This is the fourth article in our series on selling the family business. For a recap on our multipart series, read our previous articles on conducting preliminary diligence, and marketing the family business.
Entering into a Letter of Intent (LOI) is an important part of selling a business. This article briefly explains what an LOI is, what items you should include in one, and why entering into an LOI (as opposed to moving immediately to preparing definitive documentation) is beneficial.
What Is an LOI?—and How to Structure One
An LOI, (also known as a term sheet, memorandum of understanding, or preliminary agreement), is an outline of the high-level deal points that the parties will eventually put into a definitive agreement. The parties should use it to agree on the basic terms of the proposed transaction. A good LOI will serve as a roadmap for the definitive agreement, which should contain generally the same terms and address the same considerations as the LOI.
An LOI can be fully binding, fully non-binding, or anything in between. As a general matter, it is recommended that LOIs be only partially binding, such that some of the terms should be binding while others are not. More specifically, process terms which dictate how the parties will interact during the drafting of a definitive agreement should be binding while substantive deal terms should not.
- Examples of "process" terms include: a non-disclosure agreement (which can be one-way or mutual, as needed), a no-shop clause, a breakup fee in case a definitive agreement is never entered into, the makeup of each party's deal team (i.e., which people from each party are to be communicated with and how), the timeline for the deal, and things of that nature.
- On the other hand, examples of "substantive" terms include: purchase price, representations and warranties, indemnification, earnout milestones, and the like.
The LOI should be extremely clear as to which terms are binding and which terms are not. The non-binding process terms and binding substantive terms should be separated and listed under different headers that indicate whether they are binding or not. If any term in the LOI is ambiguous, the parties risk a judge ruling that the LOI is a fully binding contract.
As noted in the first article in our series, one advantage to using an LOI is that it allows the seller to easily compare the competing offers of multiple buyers. The seller can send each buyer an LOI containing the seller's ideal substantive terms and ask each buyer to revise the LOI so that it represents their best counteroffer. This gives the seller a tangible way to assess the differences between various buyer's offers and identify which buyers remain of interest.
Moreover, having an LOI allows the parties to bring relevant third parties up to speed on the proposed deal1 without having to describe it in abstract terms, and allows the third parties to gain a clear understanding of what the deal would look like. This kind of clarity can be crucial, whether dealing with a board of directors, advisory board, potential lenders/financiers, or landlords.
Lastly, LOIs can help speed up and smooth out the sale. By getting agreement on large deal points out of the way, an LOI allows for more focused and precise negotiations, which, in turn, can help keep transactional costs down. Moreover, getting the buyer to sign an LOI is an early form of commitment that can make the transaction seem "real" to the parties and motivate them to get it done.
Importantly, LOIs provide an anchor point to frame what the deal will look like, thereby allowing the parties to identify deal-breaking terms early on in the process. This allows either party the ability to walk away early, saving everyone time and money.
Even though they are meant as outlines, LOIs can be detailed and complex documents. Be sure to involve qualified legal counsel whenever you are working on an LOI, before you sign it.
1 It is imperative that any third party informed of even the potential deal's existence be limited to those that are subject to the non-disclosure agreement/confidentiality clause the parties have signed.