The Power of an LOI

August 28, 2024  |  By

I don’t need an LOI. Do I?

Vela Wood attorneys hear it every day, “We are in alignment on all the major issues. Just draft the final agreements for us. No need to do a letter of intent first.” This is often a big mistake.

This article will outline why using a letter of intent can benefit both the buyer and the seller in an acquisition transaction.

What is a letter of intent?

A letter of intent, also called an LOI, memorandum of understanding, MOU, or term sheet, is a short document meant to outline the key terms of an acquisition transaction. A letter of intent will typically include the following:

  • Purchase price and payment schedule
  • Structure of the transaction (e.g. stock purchase, asset purchase, merger)
  • Employment or independent contractor terms for seller owner(s)
  • Earnout structure (if any)
  • Other key terms of transaction (e.g. non-compete)
  • Confidentiality/NDA
  • Exclusivity/no-shop period
  • General terms (e.g. choice of law and venue)

Usually, the majority of the letter of intent terms are non-binding, with the exception of confidentiality, exclusivity, and the general terms.

Value of LOI for seller

The seller seeks to gain the most from a well drafted and negotiated letter of intent. Indeed, the seller has the greatest leverage during the letter of intent stage. Leverage normally decreases throughout the rest of the transaction. Benefits of using a letter of intent for the seller include:

  1. Alignment on Financial Terms: The letter of intent allows the seller to negotiate the total purchase price along with payment structure for the transaction. This can include:
    • Total amount of purchase price
    • The use of a purchase price adjustment
    • Size and duration of escrows or holdback
    • Interest rate, security interest, payment terms, etc. for any seller financing loans
    • Earnouts: specific definitions of key terms like net profit, payment timeframes, seller access to information, operation of the business by the buyer, etc.
  2. Alignment on Legal Terms
    • Choice of law and venue: Typically, the letter of intent choice of law will also be used for the definitive agreements. If the buyer and seller are from different countries, the choice of law and venue could be particularly important.
    • Indemnification: Frequently indemnification liability, including deductibles/thresholds, caps, and mechanics are not mentioned in the letter of intent. The buyer then proposes provisions that are very one sided in the purchase agreement. The letter of intent provides the seller an opportunity to negotiate these points upfront.
    • Restrictive covenants: This is also a term that buyers frequently push the envelope on, both in LOI’s and the definitive agreements. The letter of intent gives the seller an opportunity to negotiate a reasonable time period and business scope for non-competition, non-solicitation, and similar provisions. Without the letter of intent, the seller is typically going to have to negotiate the restrictive covenants several months into diligence, when they have less bargaining power.
  3. Alignment on structure: If structure of the transaction is critical to the seller for some reason, as it often is for startup (equity sales due to Section 1202), the LOI is the seller’s opportunity to note that.
  4. Employment, independent contractor, and other important transition items: If post-transaction employment is important to the seller or its owners, the LOI provides the opportunity to negotiate some of these terms-. Conversely, if an owner wants to quickly exit into the sunset post-transaction, the LOI is the place to set this expectation.
  5. Exclusivity: The exclusivity period length, shorter rather than longer, may give the seller more leverage by requiring that the buyer complete diligence in a timely manner and propose a purchase agreement sooner rather than later.

Value of LOI for buyer

A letter of intent offers many benefits to a buyer as well. These include:

  1. Exclusivity: The greatest advantage of the letter of intent for a buyer is preventing the seller from the deal or negotiating with other parties while the buyer is performing diligence on the target company.
  2. Alignment on financial terms: Similarly to the seller, specificity in the letter of intent surrounding financial terms is beneficial for both parties. In particular, the buyer might set expectations surrounding EBITDA or other financial targets that should be confirmed through due diligence. This may give the buyer room to negotiate the purchase price, if due diligence does not support the designated financial metrics. Further setting expectations of market holdbacks, escrows, or other terms early is valuable for the buyer.
  3. Comprehensive restrictive covenants: A buyer may be able to push for a wider or longer non-compete as part of the initial discussions in the LOI, particularly if a seller is more focused on the financial parts of the letter of intent.
  4. General alignment on key issues to parties: Having an LOI versus not allows the parties to delineate and crystalize the structure of issues most important to them. Skipping directly to the definitive agreements may result in longer negotiation time if the parties are not aligned on structure for important items. A party may also discover that an issue is more or less important to the other party during the LOI stage, helping guide the future negotiations.
  5. Setting expectations: The LOI can be used to set expectations surrounding the due diligence process, timing of certain events during the transaction process, etc. This can add value for both buyer and seller.
  6. Enforceable confidentiality, exclusivity, and some legal terms: The LOI provides both parties with enforceable terms in certain areas, such as exclusivity and confidentiality. Without the LOI, the parties typically would not have much in the way of an enforceable agreement until the purchase agreement is signed months into the process.

We hope that this blog post has been informative and helped you understand the key benefits of a well drafted letter of intent. The LOI is not something to overlook; it plays a crucial role in the purchase/sale process for both the buyer and the seller.

Posted in: M&A

About the Author(s)

Candace Groth

Candace Groth is a senior attorney at Vela Wood. She focuses on mergers & acquisitions and complex LLC matters.

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