Preparing a non-binding offer letter (also known as a ‘letter of intent’ (LOI), a heads of terms (HoT) or a ‘memorandum of understanding’ (MOU)), is a key stage in buying a privately-owned business. The main purpose of the LOI is usually to help you progress the transaction efficiently, and reduce the risk of abortive costs or being ‘gazumped’ by another buyer. The LOI does this by recording a shared understanding as to the basic deal structure and proposed terms of the transaction, and what the next steps in the transaction process will be. It will often also set out the terms of an agreed exclusivity period, giving you (as buyer) an opportunity to complete the negotiations without having to compete with alternative offers for the business.
An LOI is a selling document usually prepared by the buyer, in that it should present the buyer in the most favourable light possible. It should position the buyer as being the only viable option for the seller – or at least the preferred option, ideally for reasons other than price alone.
Addressing the concerns of a typical seller
It can be helpful to look at the typical fears and concerns of a seller about the proposed transaction, and address them upfront. These may include:
- Disruption to the operation of the business
- Damage to the business caused by leakage of confidential information or know-how
- Damage to staff and customer confidence due to rumours relating to the sale
- The buyer back-tracking on the purchase price agreed in principle, and using minor issues discovered in the due diligence process to reduce the price
- Delay and damage to the seller’s negotiating position if the buyer does not ultimately proceed after an exclusivity period
Although the work of ‘selling’ the buyer and addressing the seller’s concerns will often already have been done, it can be helpful to deal with the issues in the formal LOI – especially if other people such as minority shareholders will be involved in the ultimate sale decision.
What to include in the letter of intent
Even though the main provisions of an LOI are usually expressed to be not legally binding, some things are helpful to include, and other things are unhelpful. As a reminder, here is a brief checklist of what to include.
1. The headline price or consideration
This can be an absolute amount or, more likely, a range of amounts, subject to due diligence investigations. Often this is expressed as an enterprise value for the business as a whole, on a cash and debt free basis. This is because at this stage, the precise structure of the transaction may be unknown or may be subject to change – for example, whether the transaction will proceed as a share purchase or an asset / business purchase.
If there is a particular methodology by which the price (or range) has been calculated – for example, net assets plus a multiple of earnings – it is helpful to state that and to set out the methodology to be used to determine the final price at closing, including any purchase price adjustment, related assumptions and conditions.
2. Deferred or ‘earn-out’ elements of the price
An ‘earn-out’ is a portion of the price which is paid after closing, and which depends on the ongoing performance of the business. This is a key way for a buyer to reduce the risk of the transaction, especially if the seller’s personal involvement in the business is important for a period post-closing.
An earn-out arrangement is usually comprised of three main elements:
- The maximum amounts which may be payable and the timing of those payments
- The formula for calculating those payments
- What other conditions (if any) need to be satisfied in order for a payment to be released – for example, key people remaining engaged full time in the business or specified annual financial performance targets post-closing.
The timing of payments is often linked to the existing financial year end of the target business. This can help avoid duplication of cost in preparing accounts, and can give the buyer more comfort in the accuracy of the financial position disclosed by those accounts.
3. The buyer’s position as a prospective purchaser
As already mentioned, the LOI is often used to help emphasise the buyer’s position as preferred option for the seller. Relevant factors may include:
- The buyer’s ability to move quickly
- The availability of finance / proof of funds, both in relation to the purchase price and the provision of additional working capital for the business
- The seller’s relationship with the buyer, and status as a trusted person to do business with
- The buyer’s plans for the business, and how staff and customers will be looked after
- If appropriate, an enhanced personal role for the seller (if an individual) and key senior management in the acquired business
4. The due diligence and negotiation process
The LOI will often set out the expected process to complete the transaction. This may include a timeline for the due diligence investigations and the contract negotiations. It will also often specify how access to the target’s business will be provided, including points of contact for information requests, expected timing for answers to due diligence requests, whether site visits will be required and whether an electronic data room will be established for the project.
