A letter of intent ("LOI") can serve a variety of purposes in any business transaction. However, LOI's can contain pitfalls for the unwary. Too often business people enter into LOI's with the attitude that they are not binding. Before signing an LOI in your haste to "lock in" a deal, beware of all consequences - legal and practical.
An LOI can facilitate progress in a deal by identifying key substantive issues and terms and providing the ground rules for reaching a definitive agreement and consummating the deal. Along these lines, LOI provisions are typically categorized into deal process terms that are binding and enforceable and substantive terms that are not. The LOI will typically state that it does not constitute a binding agreement, except for certain specific terms that are intended to be "legally binding and enforceable." Nonetheless, whether a term is actually binding or not, you need to anticipate and understand its impact on the outcome of a deal.
"Non-binding" topics in an LOI for a business acquisition may include descriptions of the basic transaction (what's being sold, for what price, organizational structure), payment terms, side agreements to be entered into and other closing conditions, representations and warranties, and indemnification provisions. The LOI typically provides that these proposed terms will be finally addressed in the final negotiated agreement. These terms are uncertain at this stage because due diligence often has not yet started, much less been completed.
Of course, the extent to which you address any of the substantive topics depends on your position in the deal. For example, in an acquisition deal, a buyer may want to defer negotiations on specific deal points until it has more knowledge of the target assets through due diligence. On the other hand, a seller may want to resolve some important issues (such as setting limits on representations and warranties and indemnification) while it has greater bargaining power prior to entering into an LOI. Be careful that you do not psychologically commit yourself to a position. If you do incorporate any of these terms into the LOI, you should consider that these terms may be viewed by the other side as having been cast in stone in the context of contract negotiations.
Tax considerations are often overlooked at the LOI stage. For example, if you intend to have a tax-free business reorganization, make sure that the proposed structure qualifies as such. If later it turns out that the transaction contemplated in the LOI does not qualify, this could fundamentally affect the economic terms of the deal, and could compromise your negotiating position.
The "binding" parts of the LOI typically include provisions regarding exclusive dealing, break-up fees, access for due diligence, confidentiality of deal terms and disclosed information, allocation of transaction costs, conduct of the business prior to closing and termination of the LOI. Avoid binding provisions that require "best efforts," "every reasonable effort" or "good faith" negotiations to finalize and execute a definitive agreement containing the terms set forth in the LOI. Courts could construe these provisions as agreements to reach an agreement, and could find a party liable for the reliance costs of the other party if a definitive agreement is not reached. In any event, some courts have held that even though the particular terms of an LOI are not enforceable, parties can create duties to bargain in good faith by entering into an LOI.
A primary goal of entering into an LOI is to get some assurance that the other side is serious about doing a deal with you. This is more important to the buyer of a business than a seller, who may want the flexibility to shop the business around. An LOI provision prohibiting the other side from soliciting or entertaining offers from, or negotiating with, third parties for a certain period of time will provide some comfort that you are not wasting resources pursuing the deal. Additionally, mostly in deals involving public companies or bankruptcy sales, an LOI could provide the payment of a "break-up" or "topping" fee if the exclusivity provisions are breached and, within a certain period of time, the other party consummates a similar deal with a third party.
Depending on the complexity of a proposed deal, a variety of issues can arise in negotiating an LOI. This article touches upon just a few of the common issues to be aware of. The more complex the deal, the more careful you have to be. In those cases, it would be prudent to seek counsel, ideally from a professional you would ultimately use to negotiate and implement the deal.