We *Hearteyes* LOIs
With readily available capital, an aging baby boomer population looking to exit businesses and the uncertain impacts of the upcoming U.S. elections, we expect that middle market deal flow will continue to be robust in 2020. If this trajectory holds, 2020 would tack on another year to perhaps the longest cycle of uninterrupted M&A activity in our firm’s 60 year history (as we write this a “knocking on wood” sound can be heard through our offices...). Amidst this activity, we would like to salute one of the most useful, and easily overlooked or dismissed, tools in the dealmaker’s toolkit.
Letters of intent (LOIs), and their close relatives term sheets and memoranda of understanding, are preliminary documents entered into during the early stages of a transaction outlining the major terms of the deal. LOIs are typically executed prior to parties engaging in a complete due diligence process or exchanging drafts of definitive transaction documents. Given that there can be both legal and nonlegal risks associated with executing a LOI, both buyers and sellers are prudent to assemble an experienced deal team including financial, legal, tax and accounting professionals prior to or while engaging in LOI negotiations.
Here are three reasons why LOIs are a critical piece of the M&A process:
Identify early whether a deal exists. LOIs pin down certain essential terms of a deal—for example, amount, structure and payment mechanisms of the purchase price. By negotiating these terms at the outset of the transaction, the parties can determine if they have a good shot at an agreement before spending additional resources conducting in-depth due diligence.
Memorialize key deal terms. LOIs ensure parties remain on the same page regarding key deal terms as a transaction moves forward. Parties are less likely to have selective memory about preliminary agreements on key deal terms to their own benefit if the preliminary agreement was outlined in a LOI. Additionally, while LOIs are normally considered non-binding, for binding provisions, like exclusivity and confidentiality, putting the parties’ initial agreement into words in a LOI may serve as a deterrent for a would be breaching party. Parties may feel compelled to honor the terms of a LOI out of a moral obligation—rather than a legal obligation—to each other.
Create momentum and ensure accountability to a timeline. Some advisors may argue that preparing a LOI can kill deal momentum. Since key deal terms may be negotiated up-front before due diligence, conflicts may arise earlier, leading to frustration between the parties. However, finalizing a LOI can also leave the parties feeling accomplished and motivated to complete the necessary steps to complete the deal. In our experience, completing the LOI will often serve as a necessary springboard to further the conclusion of remaining negotiations and post-signing and pre-closing activities at an expeditious pace.
Three tips for drafting binding LOI provisions
LOIs are usually drafted to be non-binding documents, allowing parties to depart from agreed upon terms if findings during diligence justify changes to the deal terms. However, parties often enumerate exceptions to the generally non-binding nature of a LOI. Given that provisions identified as binding in a LOI may be legally enforceable, both buyers and sellers and their respective advisors should be particularly thoughtful when drafting binding provisions in LOIs.
Tip one: Sellers should focus on the confidentiality
For sellers, an important binding provision of a LOI is a confidentiality provision, prohibiting the parties from discussing the terms or existence of the proposed transaction. Sellers may be justifiably concerned that their business could be negatively impacted—and result in a lowered valuation of the business—if their customers, suppliers or employees learn of a transaction process prior to a deal being finalized.
Given the potential consequences to a seller if news of a transaction is spread prior to a signing and/or closing, sellers should not only include a binding confidentiality provision in any LOI, but also negotiate a free standing non-disclosure agreement with potential buyers. In a non-disclosure agreement, sellers can delineate in detail who the buyer may inform of the transaction, what remedies are available to seller and the length of the buyer’s confidentiality obligations. Non-disclosure agreements can further protect sellers by prohibiting buyers from using or disclosing any proprietary or other confidential information the buyer learns from the seller during the due diligence process. Non-disclosure agreements often include specific circumstances when a buyer may reveal confidential information (e.g., if a buyer is required to reveal information in a court proceeding) so having a comprehensive non-disclosure agreement in place is beneficial to both the buyer and seller.
Sellers should take care to avoid an interpretation that the LOI has somehow superseded previously executed non-disclosure agreements between the parties. Sellers should also revisit who signed prior non-disclosure agreements in relation to the proposed buyer in their LOI (i.e., has an affiliate or new subsidiary entered the picture as the proposed buyer who was not contemplated by the non-disclosure agreement which may have been signed weeks or months earlier).
Tip two: Buyers should focus on exclusivity
For buyers, an important binding provision is the exclusivity provision, which prohibits the seller from negotiating a potential deal with other parties. Particularly in a competitive process, buyers are eager to secure exclusivity so that a buyer does not spend resources on due diligence and negotiating with a seller, only to have the seller ultimately sign a deal with a different party. Buyers should seek to set an exclusivity period that is adequate for the buyer to complete its various due diligence investigations — recognizing, however, that sellers are often willing to extend exclusivity if buyers have been working diligently to complete the deal.
Sellers with leverage in the deal process may resist agreeing to any exclusivity, but exclusivity is commonly granted for at least a short period of time (e.g., 30 days). Sellers who do not want to be tied up with a single buyer who is not working diligently to a closing should propose milestones in connection with exclusivity, requiring the buyer to meet certain requirements for the exclusivity period to continue.
Sellers could attempt to include provisions which would in effect void exclusivity if the buyer seeks to “retrade” key deal terms during the exclusivity period. This type of limitation may be more or less palatable to a buyer depending on, among other factors, the length of the exclusivity period and the opportunity cost (i.e., alternatives) available to the seller at the time exclusivity is entered into.
Tip three: Sellers being acquired by newly-formed entities must consider recourse
For a seller who would be acquired by a newly-formed subsidiary or other acquisition vehicle of buyer, thought should be given to what seller’s recourse would be in the event binding provisions are breached. A guaranty of binding provisions by an uppertier parent or other affiliate can provide comfort that seller’s counterparty is not judgment proof can often overcome this concern, if seller feels it is worth raising at the LOI-stage. LOIs and their cousins term sheets and memoranda of understanding are frequently a smart, but overlooked or underinvested, piece of the middle market M&A landscape.