What you need to know about M&A letters of intent
Preliminary outlines of proposed M&A deals—whether called letters of intent (LOIs), term sheets or memoranda of understanding (MOUs)—allow parties to sketch out fundamental terms quickly before expending substantial resources on negotiating definitive agreements, finalizing due diligence, pursuing third-party approvals and other matters. M&A letters of intent appear simple (they aren’t) and as something that can be advanced without lawyers (they shouldn’t be). The opportunities for later re-trades and selective lapses in memory on key points are reduced. In addition, an LOI can facilitate discussions with debt and equity financing providers as well as allow preliminary discussions and filings with antitrust and other regulators. Lastly, some would argue that they create deal momentum and foster an emotional commitment to do the deal or, at a minimum, work towards getting one done on the agreed-upon terms. Often the parties produce a hybrid preliminary document that presents a non-binding outline of the main deal terms with certain binding provisions (such as exclusivity and confidentiality provisions as well as termination, governing law, choice of forum and other miscellaneous provisions).
There are also downsides.
While LOIs may save time and expense in the long run, they may have the opposite effect, as the parties engage in protracted negotiations on only a subset of a deal’s terms. Management time and focus may be diverted. Alternative opportunities may be missed and markets may move against the parties in the meantime. In some cases, parties reduce their lack of a workable deal framework into an LOI, with a hope of papering over differences, kicking the can and praying to make progress later. In some cases, public disclosure obligations may be triggered. And, of course, there’s the risk of leaks, exacerbated by the desire of some to tout the term sheet to the world, or shop it to other bidders.
An even greater risk, however, is that, if negotiations fail, a court may conclude that an LOI is, in fact, something more than a non-binding description of terms—either a fully binding agreement itself, capable of being enforced, or an agreement to negotiate in good faith. For example, in 2013, the Delaware Supreme Court held that an agreement to negotiate in good faith in accordance with a term sheet is an enforceable obligation and that the failure to negotiate in substantial conformity with the term sheet will, under certain circumstances, result in liability for expectation (or “benefit-of-the-bargain”) damages.
There is also a converse risk of a court failing to enforce what the parties may have thought was a binding agreement or certain of its provisions that they expected to be enforceable.
What’s in a typical LOI?
Below is an example letter of intent, including embedded commentary. This is a buyer-favorable form proposed by a prospective buyer in an asset purchase transaction. While I’ve chosen this model because it provides a reasonably good basis for discussion, please do not assume that it is representative in any way. There is broad variation in the form and substance of LOIs, and many include several provisions not reflected in this sample, including a standstill provision, a description of the acquired assets and liabilities or business, clarity about tax treatment, the terms of any indemnification escrow arrangements, confidentiality provisions, identification of important representations and warranties and more.
LETTER OF INTENT
[Date], 2015
[Target]
[Address]
Attention: [Target CEO]
Dear [Name]:
We are pleased to present this Letter of Intent (“LOI“) relating to the proposed acquisition by [Buyer], a Delaware corporation (“Buyer“), of substantially all of the assets and liabilities (the “Proposed Transaction“) of [Target], a Delaware corporation (collectively with its subsidiaries, if any, the “Company“). We look forward to working with you towards a successful transaction.
This LOI, which, except as expressly set forth below, is not binding on either Buyer or the Company, sets forth the general terms and conditions, as currently contemplated by the parties, for the Proposed Transaction. The Proposed Transaction will be structured as an asset purchase, and the details of the transaction and the following general terms and conditions are subject to Buyer’s due diligence investigation of the Company, and decision and appropriate approvals by Buyer and the Company to proceed with the Proposed Transaction and execution of definitive written agreements executed by the parties.
