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As a deal lawyer, I love getting the phone call from a client about a new transaction. My heart sinks, however, when the client happily tells me how simple it will be because they have signed a letter of intent—without a lawyer reviewing it. A letter of intent (“LOI”) is not necessarily a bad thing, but there can be pitfalls for the unwary.
The purpose of the LOI is to outline the principal business terms and time line for a transaction. When done well, LOIs allow the parties to focus on the fundamental business points without getting bogged down in the details that arise in negotiating the purchase agreement. Letters of intent can be as brief as one page, but purchase agreements can easily extend to 50 or 100 pages. Learning that parties cannot agree on the major terms contained in the shorter LOI will generally save time and legal fees for both parties. The LOI can also serve as a blueprint for the purchase agreement, often making the drafting and negotiation of the purchase agreement easier.
A poorly prepared letter of intent, however, can create problems. Delays in completing the LOI increase the potential for a deal breaking up, as unforeseen developments may change either party’s interest in completing the deal. For example, a seller may get a better offer, or negative developments may make the company a less desirable purchase (such as a quarter with poor financial results, the initiation of a significant lawsuit, etc.). Additionally, if negotiating the LOI gets complicated or drags on, not much is saved in terms of time or money.
Misunderstandings due to poorly drafted provisions in the LOI can slow negotiations because the parties may believe an issue has been settled in different ways. It can also lead to frustrations in completing the purchase agreement, since significant terms may have been left out of the LOI, or the client may have agreed to something in the LOI that the client did not understand or intend. Being perceived as renegotiating something that is viewed as already agreed upon can harm your overall bargaining position and relationship with the other party.
Here are some typical problems that arise under poorly drafted letters of intent:
- Commitment to a structure without advice regarding consequences. The structure of the transaction (i.e. stock sale, asset sale, merger) is one of the most significant factors in any transaction. An uninformed party may not recognize these consequences and sign on to a structure without having received any advice as to the potential consequences of that particular structure.
- Use of terminology without understanding the implications. For example, most smaller businesses maintain books on a tax basis and are not compliant with GAAP (generally accepted accounting principles), and the adjustments can make a big difference.
- Incomplete, vague or undefined terms. These often come in the form of high level concepts for financial formulas, such as “net profits” or “net sales.” Each party may think they know what is meant by the term, but not be on the same page at all. It is important to include a definition and, if it is a financial term, make sure the term, or at least the terms in the formula, tie to line items in the existing financial statements.
- Post-closing liability provisions are ignored. One of the material considerations in a purchase agreement is the post-closing liability, including indemnification and other remedies. This can have a significant financial impact on the parties. If not addressed at the LOI stage, when most other material terms have been addressed, it can be difficult to negotiate a good outcome in the purchase agreement.
- Creating unrealistic timelines or forgetting expiration dates. Many buyers include exclusivity or “no shop” provisions in the LOI, keeping the seller from continuing to shop the deal for a period of time. I have seen the deadline for exclusivity come and go with the buyer having forgotten it expired, which can give the seller additional leverage.
Because of the perceived benefits, LOIs will continue to be used, for better or for worse, in many transactions. Clients will also continue to sign them without receiving legal advice. Being familiar with the risks gives attorneys the chance to counsel their clients as early as possible in the process when undertaking significant transactions.