What to Expect in an M&A Letter of Intent
A recent article from Axial answering commons questions regarding LOI’s. Many times we see the LOI process skipped and go directly to the Asset Purchase Agreement and then due diligence. It depends on the deal and if the seller and buyer can agree to “high level” price and terms ahead of time. This can streamline the process and bubble all items important to the deal to help with surprises.
The letter of intent (LOI) is an important step in most M&A transactions. The LOI allows buyers to signal that they’re serious about a potential deal and to make sure that their vision lines up with the seller’s before they spend significant resources on a full due diligence process.
Here are the answers to four frequently asked questions about the LOI.
1. What does the LOI include?
A letter of intent serves in some ways as a preview or summary of the deal terms that would be expected to appear in the purchase agreement down the line. LOIs typically vary in length from about two to 10 pages, depending on a number of factors. Some argue a shorter LOI can help speed up the negotiating process as it centers the conversation around the most important elements of the deal: if there’s not agreement there, the logic goes, there’s no need to discuss other factors. Others prefer to address all potential issues upfront to avoid any surprise dealbreakers later on.
Here are some of the typical terms you’ll see in an LOI, though of course this varies depending on the deal.
- Deal Structure: Is the transaction a stock or asset purchase?
- Consideration: What are the forms of payment? This can include cash, stock, seller notes, earn-outs, rollover equity and contingent pricing.
- Closing Date: What is the projected date for closing the deal?
- Closing Conditions: What are the tasks, approvals, and consents that need to be obtained before or on the closing date?
- Exclusivity Period: This is typically a binding clause requested by the buyer, who wants to ensure that sellers are negotiating in good faith. It’s typical for buyers to request an exclusivity period from 30-120 days, while sellers will typically want as short a period as possible.
- Break-up Fee: This clause is also typically binding, though break-up fees are less common in the lower middle market. In larger deals (>$500MM), break-up fees of approximately 3% are typical.
- Management Compensation: Which members of the senior management will stay on? Who will be provided equity plans? This aspect of the deal may be vague at the LOI stage before due diligence has been conducted.
- Due Diligence: How will due diligence will be conducted? This includes the nature of information that will be disclosed and the manner in which it will be disclosed.
- Confidentiality (Binding): Both parties have likely already signed an NDA earlier in the process, but this clause further ensures that all discussions regarding the proposed transaction remain confidential.
- Approvals: Does the buyer or seller need any approvals (e.g., from a board of directors, regulatory agencies, customers) to complete the transaction?
- Escrow: This may not appear until the purchase agreement, but sometimes the buyer will include summary terms of their expected escrow terms for holding back some percentage of the purchase price to cover future payments for past liabilities.
- Representations and Warranties: This also may not agree until the purchase agreement, but if there are contentious or non-standard terms the buyer may include them in the LOI.
2. Is an LOI binding?
LOIs are generally non-binding, though sometimes there will be terms that are specifically called out as binding, e.g., exclusivity periods or break-up fees. It’s important to note, however, that in certain cases courts may interpret letters of intent as binding documents if the buyer and/or seller treats it as a contract. Still, sellers shouldn’t expect that the terms outlined in the LOI will necessarily be the final terms offered by a buyer. Buyers are looking to portray themselves in the best possible light at this point in the deal process, and have not yet conducted full due diligenceand therefore don’t have a complete sense of the business’ risk factors that may impact their ultimate purchase price and terms.
3. Are LOIs mandatory?
No. It’s not unheard of for buyer and seller to skip over the LOI and go straight to the purchase agreement. However, an LOI can be useful for a number of reasons. It helps ensure that buyer and seller have similar (or at least similar enough) expectations around deal structure, scheduling, and other big concerns. It also means that any potential deal-breakers come up earlier in the process, so that the parties can either a) stop the transaction process before significant resources are spent on due diligence and drafting deal documents or b) figure out a resolution sooner. The letter of intent also is a nice way to ensure that seller and buyer are on the same page about how due diligence will be conducted. In addition, the LOI’s terms serve as important protection for all parties in a deal (e.g., exclusivity periods product buyers, while break-up fees protect sellers). Creating a shared vision of the future transaction means that there are fewer unpleasant surprises down the line and can make the overall deal process run a lot more smoothly.
4. What happens after the LOI is signed?
The next stage is typically due diligence. The buyer may have been conducting informal due diligence already, but the formal process begins now, and the seller will be expected to provide detailed financials and customer information along with other requested materials. These findings will inform negotiations down the line as buyers aim to lower their risk and sellers look to optimize purchase price and terms. At the same time that buyers are conducting due diligence, they also begin to plan for integration — doing so early on helps buyer and seller think through potential roadblocks and concerns and address those prior to the deal close. The final stage, of course, is drafting and signing the purchase agreement, which may require significant negotiation to get to a place where both buyer and seller are comfortable.