Overview of the LOI

Negotiating is a soft science. What works for one deal won’t necessarily work for the next. That being said, understanding the intricacies of the LOI and who has leverage at what point in the negotiations will help you understand how to maximize your position and best maintain your leverage throughout the transaction. First, I’ll explain the strategy most buyers use when negotiating the LOI.

Buyer’s Strategies

A buyer will typically submit a letter of intent after spending some time assessing your business and determining if it’s a good fit. Among the items customarily included in the LOI are the price and terms, what assets and liabilities will be included, an obligation to negotiate exclusively, and conditions to close. 

For sellers, mistakes made negotiating the LOI are far more common than in negotiating the purchase agreement. Most sellers dramatically underestimate the importance of the LOI and are in a hurry to move on with the transaction and rush to sign the LOI. Experienced buyers have many strategies for taking advantage of this lack of patience. 

Here are a few of the most common strategies buyers use to maximize their leverage.

Rushing Into an LOI: Savvy buyers put pressure on you to quickly sign the LOI and move into due diligence. Why? Most LOIs contain an exclusivity clause in which you must agree to cease all negotiations with third-party buyers and take your business off the market. The moment you sign an LOI that contains such an exclusivity clause, your negotiating position evaporates. And that’s exactly what experienced buyers aim to do. 

Chipping Away at the Price: Another strategy buyers often use is to get you to invest as much time and money as possible in the deal before they begin to slowly chip away at the price and terms later in negotiations. At this point, many sellers have already spent tens of thousands of dollars with their attorneys to negotiate the purchase agreement, and they don’t have the energy to go back to square one with a new buyer. As a seller, you’re in sole negotiations with one buyer. Corporate buyers, on the other hand, may be in negotiations with multiple sellers simultaneously. The fact that you’re exclusively negotiating with one party while the buyer may be negotiating with multiple sellers has the potential to dramatically weaken your negotiating position and encourages the buyer to continue negotiating until the final minutes before the closing.

Potential Damage From Backing Out: Buyers may also take advantage of the potential downfalls of a seller backing out of a deal. Experienced buyers know that if you walk away from the transaction and put your business back on the market, other buyers might think you’re peddling damaged goods. If you put your business back on the market and restart negotiations with another buyer, that buyer might downgrade their valuation and conduct much more thorough due diligence if they are aware it didn’t work out with a previous buyer.

Buyers employ all these strategies to maximize their negotiating leverage and minimize the price they pay. A poorly drafted letter of intent will allow them to box you into a corner, which means you may eventually receive less for your business. Understanding how to properly negotiate the LOI is your best defense against these tactics. 

For sellers, mistakes made negotiating the LOI are far more common than with the purchase agreement. Most sellers dramatically underestimate the importance of the LOI and are in a hurry to move on with the transaction. 

Undefined Terms in the LOI

The tactics described above stem from weak or ambiguous LOIs. Failing to define certain terms in the letter of intent can be devastating for you. Because the buyer’s attorney usually prepares the purchase agreement, if a term isn’t defined in the LOI, it will be worded in the buyer’s favor in the first draft of the purchase agreement and it may take a significant number of rounds of negotiations to undo a term you failed to define in the LOI. With that in mind, here are some terms that could – but shouldn’t – go undefined in the LOI: 

• Working Capital: Working capital is included in most middle-market transactions, even if the transaction is structured as an asset sale. If the definition of working capital and how it’s calculated aren’t clearly defined in the LOI, the finer points of exactly how working capital is calculated will also be worded to the buyer’s advantage in the purchase agreement. The result? Depending on the size of your business, this definition can cost you hundreds of thousands, or potentially millions, of dollars.
• Transition Period: If the transition period isn’t defined in the LOI, the buyer can propose an unreasonable transition period. For example, they may propose a six-month transition period at no cost.
• Exclusivity Period: The savviest buyers attempt to include language in the LOI that grants them exclusivity for as long as you and the buyer are negotiating in good faith. This usually results in an exclusivity period of indefinite length that includes automatic extensions. If you sign such a clause, a less well-intentioned buyer may drag you along for months as they whittle away at the purchase price. A well-drafted LOI limits the length of the exclusivity period and imposes deadlines and other requirements that must be met for the exclusivity period to be maintained.
• Holdback: Many LOIs don’t mention a holdback or escrow at the outset. The seller is, therefore, often shocked to later see a large holdback of the purchase price requested in the purchase agreement. If you don’t settle this in the LOI, you’ll be left to negotiate this in the purchase agreement, at a stage in which your negotiating leverage has been exhausted. The buyer may be able to propose a larger escrow, as a result.
• Purchase Price: Some LOIs offer a price range instead of a specific price. For example, the LOI may define the purchase price as “between $25 million to $30 million, based on the buyer’s findings during the due diligence period.” I’ve got news for you – if you accept an LOI with a price range, you’ll likely find it’s not a range but rather one price – the lower one.
• Terms: How is the buyer financing the transaction? If the buyer is securing third-party financing, are they also asking you to hold a note? If so, you will be in a junior position. Do the terms include an earnout? If the terms aren’t defined, guess what? Lo and behold, the buyer will express disappointment with the findings from their financial due diligence and tell you the results are less than they expected and they believe EBITDA was overstated. What’s the result? An earnout, strong reps and warranties, and other mechanisms designed to lower the buyer’s risk and total purchase price.

