A few years ago, I was working on a transaction in Mexico. After we negotiated the major terms of the deal, we signed the Letter of Intent (LOI) with fancy gold pens, clapped with approval, “clinked” glasses of champagne, and toasted our future successes together. It was fancy and fun, but the transaction never closed. (On a side note — the buyer had lost his luggage on the way to Monterrey and had to attend the fancy LOI signing in a button-down shirt and swim trunks).
“What?!?!” you say “You signed an LOI!” “You had fancy pens!”
And I can reply in my sage, been-in-this-business-too-long-voice, there isn’t much about an LOI that is binding. The signing of an LOI is a great indicator that things are headed in the right direction, but they do not guarantee that a deal is done or will be completed as outlined in the LOI.
Don’t get me wrong — I’m not in the camp of LOI-haters (they’re out there). I think the LOI serves an important role in the transaction. But sellers do not let out a long sigh of relief and go buy a boat with the proceeds from your forthcoming sale after you sign one.
When you are selling your business and you have marketed it broadly, you may have brought seven to ten groups back for management presentations. After those, you ask those groups to “bid again” and from there you pick one or two with whom you firm up some really important concepts. At the end of these conversations, you should have a couple of candidates that are at a good value, pretty good terms, and you should know where they stand on important things like financing, management roles, and options.
It is at this point you pause, take a deep breath, assess the things you know, and pick one group. That is the group that signs the LOI.
This says you are going to try to close this transaction with this group specifically, and, hopefully, under the terms of the LOI as discussed. It’s as if the two parties are engaged to be married at this point–you do not “date” other people.
So why do we sign an LOI if it’s not binding?
It’s not just to sell more gold pens! There are usually several provisions in the LOI that are binding. It’s the sneaky non-binding-but-actually-binding document.
One of these provisions is usually confidentiality. That means you can’t go around telling people that they are buying you and they can’t walk around saying that they are buying you. All in all, a good thing.
The second binding provision is exclusivity. Exclusivity means that you aren’t going to shop the business to other buyers once you sign the LOI. This is an important provision to the potential buyer because it is after the signing of an LOI that they begin to spend a lot of money on legal fees and due diligence. This exclusivity can have an end date or specific task-by dates, so you aren’t bound to them indefinitely if things begin to go sideways.
Unless a provision is called out as binding in an LOI, assume is it not contractual, even though both parties have signed the document.
What is the difference between a term sheet and a letter of intent?
Not much except that a letter of intent is in a letter format. Term sheets generally are not signed and usually do not have binding provisions (see above), although I have seen exceptions to all of these things.
Why would the terms of a deal change from what we decided in an LOI?
Most of the time it is because something changed at the business. Performance may have dropped off, a customer may have left, or an important employee may have been terminated.
The other common reason that terms change is that something was found in due diligence. These can be accounting or tax related or even an environmental issue that a business owner was unaware of before he or she contemplated a transaction.
Many times, issues around business performance are found during diligence don’t cause a transaction to die but are instead “priced into” the deal by negotiation— thereby changing the terms of the LOI.
An LOI can be an important part of an M&A transaction. Despite its non-binding nature, it is an important milestone to measure material terms and conditions with the intended buyer before going forward on an exclusive basis. It should be looked at as a guide to completing the transaction not as a guarantee.