The letter of intent is an important piece of any business transaction. Jonathan Minnen, a Partner at law firm Smith, Gambrell & Russell, LLP, and Chris Hannah, a Vice President at Stout, joined to provide their thoughts on the subject from both a legal and investment banking perspective.
“Sure glad we got that letter of intent signed – let’s send it to the lawyers to paper the deal.”
That common sentiment suggests how the letter of intent, or LOI (sometimes also referred to as a “memorandum of understanding,” “MOU,” or “term sheet”), is often misperceived, especially by sellers in business acquisitions. Often, business parties will use an LOI to confirm only the major business points of a proposed acquisition (such as the purchase price and how it will be paid), provide a period of exclusivity to the buyer, and perhaps address how long representations and warranties will survive.
However, by not addressing in the LOI other critical issues that need to be discussed as transaction negotiations proceed, a seller risks leaving substantial economic value on the table and compromising strategic opportunities. Thus, a seller in a private-company sale transaction is well-advised to seek legal and accounting advice in the negotiation and drafting of the LOI. It’s important to keep in mind that not every acquisition transaction has an LOI. Instead, the parties sometimes proceed straight to negotiating a definitive purchase agreement. However, in transactions of significant size, the more common approach is to have an LOI precede the drafting of a purchase agreement.
The LOI is the first formal negotiating milepost for the buyer and seller, ultimately setting the tone and pace of transaction execution up and through closing. The seller’s response to an LOI is generally dictated by the buyer’s initial LOI draft. While buyers prefer to provide minimal and often vague language around key LOI terms, a seller is well-advised to address any topic that has the potential to become a negotiating element or may take significant time to fully document.
Unless the seller’s company has unique assets such as technology, intellectual property, brand, market share, or an exclusive territory, the seller’s maximum leverage likely occurs at the time when the LOI is being negotiated. The seller’s negotiating strength often will diminish from that point forward. This is because in private-company transactions, most LOIs contain an exclusivity clause, which means the seller will be precluded from speaking to anyone else about a possible sale during the period of exclusivity.
In short, the buyer gets the target company off the market, and other potential buyers may move on to other opportunities. Once it becomes known that the seller has entered into an LOI (even if the terms are confidential), if the transaction does not close, the perception may arise that the buyer found something unappealing and walked away. True or not, such perceptions can have an adverse impact on the ability of the seller to find a replacement buyer at the same price.
Despite confidentiality clauses, word of the LOI can leak, causing other complications. Employees and customers can get nervous about the possibility of change and start to look in new directions. A seller can also get emotionally attached to the idea of the sale and begin thinking about the proceeds, or, if they are owner-executives, moving on to other activities (including retirement). All of these factors make it harder for a seller to resist demands from the buyer after the LOI is signed. The phrase “becoming wedded to the deal” is an apt one.
Sophisticated buyers know this. They want to achieve this point with a seller as quickly as possible, and they want to preserve maximum flexibility to draft the purchase agreement in a way that is slanted in their favor. This is partly achieved by starting with a shorter, more general LOI that defers specifics by use of convenient stopgap wording in a way that can disadvantage the seller. Leaving an issue to be “as mutually agreed between buyer and seller in the definitive purchase agreement” is one such approach. An even more favorable phrase for the buyer states that “the definitive purchase agreement will contain representations, warranties, covenants, indemnification provisions, and closing conditions customary for transactions of this nature.”
Sellers are well-advised to take the opportunity, before they give up their optimal bargaining position, to insist on a more comprehensive LOI that addresses key transaction points.
In a competitive bidding process, we recommend that, before requesting revised terms, the seller compare all LOIs received to determine the commonality between various bidder terms and the unfavorable outliers from the leading bidders that can become negotiating points. A common strategy to deploy is a best-in-class benchmark matrix that illustrates each bidder’s shortcomings versus other LOIs received. Discussing preferred buyers’ shortcomings with them is an overarching negotiating technique to illustrate to the buyer that they are being evaluated in the context of other bidders and being asked to improve specific LOI terms to meet the market standard. Naturally, their willingness to improve their bid should also be weighed against their initial price consideration.