These points are just a sample of what can go wrong if critical terms aren’t defined in the LOI. The bottom line is that you have all the leverage when you’re negotiating the LOI. Use it. Spend as much time as you like negotiating the LOI. Savvy buyers will use momentum and pressure to get you to sign the LOI as quickly as possible. Don’t do it. Take your time negotiating, which will maximize your price and terms and help you maintain your negotiating position. 

Failing to define terms in an LOI can be devastating for a seller. Because the buyer’s attorney usually prepares the purchase agreement, every definition will be worded in the buyer’s favor. 

Comparing Offers

Which offer would you accept?

• Offer 1: $13 million purchase price, payable as follows: $3 million cash at closing and a $10 million earnout.
• Offer 2: $10 million purchase price, payable as follows: $8 million cash at closing, $1.5 million seller note, $500,000 escrow.

It’s a trick question – you can’t decide. You don’t have enough information to make a decision. 

I would ask the following questions before I could evaluate either offer:

• For Offer 1:
  • What are the terms of the earnout? Is it based on revenue, EBITDA, or some other measure? How many years is the earnout?
  • Who will control the business post-closing? 
  • How will the purchase price be allocated for tax purposes?
  • What is the extent of reps and warranties, indemnification, and escrow that the buyer is proposing?
• For Offer 2:
  • What are the terms of the seller note, such as the amortization period and the interest rate?
  • What are the terms of the escrow (i.e., holdback)? 
  • How will the purchase price be allocated for tax purposes?
  • What is the extent of reps and warranties, indemnification, and escrow that the buyer is proposing?
• About the Buyer:
  • How creditworthy is the buyer? This is relevant for both earnouts and a seller note.
  • What is the related experience of the buyer?
  • Is the buyer requesting exclusivity? If so, how restrictive is the exclusivity period they are proposing?
  • Does the buyer have the cash, or is the letter of intent contingent on the buyer obtaining third-party financing?
  • How many acquisitions has the buyer successfully completed in the past?
• Timing:
  • How long is the buyer requesting to complete due diligence?
  • How long after the completion of due diligence can the buyer close?
• Escrow:
  • What are the terms of the escrow (i.e., holdback)? 
  • How long is the escrow period? 
  • What are the limitations of indemnification, such as caps and baskets?
• Transaction Details:
  • Will the transaction be structured as an asset or a stock sale?
  • What are the conditions for closing?
  • What is the survival period of the reps and warranties?
  • Is the buyer requesting that you remain with the business? If so, what are the terms of the proposed employment agreement?

Unfortunately, I’ve seen countless buyers who propose deals with terms like the offers above. And they often get away with it because sellers commonly focus only on price. Yes, the LOI you received might look attractive enough to accept – but 90% of it may be boilerplate, and the terms may be vague enough that the buyer can rewrite them to their tastes later. When you receive an LOI, it’s critical to pin down the buyer on all the key terms of the transaction; otherwise, there’s a good chance the unwritten terms won’t be favorable for you when they’re finalized in the purchase agreement. I’ll provide details on all the terms that can be included in the LOI in this chapter.

The Major Characteristics of a Letter of Intent

This is a listing of the major terms and characteristics of an LOI, and the impact they can have on negotiations: 

• Non-Binding: The purpose of the LOI is to come to an agreement on the major terms, such as price, and to allow the parties to begin the due diligence period. The terms in the majority of LOIs are non-binding. The only elements of the LOI that are usually binding are the exclusivity, confidentiality, and no-hire provisions.
• Moral Obligation: The LOI can be thought of more as a moral obligation as opposed to a legal obligation. Unscrupulous buyers can, therefore, use an LOI to their advantage due to its non-binding nature.
• Preliminary Agreement: The LOI is a preliminary agreement to be replaced by a purchase agreement and represents a critical juncture in the sales process that marks the beginning of due diligence. The LOI allows the parties to begin due diligence based on this preliminary agreement. It reduces their legal costs by preventing the parties from having to prepare a more detailed purchase agreement at a stage when they aren’t ready to sign a binding purchase agreement. The content of the purchase agreement varies based on what the buyer discovers during due diligence.
• Basis of Negotiations: The LOI is used as the basis for negotiations and for drafting the purchase agreement. Any terms of the transaction that aren’t defined in the LOI will be drafted in the buyer’s favor in the purchase agreement.
• Exclusivity: Most LOIs contain an exclusivity clause in which you must agree to take your business off the market and cease negotiations with other buyers. This clause weakens your negotiating position.
• Limited Information: In most cases, the buyer has received limited information on your business and hasn’t conducted due diligence. The terms of the transaction may change based on what the buyer discovers during due diligence. If the buyer finds additional issues that weren’t disclosed prior to submitting the LOI, the price and key terms will change.
• Contingent: The LOI is contingent on the buyer’s successful completion of due diligence. If the buyer isn’t satisfied with the results of due diligence, the buyer can walk away from the negotiations in nearly every instance.
• Momentum: The LOI enables the parties to resolve problems before becoming deeply entrenched in a position emotionally and financially.
• Highlights Unresolved Issues: The LOI also highlights any potential undefined issues that need to be defined in the purchase agreement, such as the terms of an ongoing employment agreement between you and the buyer or the terms of an earnout.

The Term Sheet

A term sheet is sometimes used to start negotiations by allowing the parties to focus on the key terms of a transaction before preparing a more detailed letter of intent and, later, a purchase agreement. A term sheet isn’t usually necessary if the buyer is a private equity group or sophisticated corporate buyer. In these cases, the buyer or their attorney usually prepares the LOI. Note that “term sheet” is not used consistently across the industry and what some refer to as the term sheet may be called different names depending on the industry or size of the business. 

A term sheet can be as simple as a sheet of paper with your agreement regarding the basic terms of the transaction, such as the selling price, down payment, financing terms, length of time for due diligence, training agreement, non-compete agreement, and contingencies. This document allows you to focus on structuring the essential elements of the transaction without getting bogged down in the language required to document those terms. Once you agree to the term sheet, you can move straight to the LOI. I’ve seen many parties spend dozens of hours and thousands of dollars in attorney fees because they didn’t agree on the basic terms and structure of a transaction before they dove into drafting the letter of intent. A term sheet can prevent this problem by allowing the parties to focus on the critical terms of the transaction before they prepare a more detailed letter of intent.

If you decide to prepare a term sheet before a letter of intent, you’ll want to agree on the following basic terms:

• Selling price
• Earnest money deposit, if applicable 
• Down payment
• Holdback (i.e., escrow), if applicable
• Seller note – amortization period and interest rate, if applicable
• Due diligence length
• Transition period length
• Non-compete agreement
• Any contingencies

Non-Binding

Most LOIs are drafted to be non-binding, except for a few key provisions. The non-binding provisions include those relating to price and terms, such as:

• The purchase price
• How working capital is to be calculated
• The form of the transaction
• How the price is to be allocated
• The amount of the purchase price to be held back in escrow

The binding provisions relate to how the process is to be governed, including:

• Maintaining confidentiality
• Exclusivity
• The buyer’s access to information to conduct due diligence
• Payment of expenses
• Termination 

Regardless, the parties should be sure to clearly express which provisions are intended to be binding.

Why are most LOIs intended to be non-binding? It’s because the terms of the transaction may change based on what the buyer discovers during due diligence. Prior to due diligence, you’re making representations the buyer must accept at face value. It’s not until you accept a buyer’s letter of intent that they will have the opportunity to confirm, or verify, your representations – hence, due diligence is often called “confirmatory” since your representations are “confirmed” during this period. Buyers don’t want to be bound to a document that’s based on assumptions they haven’t yet had a chance to confirm. With a non-binding LOI, the parties aren’t bound to the transaction until a purchase agreement is signed, which usually occurs sometime after the completion of due diligence, or in many cases, not until the closing.

