In the rapidly paced, high-stakes game of mergers and acquisitions (M&As), the first move is not dissimilar to a game of chess; a good opening will set the pace for the rest of the game. In M&A deals, the first move must be similarly strategic, resembling an orchestrated dance that establishes the tone for the entire transaction. Thus enters the orchestrator – the Letter of Intent (“LOI”) – a vital document that can make or break any deal. These preliminary agreements are often underestimated and overlooked, yet they hold a significant strategic value for both buyers and sellers.
This blog post will explore the critical importance of LOIs when it comes to navigating buy-side transactions, delving into their significance, their form, and their potential risks.
What is an LOI?
An LOI is an agreement that outlines the fundamental terms and conditions of a proposed transaction. It signifies a buyer’s serious intent to acquire a target company yet does not create a legal obligation to complete the transaction. It is best to think of an LOI as a blueprint to the negotiation process, providing a roadmap of information that can be solidified in due diligence and hopefully a purchase agreement.
Contents of LOIs and who pays?
In most cases, the buyer will prepare the LOI, which places this party in a strong negotiating position. In rare cases will the seller draft the LOI, which could be attributed to the buyer’s desire to avoid legal expenses or the seller being in a uniquely strong position. One can expect to find very standard key terms in an LOI, such as: purchase price, due diligence, financing structures, transaction structures, exclusivity, closing conditions, termination rights, and confidentiality obligations.1 These terms establish the nature of the deal and help to protect all parties involved. These chief terms usually involve back-and-forth between the buy-side and sell-side, so that by the last iteration of the LOI, there will not be too many surprises or deal-breakers when formalizing the deal.
In respect to expenses, the party responsible for the associated costs of the LOI can vary depending on the negotiations. If the buyer is drafting the LOI, they may be willing to cover the cost of drafting the agreement to demonstrate commitment to the deal. Conversely, the seller may decide to bear the cost of preparing the LOI if they are highly motivated to sell. It is also possible that the expenses may be shared between buyer and seller. In some cases, there is also the option of conditional payment, meaning that the initiating party may agree to pay for it, but with the condition that the deal reaches a certain stage.
Are LOIs binding?
An LOI can either be binding or non-binding, depending on the language and intent that is expressed in the agreement. This does not inherently mean that the LOI in its entirety must be binding, and usually there are certain terms included in the LOI that are non-binding.2 It is essential for parties’ to clearly state expressed intention regarding the nature of the terms. It may even be best to go as far as separating the binding provisions from the non-binding provisions when creating an LOI. Non-binding provisions usually include terms that relate to purchase price, calculation of working capital, number of escrows, and the form of the transaction.3 These non-binding terms help to guide the negotiation in the right direction, serving to streamline the decision-making process without being set in stone. Binding terms in LOIs are typically referring to exclusivity, confidentiality, and expenses. These provisions relate to the management and governance of the actual process.
Why use LOIs?
The importance of LOIs is not attributed to one single factor, but rather many moving parts in the dynamic world of M&A.
- Firstly, the LOI is a good indicator of commitment level as it tests the buyer’s credibility and seriousness before moving forward. Outlining key terms in the LOI represents expressed intention and demonstrates good faith.
- Secondly, LOIs help to streamline the process of negotiations. With many key terms clarified by the buyer, proposed conditions set out, and contingencies outlined, LOIs can reduce wasted time in subsequent negotiation stages.
- Thirdly, the LOI can grant exclusivity to the buyer. This exclusivity provides the buy-side with increased negotiation leverage and prevents the seller from entertaining other offers for a specified period. If this exclusivity to the buyer is not honoured, a break fee will come into effect. A break free, otherwise known as a termination fee, is a provision that will serve as a financial penalty to a party that terminates a contract. The amount of the fee paid can be calculated numerous ways, but it is usually connected to a rough estimate of due diligence costs, recovery costs, percentage of the transaction value, and economic loss incurred due to the termination.4
As a buy-side party, managing risks when it comes to LOIs is very important, as they come with their own unique baggage. Firstly, buyers should be mindful not to overcommit. Specifying terms too narrowly in the LOI can lead to complications if circumstances are subject to change, positioning the buyer in an unattractive spot. Secondly, buyers should be cautious when it comes to outlining exclusivity periods. Employing overly aggressive no-shop clauses can backfire, causing frustration on the seller, and potentially killing a deal. It is best practice to provide reasonable time periods to exclusivity. Thirdly, buyers should ensure that the LOI grants sufficient access for due diligence. Failure to obtain complete and accurate information can lead to misinformation and eventual dispute.
Lastly, it is always best to consult legal counsel to review the LOI before signing. Subtle language changes and specific provisions can have larger impacts than foreseeably expected.
A good first impression
In buy-side transactions, LOIs will have a pivotal role in the foundation for successful acquisitions. As buyers, LOIs can otherwise be seen as making a good first impression. The first step in capitalizing on important opportunities as a buy-side party is understanding the profound nature of this opportunity and putting your best foot forward. This first impression can make all the difference when it comes to closing a deal, and a strongly positioned LOI is the first of many tactical moves in reaching checkmate.
Special thanks to Ellen Yoo, Articling student, who helped write this article.
1 A complete guide to M&A letter of intent (LOI). Morgan & Westfield. (January 13, 2022) online: <https://morganandwestfield.com/knowledge/letter-of-intent/>.
4 Break fees in Canadian M&A. (Thomson Reuters: Practical Law. Canada) online: