When you’re ready to buy a business, the letter of intent (LOI) is one of the most important legal documents for the transaction. It spells out the terms and conditions of the deal between the buyer and the seller and sets expectations for both parties as to what the purchase agreement will contain.
In this article, we’ll discuss everything you need to know about letters of intent when buying a business. We’ll answer common questions like “what goes into a letter of intent?” and “why is the letter of intent so important?” We’ll also help you understand how to negotiate and draft an effective letter of intent that will benefit both parties involved.
Letter of Intent – The Basics
A letter of intent is a document that outlines the key terms and conditions of a proposed transaction. It’s used to formalize an agreement between two parties before entering into a binding contract. The LOI can be used for various types of transactions, but it’s most commonly used in business acquisitions.
The letter of intent is also sometimes referred to as a term sheet. While the two documents are similar, there are some key differences. An LOI is typically more detailed than a term sheet and includes a broader range of topics. A term sheet is usually shorter and only covers the most important terms of the deal.
What Are the Key Elements of the Letter of Intent?
When you’re drafting a letter of intent, there are a few key elements that should be included. First, the letter should state that it’s generally non-binding (there are some exceptions to this rule discussed more below). This means that neither party is legally obligated to follow through with the proposed transaction.
The letter of intent should also include an intended date for closing and a specific time period in which due diligence should be completed. Buyer exclusivity usually coincides with this same time period. Ultimately, deadlines and time periods keep the acquisition moving and ensure parties stay on task. After all, a seller doesn’t want to wait for months only to have the buyer decide to walk away.
On a similar note, it’s not uncommon to have a provision that allows for either party to terminate the letter of intent and end the negotiation process upon written notice. This is typically included so that if the acquisition falls through, the letter of intent doesn’t turn into an open-ended agreement.
Reasons for having the deal fall through can vary, but here are some common reasons:
The buyer decides the financial statements or the balance sheet of the target company are problematic (i.e., the numbers don’t add up)
The buyer decides the tangible assets it plans to acquire are not a good fit or do not meet its needs
The buyer finds the target company’s business models are not sustainable (i.e., all the revenue comes from one main customer)
The target company’s key employees will not stay post-closing making it difficult to continue to operate the existing business without material change
Structure of the Deal
The letter of intent should also cover the key terms of the acquisition, such as, in an asset purchase, which business assets are being acquired and which liabilities will be assumed by the buyer.
When purchasing tangible assets, the LOI should contain a brief explanation of what those tangible assets will include such as inventory, consumables, vehicles, etc. Some businesses also have intangible assets such as intellectual property and a book of business. These should be mentioned as well.
If there is real estate involved, the LOI needs to at least make mention of it. For example, perhaps the business doesn’t own any real estate but instead leases its office space. Assigning and assuming this lease with the landlord must be a condition to closing unless the buyer has elected to move all operations to its pre-existing business location.
It can be fairly common for small businesses to rely on a business broker to assist them with locating a buyer. The LOI should include detail as to how the transaction expenses will be handled. Typically, the business owner is responsible for the fees of his or her business broker.
Besides broker fees, the LOI should address whether other costs, such as legal fees, should be paid by each respective party. Sometimes the target company will desire to have its legal fees reimbursed if the buyer elects to walk away due to no fault of the target company. In exchange for this right, the buyer will often negotiate that its earnest money deposit be returned if the seller elects to terminate negotiations on its own accord.
The LOI should also include a purchase price and any proposed financing arrangements. Will it be seller-financed or paid in cash? If the seller will help finance the sale, what will be the terms of the promissory note?
If the buyer is a small business, they may elect to seek financing with the small business administration (SBA). When electing to finance the purchase, this can add time while waiting for approval, which, if anything, should be factored into a realistic expectation for the time needed from the execution of the letter to the closing date.
Whether it’s a small business loan or traditional financing, approval for the loan should be detailed in the LOI as a condition to closing.
Debts at Closing
If the seller has debts from earlier rounds of investment, personal loans, or a PPP loan that’s outstanding, the LOI needs to address what the parties intend to have happen at closing.
Typically, debt will be paid off by the seller at or prior to closing; however, in some instances, based on the economic situation of the seller, the parties may agree to have the buyer pay off debts and deduct these payments from the purchase price.
Transition of Business
The LOI should also include whether the seller or its individual owners will provide transition services post-closing. While a buyer may feel confident in taking over an existing business and enjoying complete control, sometimes it can be beneficial to have the seller stick around for a bit to help ensure a smooth transition.
The prior owner can support the hand-off by sharing his or her skill set, introducing current customers, and helping the new owner to avoid mistakes thereby creating cost savings.
This is where a transition services agreement, independent contractor agreement, or post-closing employment agreement comes into play. All three of these agreements have different forms and functions.
