When Is A Deal A Deal? Letter Of Intent Fundamentals
When parties begin the negotiation process for the sale of a business, a buyer will usually present a letter of intent summarizing the material terms of the offer. A letter of intent may also be called a term sheet or memorandum of understanding. The goal of a letter of intent is to settle the key material terms up front and specify what each party brings to the table.
It is important to review a letter of intent in light of all of the deal terms and to ensure that the parties agree on key issues in advance that could turn into deal breakers if not resolved early on. Letters of intent come in all shapes and sizes, and not all terms are necessary or appropriate to set forth in each one — certain transactions may not require a letter of intent at all.
Parties, however, must keep in mind that most aspects of a letter of intent are not legally binding. While the terms do lay out the framework for the parties’ deal, the intent is to create alignment that may still be subject to further negotiation based on the parties’ diligence.
NON-BINDING KEY TERMS
Deal Structure: The deal structure has significant business and tax implications that must be carefully considered. A letter of intent should clearly set forth whether it involves an asset purchase, equity purchase, or type of merger. The tax classification of the seller should be evaluated as it may lead to preferred deal structures. Further, operational considerations should be reviewed for assignability or transfer restrictions in licenses, permits and contracts, because such restrictions might limit transferability under certain deal structures but not others.
Price: The letter of intent should set forth the agreed purchase price, including how it will be paid (i.e. in installments, by cash, promissory note, through equity rollover, etc.) and whether it is fixed or subject to adjustment. If the purchase price is subject to adjustment, a seller should negotiate for as much precision as possible in the adjustment approach (such as specifying range of values, using formulas, etc.), and a buyer should qualify all adjustments subject to its due diligence review.
Retention of Seller / Key Employees: If the parties intend that the seller, its owners and/or key employees will work for the buyer after the transaction, the letter of intent should specify the terms of employment, equity incentives, and any desired restrictive covenants (e.g., covenants not to compete or solicit). More generally, the parties may desire to specify up front how employees of the business will be handled — is the buyer expected to offer employment to all employees? Is the buyer required to match or exceed existing salaries and benefits? Should the buyer maintain these benefits for a certain period of time following closing?
Due Diligence: A letter of intent will often describe the scope of the buyer’s proposed review. Buyers will want a provision in the letter of intent specifying that the seller will cooperate with the buyer and its due diligence investigation into the seller’s business, including that the buyer will have reasonable access to books and records. In turn, the seller will want to specify any limitations on access to its facilities, such as restricting the buyer’s entry to reasonable business hours or requiring prior notice.
Closing Conditions: Both buyers and sellers will want to set expectations in advance on the conditions that must be satisfied in order for the parties to be obligated to close the transaction. Common conditions include receipt of third-party consents, regulatory approvals, and the completion of due diligence by the buyer. If a buyer is financing all or a portion of the purchase price, it will often want to have a financing condition to close (so that the buyer does not have to go forward with the transaction if it is unable to secure financing).
Standard Definitive Deal Terms: The parties should agree that the definitive transaction agreement will otherwise have standard representations, warranties, and indemnifications.
It is imperative that the parties make clear that terms intended to be non-binding are explicitly specified as such in the letter of intent. Standard terms should also be included clarifying that neither party is required to consummate any transaction as a consequence of the letter of intent. Establishing that certain terms in the letter of intent are non-binding will help protect parties from being obligated under provisions-in-progress before signing a definitive agreement.
BINDING KEY TERMS
No Shop / Exclusivity: This provision prevents a seller from pursuing other buyers or soliciting other offers. The restriction is tied to a set period that typically reflects an appropriate timeframe needed by the parties to negotiate a definitive agreement in good faith (for example, 45 days or 90 days). Buyers will likely request to be notified of any third-party solicitations the seller receives. Sellers may request carve-outs to the “no shop” provision allowing for the seller to entertain unsolicited offers or continue to review offers that were on the table prior to receipt of the buyer’s proposal — these are often heavily opposed by a buyer.
Termination; Break-Up Fees: A letter of intent should spell out when, and how, the negotiations and letter of intent may terminate, and which provisions (such as confidentiality and non-solicitation covenants) survive termination of the letter. The parties may also desire to have a “break-up fee” provision, which specifies the amount one party will pay to the other if the party walks away from the deal. Buyers often want this provision as a way to recoup diligence expenses if the seller changes its mind or finds a better offer. If a buyer insists that seller be bound by a “no shop” provision, a seller’s ability to negotiate a purchaser break-up fee becomes stronger (based on the rationale that the break-up fee is a way to compensate seller for lost marketing or sales opportunities while it was bound by the “no shop”).
Confidentiality: Confidentiality obligations benefit both parties. If the parties have not signed a separate confidentiality agreement, the letter of intent should require the parties to keep confidential the information received by the parties in connection with the deal discussions. Even if the parties have a separate confidentiality agreement in place, the letter of intent will generally specify that it’s subject to any previously-executed confidentiality agreements. The letter of intent should specify the fact that the parties are even considering a transaction will be kept confidential — it prevents subsequent bidders from learning there was a possible transaction and, in the event the original buyer walks away from a deal, inferring there was a reason the business was not worth buying. The confidentiality provision may also specify individuals of the seller and buyer who serve as the “point person” for negotiations and requests for information to streamline the process and prevent premature disclosure of the deal to a party’s employees, customers, suppliers, etc.
Non-Solicitation of Business Employees and/or Customers: During due diligence, buyers will often learn about specific employees and key customers of the seller. Understandably, sellers are often very concerned about a buyer soliciting or “poaching” employees or customers of the business if the transaction falls apart. Therefore, sellers will want to include a binding provision in the letter of intent specifying that if the transaction is not consummated, the buyer will be prohibited from soliciting or hiring seller’s employees or soliciting key customers. Buyers often resist these provisions or seek to limit them by allowing the buyer to solicit or hire employees in connection with generally advertised postings or contacting customers in the ordinary course of business.
Publicity: The parties should include limitations on when and how the parties can discuss the deal with third parties. Certain distinct considerations are needed in a transaction involving a publicly-traded company.
Transaction Expenses: Often, a letter of intent will describe how the transaction expenses will be allocated between the parties. The most common way expenses are split is that each party will pay for their own legal, accounting, and any broker fees and the parties will split fees for any regulatory filings.
Conduct of Business: Buyers are often concerned that after signing the letter of intent, the seller may take actions to reduce the value of the business being purchased (such as selling assets or paying dividends to the owners). This provision generally obligates a seller to continue to operate the business in the ordinary course and avoid entering into any extraordinary transactions.
Governing Law: A letter of intent commonly includes a governing law provision specifying which jurisdiction’s laws will govern any disputes that may arise.
Just as it is imperative to identify which terms of a letter of intent are non-binding, it is equally important to clarify which terms the parties intend to be binding. This ensures that if a dispute arises, the injured party will be able to enforce any rights they may have under a letter of intent (such as obtaining relief for violation of a non-solicitation provision or enforcing payment of a break-up fee).
There are benefits to both parties in negotiating a clear and concise letter of intent and working with experienced M&A counsel to ensure no foot-holes are stepped in and that all essential parts of the business are protected. Negotiation of a letter of intent can help the parties tackle key issues up front and avoid costs later on by identifying potential deal breakers before investing more resources into a transaction that isn’t feasible. Failure to negotiate leaves open the opportunity for parties to change deal terms later on and promotes misunderstanding on key provisions.
Reach out to McGrath North’s M&A team today. A properly drafted and fairly negotiated letter of intent can benefit both parties and set the stage for a successful negotiation and efficient deal process.