A provision stating that the LOI is intended to be non-binding is usually concluded by the courts to be non-binding. But some courts have ruled that an LOI may be binding in certain circumstances. When determining the binding nature of an LOI, the courts typically look at the parties’ intent, the language used in the agreement, and the degree to which performance has already been completed. Although most LOIs aren’t usually intended to be binding, the courts have ruled that the parties have a duty to negotiate in good faith, even when the agreement doesn’t explicitly state such an obligation. This should give you comfort if you’re negotiating with a direct competitor and have concerns regarding their intentions, such as if their objective may be to appropriate your trade or other secrets. 

Reasons Why an LOI Is Necessary Even if It’s Non-Binding 

As stated above, an LOI is an integral document to any M&A transaction, even though it’s non-binding. Here’s a list of the value a well-drafted, non-binding letter of intent adds to the transaction despite its non-binding nature:

• Moral Obligation: Most parties prefer the assurance of knowing each party has a written moral obligation to the preliminary terms in a transaction before they incur the significant expenses of conducting due diligence and negotiating the purchase agreement. The LOI morally commits each party to the transaction and is a test of good faith and evidence of sincerity. In some circles and industries, a buyer’s reputation can be harmed if word leaks that they entered into an LOI without serious intent.
• Commitment: The LOI tests how serious and committed a party is to a transaction. Asking a buyer to submit an LOI is a useful tool to gauge whether the buyer is willing to invest significant time and energy into the transaction. Think of it this way – an LOI is an engagement, while a purchase agreement is the marriage ceremony. Just as a marriage proposal is non-binding, so is a letter of intent. But, both play a valuable role in committing the parties in their moral obligations to a shared objective. The parties then progress toward consummating the transaction in a series of steps, with each step further strengthening their level of commitment.
• Express Intentions: Even though the LOI isn’t usually intended to be binding, the main purpose of a letter of intent is to express each party’s intentions and priorities. For example, is the buyer planning to pay cash or are they asking you to finance a significant portion of the purchase price?
• Clarify Key Terms: Despite being non-binding, an LOI memorializes the key terms, so there’s no confusion later in the transaction when the purchase agreement is being prepared and negotiated. The result is less disagreement or confusion. This is a key feature of the LOI, even though it isn’t a binding document. 
• Grant Exclusivity: Few buyers will commit the time and energy to conduct due diligence without having a commitment from you that you won’t shop their offer for a better deal.
• Reduce Uncertainty: By defining the major terms of a sale, an LOI, even if non-binding, dramatically reduces the likelihood the parties will disagree on the terms of a transaction in later stages of the negotiations.
• Clearly Define Contingencies: The LOI also clearly defines what must happen before the transaction takes place, in the form of conditions or contingencies.
• Enable Financing Pre-Approval: Most lenders require an LOI before they’ll commit to the expense of underwriting a loan.
• Grant Permissions: The LOI also allows the parties to conduct due diligence on one another to make sure they’d like to proceed with the transaction before committing to the expense of preparing and negotiating a purchase agreement. 
• Agree on Price: While the price will almost certainly change during due diligence, the LOI provides a common starting ground.

Why are nearly all LOIs non-binding? It’s because the terms of the transaction may change based on what the buyer discovers during due diligence. 

Problems and Solutions

Many problems can arise as a result of signing a letter of intent. Here’s a list of the most common ones and how to prevent or resolve each:

• Terms Degrade During Due Diligence: The terms of an LOI will never improve after you’ve signed it.
  • Solution: Define as many terms as possible when you have the maximum amount of leverage (i.e., before signing the LOI). But remember that doing so is a balancing act because buyers have access to a limited amount of information at this stage.
• Undefined Terms: Undefined terms will always be slanted in the buyer’s favor.
  • Solution: Define as many terms as possible in the LOI.
• Long Exclusivity Periods: The longer the exclusivity period, the weaker your negotiating leverage. Most exclusivity periods range from one to three months, while some buyers propose an open-ended exclusivity period.
  • Solution: Keep exclusivity periods as short as possible. Include milestones in the LOI for the buyer to continue to be granted exclusivity.
• Losing Negotiating Leverage: Signing the LOI disarms you. You give up nearly all your bargaining power the moment you sign the LOI.
  • Solution: Take your time negotiating the LOI. Rush to close the transaction once you’ve signed the LOI.
• Due Diligence Problems: Problems discovered during due diligence will result in a less favorable price and terms.
  • Solution: Prepare for due diligence to minimize the number of problems the buyer discovers during due diligence that they can use to renegotiate the price or terms.