| Purchase Price | The aggregate purchase price for the Proposed Transaction will be up to $[amount] million payable in cash. $[amount] million will be paid at closing and an additional $[amount] million will be payable upon achieving certain milestones as more specifically set forth below (the “Earn Out“). The $[amount] million payable at closing will be distributed as follows,
| |
| Commentary: Note that the provision only states that the purchase price will be “up to” an agreed-upon amount. This provides the Company with very little certainty as to the ultimate sale price. It essentially means that Buyer is leaving open the option to reduce its offer price if it discovers anything undesirable during due diligence. If I were representing the Company, I would advise against granting exclusivity without greater assurance that the parties have a mutual understanding of the purchase price. | ||
| Earnout | $[amount] million will be payable in cash upon achievement of milestone targets defined during the due diligence investigation period and under mutually agreed to Company performance objectives for calendar year 2016, including but not limited to a Contribution Margin dollar target. In general, Contribution Margin is defined as Gross Margin as presented in due diligence materials delivered by the Company to Buyer plus/minus mutually agreed to adjustments. Payments of portions of the total of $[amount] million may be payable upon sliding scale achievement of such milestones. | |
| Commentary: Once again, there isn’t must certainty in this provision, which may govern a substantial portion of the purchase price. Normally, a target company would want more clarity about the referenced adjustments and sliding scale as well as an understanding of covenants that may be agreed-to to make achievement of the milestones more likely. For more on earnouts, see my posts here and here. | ||
| Key Employees | Buyer will determine in good faith during its due diligence investigation which employees of the Company it desires to offer employment. Buyer ascribes meaningful value to the Company’s employees and anticipates making offers to a substantial majority of the Company’s employees. Company employees who are offered employment with Buyer will be offered (i) base and variable cash compensation and (ii) equity compensation, each in amounts that are comparable with such benefits of similarly-situated employees of Buyer. | |
| Commentary: Buyer is offering little in this provision, aside from saying that it will pay acquired personnel consistently with the way it pays its own employees. There is no commitment to take all or substantially all target employees, no enticement to target company management to pursue this deal, no obligation to pay all or any part of employee severance costs and no statement that acquired personnel will be offered compensation arrangements comparable to their current arrangements. A well-advised target will at least demand some clarity as to how the costs of any employee layoffs will be allocated between the parties. | ||
| Due Diligence Investigation | As soon as practicable after execution of this LOI, Buyer will commence its due diligence investigation of the Company. Such due diligence investigation will include the review of all books, records and business affairs of the Company, and Buyer and its representatives will be entitled to full access to the personnel and facilities of the Company during normal business hours. | |
| Commentary: Note that Buyer does not acknowledge having completed any due diligence yet. This omission would make it easier for Buyer later to reduce its proposed purchase price. It may, of course, be the case that no diligence has been conducted yet. However, before granting exclusivity, many sellers will expect the prospective acquirer to conduct at least preliminary due diligence to be followed by confirmatory diligence after receipt of exclusivity. Also, some LOIs will include here an indication of the parties’ understanding of how much time additional due diligence will require. | ||
| Closing; Conditions Precedent | The closing of the Proposed Transaction (the “Closing“) will be subject to the satisfaction of customary conditions at or prior to the Closing, including, without limitation: (i) satisfactory results of a business, technical, financial, accounting, legal and tax due diligence of the Company; (ii) the negotiation, documentation and execution of definitive acquisition documents acceptable to both parties; (iii) the receipt of all necessary regulatory approvals and any required consents of third parties; (iv) the absence of litigation challenging the Proposed Transaction; (v) the absence of any material adverse change (including litigation) affecting the financial condition, assets, liabilities, results of operations or prospects of the Company; (vi) the execution of employment, consulting and/or non-competition agreements with certain key individuals involved with the Company to be identified by Buyer, with terms and conditions reasonably satisfactory to Buyer; and (vii) debt free / cash-free transaction with the inclusion of minimum net working capital of $[amount]. | |
| Commentary: Again, the buyer offers little. The inclusion of the words “without limitation” before the list of conditions means the buyer is at liberty to add whatever conditions to closing it desires, reflecting a lack of commitment to the terms in the LOI. Similarly, the omission of any materiality or other qualifiers to the conditions, broadly defined “material adverse effect” contingency and requirement that an unspecified group of “key individuals” must all sign contracts make consummation of the deal on the seller’s preferred terms less likely. The only term that is even remotely concrete is the requirement to deliver a certain amount of net working capital at closing. However, even that is open-ended in that net working capital may vary based on how long it takes to consummate the deal, what GAAP determinations are made, how the different elements of net working capital are valued and whether the Company modifies its inventory, collections and payments practices. Moreover, most private M&A deals include a purchase price adjustment mechanism designed to allocate fairly any unexpected shortfall or overage at closing in an agreed-upon bucket of assets and liabilities, such as are reflected in net working capital. The omission of such a mechanism here reflects the buyer’s desire to require a minimum amount of net working capital (protecting its downside exposure) while retaining 100% of the benefit of any excess net working capital delivered to it at closing. | ||
