Once you’ve completed your preliminary due diligence, you’re ready (hopefully) to make a formal approach. This is usually done by sending a Letter of Intent (LOI).
There have been rumors that the Letter of Intent is going out of style. That you can save time and money by making a less formal approach and moving straight onto signing contracts. That preliminary due diligence is enough to know whether you want to buy a company.
I’m here to tell you that rumors of the LOI’s demise have been greatly exaggerated.
It’s as necessary today as it ever was, and it’s an essential part of the PATHS framework. Here’s why.
What is a Letter of Intent in M&A?
The “intent” in an LOI refers to your intent to fulfill certain obligations in the deal going forward. These may include:
- Accurately valuing the target company
- Having funding prepared to complete the deal
- Meeting the terms presented by the other party
- Keeping any information covered by an NDA strictly private
- Abiding by other criteria, such as no-solicitation agreements
- Going through with the final purchase
The acquiring party will draft the initial LOI with the help of their legal team. It’s a quick and affordable process, which is the main reason I think it’s bizarre that some rookie acquisition entrepreneurs seem to think it’s not 100% necessary.
There may be amendments or redrafts of the letter of intent depending on whether the seller finds it acceptable. If one side makes stipulations that the other can’t agree to, the LOI also serves the purpose of ending negotiations before either side has invested significant time and resources.
Supposing that both sides can agree on the terms, the LOI then makes provisions for further due diligence to work out the finer points of the deal before contracts are signed.
LOI vs. Term Sheet
A notable difference between an LOI and a term sheet is how they’re structured. An LOI will typically be a long-form written document, whereas a term sheet is often presented as a list of bullet points.
Term sheets are often used to discover whether the buyer and seller are roughly in agreement on a transaction’s structure and final price. It tends to be sent as a preliminary document before a full LOI is prepared.
There’s also less likely to be binding terms on a term sheet. While LOIs aren’t inherently legally binding, they often contain binding clauses such as NDAs and no-solicitation agreements.
What Does a Letter of Intent Include?
The content of an LOI is determined by the size and structure of the deal. Larger deals involving multiple parties may require bespoke, extensive LOIs, but for smaller transactions, the details are usually limited to a few key points.
This describes the party or parties on the buying side and their interest in purchasing some or all of the seller’s business. Key parties like financial backers may also be included in an LOI.
Terms & Structure of the Acquisition
The acquiring party proposes how the purchase will be structured, financed, and closed. This section tends to include the nuances of each party’s needs and may be revised several times before the LOI is signed.
The buyer will set out a timeline for the acquisition. This will include milestones indicating when certain phases of the purchase should have been completed. Again, the seller may suggest amendments to the timeline.
Once signed, this part of the LOI is considered binding. Failing to abide by the timeline may be seen as sufficient cause for one party to back out, as the other has broken faith.
The acquiring company may present its initial valuation in a term sheet and/or an LOI. This is subject to change based on formal due diligence but is considered roughly accurate if agreed upon by both parties.
Letters of intent almost always include NDAs. After the LOI is signed, the seller provides the buyer with detailed internal information, which the buyer must agree to keep private even if the deal falls through.
These are especially common in horizontal acquisitions and are mostly designed to protect the buyer once the acquisition has been completed.
Each party agrees not to poach key talent from the other. This means that the seller can’t just start up elsewhere and re-hire its former employees after the sale, stripping the sold company of its most important assets.
When to Send a LOI
In my opinion, you should always send a letter of intent in an M&A transaction. Skipping the “formality” is like walking into a meeting and not offering to shake someone’s hand.
There’s no reason not to – it’s affordable, it shows that you’re serious, and it lets you negotiate the deal in minute detail. And as many novice acquisition entrepreneurs have found out to their cost, that’s where the devil lurks.
However, you should be wary of sending a LOI before you’ve completed proper preliminary due diligence. Walking away after signing an LOI is frowned upon unless the other party has acted in bad faith.
You can’t just back out because you made a massive overvaluation due to sloppy pre-diligence. Well, you can, but your broker will think you’re a moron and a waste of their time.
In summary – be sure you’re ready to send it, but do send it.
Negotiating a Letter of Intent
A letter of intent must be signed by both parties before it’s valid. The seller has the opportunity to request amendments or even draft a completely new LOI after receiving the initial document.
The seller may request revisions to details such as:
- The initial valuation
- Information covered by NDAs
- Stipulations about the deal’s structure
- The timeline
- How the deal is financed
It’s common for a seller to make a few tweaks. However, they may also add entirely new provisions that aren’t related to what was proposed in the initial draft. The buyer may then respond to these until a satisfactory compromise is found.
If a seller finds an LOI broadly unacceptable (or too vague), rather than changing certain details, they may draft an entirely new letter. This is fairly uncommon and tends to get negotiations off to a rocky start, as it represents a full-throated rejection of the initial proposal.
However, it’s worth reviewing a counter-draft on its merits rather than taking it as a setback. If it doesn’t make the deal impossible or run counter to your strategic objectives, you may still be able to negotiate a worthwhile acquisition.
Sometimes, one party insists on a clause in the LOI that the other simply can’t agree to. This is one of the strongest arguments for why you should always send a letter of intent – it prevents time being wasted.
Better to have these conversations up-front than months into negotiations, by which time you’ve been paying a legal team, financial experts, and an M&A broker for assistance on a deal that was never going to work.
If it doesn’t work, it doesn’t work. You can write it off and move on cordially with all reputations intact.
What Comes Next?
Once the letter of intent has been signed by both parties, the seller will give the buyer access to the company’s internal data for review. This is the beginning of formal due diligence.
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