an Expression of Interest or EOI.
Such letters may be delivered directly to business owners by way of the postal service or express courier even when the business is not on the market for sale. Again, in today’s hot seller’s market, buyers are resorting to direct solicitation to acquire the types of profitable businesses they desire.
The use of an EOI is one way to get the attention of a business owner. And often, it’s very effective. Effective because if the business is not on the market, it’s likely the business owner will be relieved to only have to negotiate with the buyer who sought them out! This seems to be advantageous to the business owner. It is not.
The EOI letter typically expresses the buyers capabilities to buy the business and a range of value they’d be willing to entertain offering. It’s unlikely this type of solicitation is based on publicly-available data that’s accurate. So, if you’ve received such an unsolicited Expression of Interest letter from a buyer, beware.
Additionally, many private equity firms who are seeking businesses for sale in the lower and middle market are accelerating their acquisition process by preparing Expression of Interest letters after their initial review of the business’ Confidential Information Memorandum or CIM. Again, due to the competitive acquisitions market, private equity and competitors are doing what they can to be on the short list of buyers to negotiate with sellers.
A Letter of Intent is a more formal and substantive document which is typically prepared after significant negotiations and is based on information shared between the parties prior to its receipt.
What Happens After the LOI is Signed?
A lot. The acceptance of the Letter of Intent by both parties marks the time when the due diligence phase begins. The due diligence phase is when the real work happens. And that’s when most deals fall apart.
We’ve addressed the 10 steps to selling a business in this post. Yes, we had a little fun drafting this one, albeit we truly appreciate all the hard work it takes to successfully sell a business!