| Shareholder Approvals | Prior to or contemporaneously with the execution of the definitive acquisition documents, holders of a sufficient number of shares of each class of the Company’s capital stock to approve the Proposed Transaction will either (i) execute written consents approving the terms of the Proposed Transaction or (ii) enter into voting agreements in which they agree to vote in favor of the Proposed Transaction and any necessary amendments to the Company’s charter in connection therewith. | |
| Commentary: This is a reasonable provision reflecting the need for a Delaware corporation selling all or substantially all of its assets to obtain shareholder approval. | ||
| Indemnification | The Company and each of its shareholders, severally and not jointly, will indemnify Buyer after the Closing for claims relating to (i) a breach of any representation, warranty or covenant, (ii) any liability relating to the Company other than the liabilities that are expressly assumed by Buyer, whether contingent or otherwise, and (iii) all liabilities of the Company other than liabilities that are expressly assumed by Buyer. | |
| Commentary: There are three glaringly pro-Buyer aspects to this term. First, it is one-sided—Buyer is not making any commitment to provide reciprocal indemnity to the seller. Second, there are no limitations specified, such as a representation and warranty survival period, liability cap or deductible. (However, these missing limitations are briefly addressed in the following section of the LOI.) Third, Buyer is requesting that each shareholder of the Company, and not just the Company itself, indemnify Buyer. It is helpful from the Company’s shareholders’ perspective that the proposed indemnity would be “several” and not “joint,” which means that each shareholder would only be responsible for his, her or its proportional share of any liability, rather than all of it, and it is not unreasonable for the buyer to want to ensure it has recourse if it is entitled to recovery, given that the Company is selling all or substantially all of its assets and will likely be dissolved post-closing. Nevertheless, provisions like these are generally the focus of lengthy and difficult negotiations between the parties. They would not normally be accepted wholesale by a typical seller without additional clarity or limitations. | ||
| Definitive Agreements | In addition to the provisions specifically described herein, the definitive agreements relating to the Proposed Transaction will contain standard representations, warranties, survival periods, limits on indemnification, escrow provisions, conditions, covenants, termination rights and other provisions appropriate for a transaction of the type contemplated herein. | |
| Commentary: This is a reasonable and generally acceptable provision through which the parties are acknowledging that many key terms and conditions have been omitted from the LOI. However, I would advise the Company to try to convince Buyer to agree to some additional language covering survival periods, limits on indemnification and escrow. These terms will all be profoundly important to the seller post-closing, as they impact the Company’s ability to dissolve and distribute the proceeds of the sale to its shareholders, which has already been made more difficult by the inclusion of an earnout in the transaction terms. | ||
| Conduct of Business | The Company will continue to conduct business in the ordinary course consistent with past practice and will not, among other things, (i) engage in any transactions outside of the ordinary course consistent with past practice, (ii) enter into any material contracts, (iii) make or rescind any tax elections, (iv) increase any employee salaries or benefits, or (v) take any action that would tend to materially diminish the value of the business after the Closing or that would interfere in any material respect with the business of Buyer to be engaged in after the Closing, in each case without the prior written consent of Buyer; provided that, notwithstanding the foregoing, the Company may (i) borrow under its current secured bridge financing facility and (ii) renegotiate debt service and repayment terms with its principal secured lender. In addition, the Company will use its best efforts to obtain, or cooperate in obtaining, the receipt of all necessary regulatory approvals and any required consents of third parties. | |
| Commentary: It is common for M&A transactions anticipating a gap period between signing and closing to restrict the seller’s ability to operate the acquired business in any manner it wishes. After all, once the definitive agreements have been signed, the buyer will have agreed to pay a specified amount (subject to adjustment) for the Company and quite reasonably wants to receive the full benefit of the bargain. On the other hand, the deal isn’t closed until it’s closed. Until then, the target will want the freedom to manage its operations as it deems appropriate. Thus, provisions like this one are crafted in an effort to impose limited restrictions on the target company while preserving its value and requiring the seller to obtain Buyer consent to actions subject to restriction. This particular provision is more detailed and limiting than one would normally encounter in an LOI, and it favors Buyer, particularly in restricting the Company’s execution of “material contracts,” which is not a defined term, and taking actions that could diminish value or interfere with post-closing operation. These are ambiguous and restrictive and not likely to be acceptable to most sellers. Also, note that Buyer has included the phrase “among other things” before the list of restrictions, which has the effect of making this list represent the minimum restrictions to which the Company will be subject. Obviously, this would be undesirable for the seller. | ||
| Governing Law; Jurisdiction | This LOI and all claims and disputes arising hereunder or related to this LOI, the Proposed Transaction or the conduct of either party in connection therewith shall be governed by and construed in accordance with the laws of the State of Delaware, without regard to its conflicts of laws provisions. All disputes arising out of or related to this LOI will be adjudicated exclusively in the state or federal courts located in the County of New Castle in the State of Delaware. | |
