Letter of Intent (LOI)

A brief, non-binding agreement before a more formal contract, like a share or asset acquisition agreement.

A letter of intent (LOI) is a brief, non-binding agreement before a more formal contract, like a share or asset acquisition agreement (definitive agreement). But other clauses-like those relating to confidentiality, exclusivity, and the law's applicability-are mandatory. 

It outlines the buyer's intentions in detail. The receipt of an LOI marks the beginning of the M&A process and the formalization of the buyer's interest by putting their intentions for the deal in writing.

The letter's length can vary depending on the nature of the discussions and the parties' objectives.

It typically includes the purchase price and terms, the assets and liabilities covered by the deal, exclusivity, and the requirements to consummate the deal. It is required before the buyer proceeds with the due diligence phase of the transaction.

It paves the way for a thorough due diligence procedure. The seller typically sets up a "data room" for the buyer after receiving the letter and gives further information and access to confidential documents.

When is the LOI issued?

It is issued before the due diligence phase and starts with informal chats. When the dialogue progresses to a more formal or serious tone, the buyer moves through drafting the LOI. 

Communication with potential customers typically happens in three stages.

1. First level: 

Without disclosing the company's actual name, the first level consists of a general discussion about revenue, earnings, and the industry.

2. Second level: 

If the buyer is genuinely interested and qualified to buy the business, the second level of conversation will start, where they will sign a non-disclosure agreement. This allows them to obtain a Confidential Information Memorandum (CIM), also known as "the book", with specific information about the business. 

The CIM should provide enough details about the company for a potential buyer to express interest, which can result in a meeting with the owner.

3. Third level:

The buyer presents, negotiates, and agrees with the seller on the key terms of the deal they are proposing at the third level, which is often handled in an LOI or Term sheet. 

What should a letter of intent include?

One of the most exciting occasions for a corporation is during mergers and acquisitions. Your company must manage the procedure properly with so much money on the line. The right way to handle the procedure includes writing, using, and delivering a letter of intent.

This letter is used in mergers and acquisitions to specify the terms and timing of the transaction and to ensure that the seller will end any further discussions with prospective purchasers. The following items are usually included in the letter.

1. Transaction Structure 

It is nothing but the proposed structure of the deal, i.e., Shares or Assets acquisition.

2. Proposed Terms

Apart from the deal's price, the letter should also make it clear that:

  • If the amount will be fully paid in cash, stock, or another form of payment
  • If the payment will be made, whether it is an upfront payment at settlement or a deferred payment plan
  • The method used to value assets like stock inventories
  • If a trade restraint is required, and if so, what the conditions of that restraint are;
  • When it comes to sharing sale agreements, how will elements like retained earnings be handled?
  • Who will care for outstanding amounts - debtors, creditors, and employee entitlements?

3. Timeline for the acquisition

The letter should specify the completion date for the following items:

  • When the buyer is given access to the results of the due diligence
  • When the acquisition agreement is anticipated to be signed
  • The deadline for finishing the due diligence
  • The anticipated date for settlement or completion

Why should you use an LOI?

Everyone in the M&A industry agrees that using an LOI is a good practice. Additionally, it gives the procedure transparency and clarity. The procedure will involve discussions, some document sharing, and a small amount of research into the company under consideration until the LOI.

Before the start of due diligence and the drafting of the definitive agreements, it is crucial to address all the concerns and ensure that the parties understand each other entirely.

Following this procedure will ensure a maximum chance that it will complete the transaction. Also, there will be a minimum chance of miscommunications or renegotiations between the parties. 

Deals typically fail because misconceptions arise due to the lack of clearly stated essential points in the LOI.

It paves the way for tremendous success and proves to the seller that the buyer is acting honestly and has put some thought into crafting the terms of a contract; It mainly creates a line in the sand. The buyer will be authorized to conduct due diligence if the seller agrees to the terms stated in the letter. 

If the terms are rejected, the parties might start discussing the issues, causing friction. If these issues are resolved, the parties return to the "final" version of the letter, sign it, and the process of conducting due diligence officially starts. Thus, it represents a crucial turning point in the development of a deal.

How to write an LOI?