5. Expected contractual terms
Often this will be left vague, and the letter of intent will merely say that the definitive legal documentation will include “warranties, indemnities and covenants customary for a transaction of this nature and size.” However, if the buyer has a particularly strong negotiating position – for example, because it has a number of different options as regards acquisition targets or is a preferred buyer for other reasons – then the LOI may include key terms which the buyer will insist on. For example only:
- Joint and several liability if there are multiple sellers
- Retention of part of the purchase price against warranty and indemnity claims
- The scope and duration of restrictions on the seller from competing with the target business after closing
- If a share purchase rather than an asset purchase, purchase price adjustments based on working capital in the business at closing or net assets to be set out in completion accounts prepared by the buyer within a fixed period following closing
- Caps on liability
- Limitation periods for warranty and indemnity claims
6. Preconditions for closing
The LOI will usually set out any matters which the buyer already knows will be preconditions for completing the transaction, other than the normal legal, financial, tax and other due diligence investigations and agreement of the transaction documents. These may include:
- Minority shareholders agreeing to the proposed terms of the LOI
- Resolution of specific litigation or third party claims
- New employment contracts being agreed with key members of staff
- Termination of a particular contractual arrangements, such as those relating to premises used by the business
- New contractual arrangements, such as leases and licenses to use property or other assets, which will not transfer to the buyer with the business
- The consent of key customers and key suppliers
- Confirmatory assignments of intellectual property used by the business
- Suitable arrangements being put in place in relation to assets shared between the target business and another business not transferring to the buyer
- Any applicable regulatory or competition authority consents
- There being no material adverse change in the financial position of the target business between the date of the LOI and completion of the proposed transaction
7. The seller’s involvement in the business after closing
In many cases, the seller’s personal involvement in the business (or that of other key employees) is key to its current and ongoing operations and success, and it is usual for the seller (and/or other key employees) to be retained for a specified period following closing, whether on a full time or part time basis. The LOI will commonly set out the buyer’s expectations in this regard, including what additional remuneration (if any) will be paid for this role, in addition to the purchase price. If employee retention is key to the ongoing success of the business following closing, it is not uncommon to include provision for an employee retention bonus pool, to incentivize employees other than selling employees who may not otherwise profit from the transaction.
This is a key provision from a prospective buyer’s perspective, and will be one of the few provisions expressed to be legally binding in the LOI. It would usually restrict the seller and its shareholders and advisors from carrying on discussions with any other party regarding the sale of the shares or the business of the target company, and from providing information about the target’s business to any other third party, other than in the ordinary course of business. The period of exclusivity is a matter for negotiation, but would need to give a realistic opportunity to complete due diligence and the other steps to bring the transaction to completion – often at least 3 or 4 months.
Unless a confidentiality agreement (also known as a ‘non-disclosure agreement’ or NDA) has already been signed, the letter of intent will often be signed together with an NDA or include confidentiality provisions itself. In either case, these provisions will also be expressed to be legally binding on the parties.
10. Applicable law and jurisdiction
It is advisable to include a clause which specifies which law applies to the LOI, especially the exclusivity and confidentiality provisions, and especially where the transaction has a cross-border element. For buyers, it is usually preferable to choose the law of the target business (or its headquarters), so that issues affecting the local enforceability of those provisions are properly taken into account. English law is also often used for transactions involving the acquisition of non-UK headquartered businesses for a number of other reasons outside the scope of this article.
What not to include in a letter of intent
Some types of conduct may create an unnecessary risk of a complaint of anti-competitive practices. Such a complaint may be made by the relevant public authority (such as the UK’s Competition and Markets Authority), or by other businesses who feel that they have been or will be prejudiced. Although matters of competition law will always depend on the specific circumstances involved (including the size of the respective businesses of the buyer and seller), some things should be avoided, both in an LOI and in correspondence or other documents (whether internal or external) relating to a proposed transaction. Here are a few examples of what to avoid:
- Suggesting that the transaction may allow the business to avoid price competition, raise prices, reduce quality, reduce customer choice, or force customers to accept less favourable terms
- Referring to benefits from the transaction as being to increase market share, reduce, eliminate or block competitors, or become dominant in a particular market
- Referring to plans to shut down any part of the target business
- Co-ordinating business operations – especially pricing – before the transaction has actually closed. This is often referred to as ‘gun-jumping’ and is prohibited under most competition law regimes.
As mentioned above, the LOI should record the parties’ shared understanding of the basic deal structure and proposed terms of the share or business acquisition. It should also set out what the next steps and timing of the various stages of the transaction process will be. The intention is to make the transaction process as efficient as possible and to minimise disruption to the target business during that process. For this reason, it is often in all parties’ interests to agree in principle as many of the terms of the transaction as possible in the LOI. This can significantly streamline the later negotiation of legally binding transaction documents and, ultimately, the completion of a timely and successful acquisition.