Transition Services Agreement
A transition services agreement comes into play when there are a host of services critical to the existing business that need to be continued by the old company. For example, hosting certain software infrastructures and conducting accounting services. This form of agreement is long-lasting — typically a year or more with certain services lasting longer than others.
Independent Contractor Agreement vs Employment Agreement
The main difference between an independent contractor agreement and an employment agreement is that an independent contractor is not an employee of the company. The agreement should be very clear as to what services will be provided, how long those services will be needed, and the compensation for said services.
A post-closing employment agreement is just that: an employment agreement between the buyer and seller wherein the seller agrees to stay on board typically in an executive role. You can expect this agreement to cover basics such as job title, role responsibilities, bonus structure, and benefits.
While the LOI is typically non-binding, there are often certain provisions the letter will carve out as binding. These often include confidentiality and survival provisions related to the return of earnest money or payment of expenses.
In addition, the LOI should include some basic language about restrictive covenants, which are covenants that restrict the seller’s or buyer’s ability to act in some capacity. These restrictions come into play after closing and should not be binding unless the transaction is successful.
The non-competition and non-solicitation provisions are used to protect the buyer’s interests in that they specifically restrict the seller post-closing.
Non-competition is typically defined as an agreement not to compete with the buyer in the same line of business, either for a period of time and/or within a certain geographic area. This can be included within the purchase agreement or in a separate non-compete agreement depending on the size and complexity of the transaction.
A non-solicitation provision might state that the seller agrees not to solicit the buyer’s customers or employees for a certain period of time after closing. Combined with a non-competition provision, non-solicitation ensures that the seller cannot undermine the value of the business assets or interest the buyer is obtaining through the sale by immediately turning around after the closing and starting a competing business and/or poaching prior employees.
Even in the purchase of a small business, these restrictive covenants can be critical to new owner success. With years of industry knowledge, established business connections, and prior employees who are likely loyal to the company and the business owner, it’s easy to see why a buyer would be nervous in the absence of these restrictive covenants that the seller could easily replicate the business.
Intellectual Property and Confidentiality
The LOI should also address intellectual property (IP) and confidential information transfer and protection.
It’s natural during the due diligence process for the target company to share with the potential buyer important documents related to the business sale including its customer base, customer contracts, information about the current owner, and confidential financial statements such as tax returns and balance sheets.
The buyer should feel comfortable agreeing not to disclose or use for its benefit the confidential information it receives through the due diligence process as the target company will need this assurance in the event the buyer elects to terminate negotiations after important information has already been shared.
Other Key Elements
Other key elements that are often included in a letter of intent are:
If acquiring company stock or member interest, whether the purchase constitutes all of the outstanding stock or interest
Whether the buyer intends to form a new company for the acquisition
The structure of the payment (earnest money, down payment, wire transfers of cash)
The closing contingencies (what needs to exist/happen in order for both parties to close)
Who is drafting the initial form of the purchase agreement (usually the buyer)
Are there key employees that need to be retained?
Why Should I Enter Into a Letter of Intent?
Now that we’ve discussed what goes into a letter of intent, let’s talk about why you should enter into one when buying a business.
Road Map of the Deal
The LOI serves as a road map for the final purchase agreement. It ensures both parties are on the same page from the start and helps avoid any misunderstandings down the road.
When an attorney drafts a purchase agreement, they rely on the LOI to guide them in determining what provisions to include. Should the purchase price have an adjustment mechanism? Should the earnest money be returned to the buyer if the target company terminates negotiations?
A well-drafted LOI will cut down the time your lawyer spends hashing out the details needed to create the first draft of the purchase agreement.
Keep Negotiations on Track
Without an LOI, there are no pre-agreed terms for the purchase agreement. This means either party can re-open the negotiations on key deal terms, such as the purchase price, which may unnecessarily increase legal costs and delay the closing. In other words, having an LOI in place can save money by reducing the back-and-forth negotiation process.
Protect Buyer Interests
A letter of intent also protects a buyer’s interests during the diligence process. It should give the buyer exclusive rights to purchase the business for a set period of time (usually 30-60 days). This means that during this time, the target company cannot entertain other offers or enter into negotiations with other prospective buyers.
Lastly, a letter of intent is important because it demonstrates to the seller that the buyer is serious about acquiring their business. A letter of intent signals that the buyer has the financial ability to close the acquisition and is committed to seeing the process through.
Putting together a letter of intent may seem like a daunting task, but with guidance from your lawyer, it can be simple and straightforward. As we discussed, there are many benefits to having a letter of intent in place when buying a business. It solidifies the terms of the deal, keeps negotiations on track, and protects the buyer’s interests.
If you’re ready to start drafting your letter of intent or have any questions, contact us today. We’ll put you in touch with our experienced mergers and acquisitions lawyer who can help guide you through the process.