Usually, it should be two or three pages long, concise, direct, and formal in tone. The letter should strike a balance between official business writing and drafting a friendly letter to a counterparty to avoid coming out as excessively antagonistic or demanding.

In the end, the deal terms should convince both the seller and the buyer that they are getting a fair deal in those circumstances and cannot get a better deal elsewhere. When parties reach this midpoint, it feels easier to continue with the deal and close it eventually.

1. Introduction

The purpose of the LOI is generally stated at the start of the letter, along with a general description of how the target company fits into your own company's strategy. The letter should state the non-binding nature should in the introduction.

2. Deal Structure

The brief introduction is followed immediately by the deal structure, which is the most significant section of the letter. If the structure is more complex than a simple 100% takeover, legal advice about the phrasing of this section may be necessary.

Importantly, this part should also state when and how payments are made (for example, in installments, based on revenue. etc.). The conditions around accounts receivable are a crucial part of this. Hence, the company's current assets are a factor in your decision to purchase it.

You must account for receivables in the letter since you cannot be certain that you will be paid for them. The type of such provisions will vary depending on the financial magnitude of the receivables and the firm's short-term profitability. 

The employment conditions of the acquired business's owner(s), if any, may also be specified in this section. This needs to be direct but non-aggressive. The seller should not feel forced into the new set of terms; instead, they should believe they stand to gain from the transaction.

The management team should be given incentives, like in any other employment contract, and should describe their contributions. This usually includes some equity rewards in the new business and possibly better working circumstances like shorter hours.

3. Indemnification Obligations

Since the seller's indemnity responsibilities come after the previous section, the respectful tone of that paragraph is particularly crucial. The recourse you have if the business's conditions significantly worsen following the deal is outlined in the section, which is likely the second most critical after the deal structure.

It is sufficient to note the scope of indemnities is thought of in terms of "caps" and "baskets" because this is discussed in greater detail elsewhere.

Caps establish the maximum amount the seller will have to pay the buyer in the case of such a deterioration. Baskets protect the seller regarding the number of losses that might occur before the buyer is compensated.

4. Transaction Closing Conditions

The closing requirements often include financial and regulatory requirements that must be satisfied before the deal can close. For instance, a takeover could be contingent on receiving regulatory approval (overseas takeovers) or the buyer securing funding from their third-party lender.

You should now have a written document (in the form of a letter) as a guide for the transaction. The intention is that it's written in good faith, even if it's technically not binding. Anything within it that is significantly changed puts the likelihood of the deal concluding in jeopardy.

It will also act as the starting point for your negotiations once it is forwarded to the seller.

How to Negotiate an LOI?

It is evident that in this process, some negotiating is anticipated. Even after the buy-side and sell-side have thoroughly reviewed a deal, it is typical for the letter to include concerns yet to be fully disclosed.

The significant numbers are typically known in advance, but the more minor clauses have rarely been discussed. The following are matters that the seller is likely to contest:

To ensure that the parties fulfill their obligations and prevent a breach of the LOI and any subsequent recourse actions, it is crucial to define the binding and nonbinding aspects of an LOI clearly. This makes a well-written LOI more likely to result in a successful transaction closing.

Engaging a professional team with broad transaction experience can assist you through the process of negotiating an LOI effectively and efficiently.

Conclusion

When a buyer writes a letter of intent, they go from being a "tyre kicker" to a serious buyer. In under three pages, a well-written LOI should summarize the transaction. Its drafting is crucial for both parties to the transaction.

Although the legally binding agreement may not always bring the transaction to an end, it is a significant milestone in the M&A process.

It has many uses, including:

  1. Making it easier for the parties to understand the important details of a complicated transaction.
  2. Officially stating that negotiations are ongoing.
  3. Offering protection if a deal falls through during negotiations.

It is the first step towards a final agreement containing the transaction's parameters. The buyer not only completely communicates their intentions to the seller in a clear, concise, and transparent letter but also clarifies their viewpoints.

Because of this, an LOI is a crucial part of any deal and requires your attention.

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Researched & Authored by Frank Pereira | LinkedIn

Reviewed and Edited by Raghav Dharmarajan

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