| Commentary: Unlike the other provisions discussed above, this provision only relates to the LOI itself rather than the terms of the agreements that will govern the transaction. It is important to include governing law and jurisdiction provisions like these in LOIs, particularly when the transacting parties are not resident in the same state. The choice of law may have a significant impact on the interpretation and enforceability of the LOI (discussed below). For example, generally speaking, the state of Delaware recognizes an implied contractual covenant of good faith and fair dealing while the state of Texas does not. The parties may, but do not usually, extend the governing law and jurisdiction provisions of an LOI to the definitive transaction agreements, as well. | ||
| Good Faith Negotiation | After execution of this LOI, the parties will cooperate, and exercise their respective commercially reasonable efforts in good faith, to negotiate, draft and sign an Agreement consistent with the terms of this LOI as promptly as reasonably practicable. | |
| Commentary: This provision is designed to address the uncertainty about the application of the implied contractual covenant of good faith and fair dealing to LOIs. By including this language along with the enforceability language below, Buyer is attempting to ensure the parties have a legally enforceable obligation to endeavor in good faith to sign definitive agreements governing the transaction. | ||
| Exclusivity | From the date of this LOI through 11:59 p.m. [Eastern] Time on [date 15-60 days later] or such earlier time, if any, as Buyer notifies the the Company that it wishes to terminate the negotiation of the Transaction (the “Exclusivity Period“), the Company shall not, and shall cause its affiliates and their respective directors, officers, stockholders, employees, agents, consultants and other advisors and representatives (collectively, “Representatives“) not to, directly or indirectly, (i) solicit, initiate, encourage, knowingly facilitate or entertain any inquiry or the making of any proposal or offer from any person (other than Buyer) relating to any sale or lease of all or any part of the Company (an “Alternate Transaction“); (ii) enter into, continue or otherwise participate in any discussions or negotiations with any person (other than Buyer) relating to any Alternate Transaction; (iii) furnish to any person (other than Buyer) any non-public information or grant any person (other than Buyer) access to its properties, assets, books, contracts, personnel or records for the purpose of determining whether to make or pursue any inquiries or proposals relating to any Alternate Transaction; or (iv) enter into any agreement or understanding with any person (other than Buyer) with respect to, or otherwise cooperate in any way with, or assist, participate in, facilitate or encourage any effort or attempt by any person (other than Buyer) to seek to do, any of the foregoing. | |
| Commentary: As briefly discussed in another post, exclusivity provisions are generally sought by buyers who do not wish to compete or continue competing with third parties for a deal. As one might expect, sellers agree to exclusivity reluctantly, as doing so may reduce their ability to maximize value from the transaction by inducing competing bids. However, without exclusivity, many buyers will refuse to invest the time and resources in conducting fulsome due diligence and negotiating definitive transaction agreements. This example exclusivity provision is short and somewhat atypical. In most cases, where the parties agree to exclusivity, either longer provisions are included in LOIs or separate exclusivity agreements are signed simultaneously with the LOI. | ||
| Expenses | Each party will pay its own expenses and any other professional fees (including, without limitation, all legal, accounting and investment banking fees and expenses) for due diligence, preparation of this LOI or the definitive agreements and any other deal-related expenses. | |
| Commentary: In some respects, this provision simply clarifies what most parties would assume: that each party will be responsible for its own costs in pursuing the transaction prior to signing definitive agreements. However, given that this LOI includes an exclusivity provision, which frequently contain requirements for sellers that breach such provisions to cover the buyer’s costs and expenses, it may be viewed as mildly pro-seller in this case. Moreover, if the parties elect to make an HSR filing based on the execution of the LOI rather than waiting for definitive agreements to be signed, the associated expense would fall on the buyer because the fee is imposed on the buyer absent an agreement to the contrary. | ||
| Binding Terms | Only the terms of the sections of this LOI entitled “Governing Law; Jurisdiction”, “Good Faith Negotiation,” “Exclusivity” and “Expenses” shall be legally binding and enforceable agreements of the parties. All other provisions of this LOI constitute only preliminary statements of the intentions of the parties and do not contain all matters upon which agreement must be reached for the Proposed Transaction to be effectuated. It is understood that this LOI does not constitute an obligation or commitment of either party to enter into the definitive agreements, and any obligations or commitments to proceed with the Proposed Transaction will be contained only in mutually acceptable definitive agreements relating to the Proposed Transaction that have been prepared, approved, executed and delivered by the parties hereto. | |
| Commentary: Clarity about which, if any, terms of an LOI are binding on the parties is of paramount importance. Absent such language, courts may find an LOI to be sufficiently clear as to the parties’ intentions to constitute an enforceable agreement. |
Unless accepted, this offer expires at 5:00 pm [Eastern] Time on [date 7-15 days later]. Please acknowledge your acceptance of the terms of this letter by signing and returning it on or before 5:00 pm [Eastern] Time on [date 7-15 days later].
Very truly yours,
[BUYER]
Accepted and agreed:
[TARGET]
* * *
If you’d like a more detailed discussion of letters of intent, I recommend this attachment to the American Bar Association’s Model Stock Purchase Agreement, Second Edition.
Erik Lopez is the M&A lawyer responsible for this blog. Feel free to contact Erik at erik@jassolopez.com or +1-214-601-1887.
Erik Lopez
Partner at Jasso Lopez PLLC
Erik is an M&A lawyer with over 23 years of domestic and cross-border, public and private M&A experience. He has successfully closed hundreds of deals totaling tens of billions of dollars in value for a global client-base. He is a graduate of the University of Chicago and New York University School of Law. You can reach Erik at erik@jassolopez.com.