There are a variety of provisions that can be layered into the LOI to protect a seller during exclusivity and throughout the diligence period. Sellers and their advisors should design a strategy that determines which LOI terms require additional language to provide seller protection, keeping in mind that too many revisions may slow the momentum and place the LOI at risk. The importance of a balanced approach here cannot be overstated.
The following areas can potentially provide more leverage for the seller if better defined within the LOI. Additionally, these may be applied within a milestone framework that, once completed (or sufficiently completed for the seller), grants the buyer continued exclusivity until the next milestone or until closing.
As opposed to simply providing a 60- to 90-day exclusivity period, the seller may suggest one or two milestones to allow the buyer further exclusivity. With thoughtful consideration, the seller can design a milestone framework that essentially allows advanced termination of exclusivity in the event the buyer is having difficulty executing the transaction within the early stages. A quick break will better enable the seller to go back to alternative bidders while the transaction remains fresh.
In LOIs, buyers should be required to provide some form of financing commitments to ensure they have the wherewithal to fulfill their funding obligation.
Sellers are advised to define the length of time and type of access they will provide to a buyer. The buyer will typically request a time frame in which they can visit management or hold Q&A conference calls. The seller should supplement this with tentative dates for site visits and, if required, identify which management personnel will be included in diligence discussions.
Defining which working capital accounts are to be included in the working capital peg calculation can be subjective, which may lead to a lengthy delay. Again, the seller has the most leverage to negotiate a favorable working capital outcome prior to signing an LOI. Attempts should be made to conceptually agree on a formula or mechanism to determine working capital in which the buyer and seller are in the same ballpark.
Although the buyer will be burdened with the majority of the diligence costs during exclusivity, the seller will experience some attorney and advisory expenses. Although immaterial to the overall size of the transaction, including a seller expense recovery clause prevents buyers from engaging in an LOI unless fully committed and provides cost recovery in the event buyers decide to terminate their interest. If a buyer doesn’t agree to this, a two-way breakup fee structure can typically be agreed upon.
If a price for the acquisition of a business is agreed to in the LOI, then the form and structure of the transaction should also be specified. It is common practice for a buyer to prefer to acquire the company’s assets and selected liabilities to attain a step-up in tax basis and to avoid unknown liabilities, as opposed to a stock transaction that generally provides favorable tax treatments for the seller but not these advantages to the buyer. Sellers may include language in an LOI that protects them from a potentially larger tax liability.
A general representation-and-warranty survival period between six months and three years is considered under the “bell curve” depending on the nature of the business being sold and the specific transaction at hand. But a buyer can be expected to push for as long a period as possible, including certain “fundamental” topics that would have an even longer period of survival. For a seller, the best time to quantify (and limit) what will be on that list of fundamental representations is during the negotiation of the LOI. The survival period should be determined in the LOI and address both the length of time for the escrow and what specific items will be used to resolve the claims. Due diligence findings, however, can lead to escrow and survivability of reps and warranties being materially renegotiated.
If structured as an asset transaction, the buyer may state that all customer and supplier contracts are to be assigned as a condition to closing. In the event that there is a high volume of contracts, the seller should adjust the language to include key contracts (which can be separately defined and agreed upon) to be assigned effective with the closing as a condition to closing and the others on a “best efforts basis.” A sophisticated buyer would include burdensome “all contracts” language knowing that the terms would be difficult for a seller to fulfill and would ultimately provide buyers with an option to terminate if they later desired to exit the relationship.
For a seller, the LOI often provides the point of maximum negotiating leverage to insert a few phrases or sentences that can make a material difference in the overall transaction. Experienced professional advisors have a highly useful role to perform, and wise sellers will take full advantage of this important opportunity to maximize their strategic transaction position and thereby put more dollars in their pockets.
A previous version of this article was published in the Winter 2017 issue of Trust the Leaders, a quarterly legal publication produced by Smith, Gambrell & Russell, LLP.
Jonathan M. Minnen
Partner, Smith, Gambrell & Russell, LLP