by Jonathan B. Wilson Taylor English Duma LLP
The first step in nearly every acquisition or merger negotiation is preparing a term sheet or letter of intent. The letter of intent ("LOI") (which I will treat synonymously with “term sheet”) is a brief document that parties order to establish expectations for the transaction and establish some ground rules for the negotiations moving forward. Yet, despite their importance in getting the acquisition process underway, many business people (and even some attorneys) sometimes treat the LOI as an unimportant after-thought. It is not.
Binding versus Non-Binding
Letters of Intent may be (a) binding contracts, (b) entirely non-binding statements of present intention or (c) partially binding and partially non-binding. Attorneys who practice in the M&A space should take care when drafting and negotiation LOIs.
A key first question to ask when drafting an LOI is whether all or any of the provisions in the LOI should be legally binding. If the parties intend for all the provisions in the LOI to be binding, the LOI should say so expressly, using the same language that parties would ordinarily use in a binding contract. If the parties intend for none of the provisions in the LOI to be binding, the LOI should explicitly provide that it is non-binding to prevent misconstruction. One potential construction might read:
"This LOI is a non-binding statement of the parties’ current intentions but the parties do not intend for any of the provisions in this LOI to be legally binding. Neither party is bound to consummate any transaction because of this LOI."
Most M&A LOIs between private companies are non-binding except for a few select passages, usually governing confidentiality, responsibility for attorneys’ fees and expenses and (where applicable) any “no-shop” or “exclusivity” provisions.
Private company purchasers tend to prefer this arrangement between they want the “No-Shop/Exclusivity” provisions to apply for the period that follows the execution of the LOI and that continues until the executive of a definitive purchase agreement. Having a binding “No-Shop/Exclusivity” provision in place assures the purchaser that the target will not leverage the purchaser’s pricing and other deal terms in negotiations with alternative purchasers, in an attempt to get a better deal or push the purchaser’s price upward.
The “Expenses” provision may provide that each party will pay its own expenses and bear its own attorneys’ fees. In some transactions one party or the other may require that the counter-party pay all (or a stated portion of) its attorneys’ fees or specified transaction expenses. In either arrangement, having an enforceable “Expenses” provision allows the party to rely on the provision even if all (or nearly all) of the balance of the LOI is non-binding.
The “Confidentiality” provision is usually mutual so that each party is assured that its confidential information will be maintained by the counter-party in secrecy. In an asset purchase deal, however, where the seller is the party primarily disclosing its own information as part of the due diligence process, the confidentiality provision will mostly benefit the selling party.
Rationales in Favor of a LOI
Business clients may sometimes ask why a Letter of Intent is necessary or advisable when it is mostly non-binding and does not necessarily guarantee that a deal will get closed. Some of the key rationales favoring a LOI are:
• The LOI memorializes key deal points. Forcing the parties to summarize the deal terms helps to identify any deal breakers in advance.
• The LOI provides a “map” for the deal and guides counsel on the key terms and documents that need to be prepared.
• The LOI can set expectations for key activities during due diligence and the timing of key milestones in the negotiation process. For example, the seller might commit to upload all of its responsive documents to the data room within a specified period while the buyer might commit to produce a first draft of all definitive documents within another period. While these timing commitments will usually not be binding, setting expectations can be a helpful part of the process through which the parties develop confidence in each other.
• The LOI can help to inform regulators, investors, lenders, insurers and other ancillary parties about the key terms of the deal and the level of the parties’ commitment to the deal. If a Letter of Intent for an acquisition requires financing, for example, a prospective lender to the purchaser might require a Letter of Intent to ensure that it has a “real” deal and to identify key issues in the financing (such as the scope of possible collateral).
• The LOI also helps the parties, especially where the individuals are not experienced in the M&A process, to ensure that they truly understand the process. It is common for non-lawyers to use terms like “buy-out,” “acquisition” and “merger” as if they were synonymous when, in fact, they are not. By forcing the clients to articulate their intentions in writing, the attorneys have a platform from which to ensure that their clients have a clear understanding of the proposed transaction.
Risks of a LOI
Most parties prefer to have a well-crafted LOI in place before proceeding with a transaction. Nevertheless, a faulty LOI can create liabilities and there are risks inherent in the LOI drafting and negotiating process.
• Drafting and negotiating a LOI takes time and money. Inexperienced parties and those who cannot distinguish between necessary points and negotiable points can cause the process to become protracted. Sometimes the process breaks down to a part where the deal cannot go forward.
• Depending on the circumstances, such as when there is a publicly traded participant, an LOI can trigger a public disclosure obligation.
• A seller, who is enjoying the pursuit of two or more prospective buyers, may prefer to keep the bidding process open in order to maximize its selling process. Halting the process through the “Exclusivity/No-Shop” provisions of an LOI may run contrary to that goal.
• A defective LOI may bind the parties in situations that they did not intend, resulting in liability.
• Some courts have found that even a “non-binding” LOI can obligate a party to “negotiate in good faith,” creating potential liability where the parties did not intend.
Drafting and negotiating a Letter of Intent LOI gives counsel for the purchaser and the seller to get acquainted. Since the deal process will inevitability have an adversarial element, making a human connection with opposing counsel early in the LOI process helps to establish a positive working relationship. By collaborating in the LOI, opposing counsel can develop a rapport that may prove helpful later in the process.
Because the tax effects of the transaction will always be important to the parties, it is important to have tax counsel contribute to the LOI. If there are any particular tax outcomes that are material to the deal, the LOI should spelled them out. If the tax analysis is not complete at the time the LOI is being prepared, and either party is going to reserve the right to require structuring changes to accommodate its tax planning, the LOI should expressly state that reservation.
If the approach to due diligence has not already been discussed an agreed between the parties, it can be helpful to include due diligence requirements in the LOI itself. The LOI should list details such as lien searches, title searches, third party consents, a quality of earnings report and similar activities that require out-of-pocket expense or significant leadtime so that the parties are clear on which party needs to act.
If the deal structure is sufficiently definite in the LOI, counsel for the purchaser may also want to provide a preliminary closing checklist along with the LOI. Preparing a checklist makes clear to the parties the documents they expect to complete, the party responsible for the first draft and similar details.
If a well-crafted Letter of Intent is a map that charts the course of a transaction, parties expecting to cross the turbulent oceans that represent the negotiation of an asset purchase or merger agreement should make sure that their LOI provides clear direction to the parties.