I have been somewhat absent from the blogging world since the presidential election.  Like most people, I got caught up in following it, which left little time for other outside activities.

Today’s blog discusses Letters of Intent.  Although the terms are as varied as the transactions that they address, there are two basic kinds: binding and non-binding.  Binding Letters of Intent are exactly that: they are legally binding on the parties who sign them. They attempt to describe in as much detail as possible the material terms of the transaction to which the parties agreed.   Even though binding, they generally anticipate that a more definitive agreement will follow as the parties progress through due diligence.

Non-binding Letters of Intent intend to articulate the proposed terms of a particular transaction, but are subject to a variety of conditions occurring before the Letter is satisfied and a definitive agreement is executed.  Certain terms, however, in a non-binding Letter, such as confidentiality, no-shop, etc. are binding regardless of whether the transaction moves beyond the Letter of Intent.

The issue arises when a seller signs a non-binding Letter of Intent without paying close attention to the details of the proposed terms.  Although non-binding, the buyer expects that the material terms will not change provided its due diligence investigation supports the proposed terms of the transaction.  The buyer expects items like purchase price, deposits, escrows, indemnification periods, earn-outs, payment terms, etc. to carry over into the definitive agreement.  In other words, when the seller signs the Letter of Intent, the buyer assumes that if these terms are incorporated into a definitive agreement, the seller is prepared to negotiate the other terms in good faith.

The problem arises when the seller grasps the true significance of some of these material terms with respect to the realization of his/her full value of their business.  This occurs because after the Letter is signed, the seller decides to seek advice from his/her trusted advisors, such as accountants, attorneys, business consultants, etc. in finalizing the transaction.

The Seller’s reaction, in almost every case, is: “Well, its non-binding, so let’s just change the unacceptable term(s)!”

This is how many deals get derailed.  The Buyer feels that the deal, although non-binding, has been made. The “non-binding” aspect is generally to protect them during their due diligence investigation and not to reshape the deal that the Seller agreed to.

Simple Preventions:  Seller should make his/her signature contingent upon review and approval of the letter by his/her advisors, or, even better, have these advisors review the Letter of Intent before signing.

As an advisor, when we know that a client intends to sell his or her business sometime in the near future, we should educate them about this process so that they don’t create this dilemma.