Is An LOI Legally Binding? – Implications For Fundraising And M&A Success

Is an LOI legally binding? The short answer is no–and yes! Legally, a standard LOI or Letter of Intent for fundraising campaigns is always non-binding. This document only indicates the investors’ interest in backing the company, but does not create a legal obligation.

Typically, a non-binding LOI explicitly states that the document is not legally binding and is only a preliminary agreement. Both parties to the agreement underscore that they intend to further negotiate the terms and conditions before finalizing the deal.

A letter of intent is used in various business transactions, such as startup fundraising and mergers and acquisitions. Companies collaborating on joint ventures and other complex deals may also create an LOI in the early stages of discussions. It indicates their mutual interest in dealmaking.

A non-binding LOI is not enforceable in a court of law but lays down the framework or scope of talks. Parties to the deal use this tool to establish the underlying terms of the transaction. As a result, neither can back out of the deal without a genuine cause. They must act in good faith.

A Standard Letter of Intent is Assumed to be Non-Binding

Essentially, even when not expressly specified, a standard LOI is considered non-binding. It does not bind the investor to offer funding in a capital-raising deal. Both parties have the right to withdraw from the deal without closing without the fear of incurring a penalty.

The LOI evokes confidence in fundraising campaigns and entices investors to back the company. At the same time, founders should be aware that the letter of intent does not guarantee a successful round. Even if the investor has signed the LOI, they can choose to withdraw their offer.

For this reason, until the deal is finalized, you’ll continue with outreach activities and continue talks with other potential investors. However, if the deal closes, the terms in the LOI act as a precursor to drafting the definitive agreement.

Similarly, in an M&A transaction, the LOI indicates the buyers’ intention to purchase the company. It outlines the basic framework and sets the tone for negotiations. It also infuses flexibility to allow dealmakers to modify the terms if needed.

Is an LOI Legally Binding?

Although the LOI, in its entirety, is NOT legally binding, you can include certain conditions that are enforceable. By including certain terms and language, specific aspects of the LOI can be binding. For instance, confidentiality agreements and exclusivity clauses.

For that to happen, the LOI must clearly specify which provisions are legally binding and which are not. If the LOI does not expressly state that it is binding, both parties can assume it is not binding.

In case of a dispute, the court will examine the language used in the letter of intent. It will also scrutinize the terms of the document. For instance, if the document clearly specifies that the parties will create a definitive agreement, the LOI becomes non-binding.

If there is no mention of a future definitive agreement, the court can consider the LOI to be binding. That is if the parties determine the material terms in the LOI. But if the final terms and conditions of the deal are open for discussion and negotiation, the LOI is non-binding.

A typical letter of intent discusses the potential terms and conditions of the agreement. For instance, purchase price and payment terms in M&A transactions. Due diligence processes are universal for fundraising or M&A deals and both parties agree on the scope and costs.

They also discuss who will carry the expenses if the deal falls through. Other clauses include the timeline within which the deal should close, along with representations and warranties. In the case of an M&A deal, the LOI specifies the scope of sale or the precise assets included with the company.

The LOI is a precursor for the purchase agreement, which is updated according to discoveries made during due diligence.

Provisions that Make the LOI Binding

Both parties to the business transaction can include certain provisions that are enforceable by law. If that happens, the parties express the binding provisions in clear and precise language to avoid any chance of ambiguity. These clauses are designed to protect their interests in case the deal fails.

To answer the question–is an LOI legally binding, here are some of the provisions they might add.

Exclusivity in M&A Transactions

In an M&A transaction, the exclusivity clause prevents the seller from contacting or negotiating with other potential buyers. The clause comes with a time limitation and protects the buyer’s interests. It reassures them they will not lose the acquisition while conducting due diligence.

The LOI clearly specifies the exclusivity period, ranging from 30 to 60 days. However, this period can also be as long as 120 days or more, starting right after the parties sign the LOI. This period depends on the complexity of the deal and the company’s operations.

The buyer may need more time to meticulously examine the company they intend to purchase, specifically if they have received only limited information about it. The exclusivity clause has provisions for this possibility, and both parties agree to extend the period if necessary.

Exclusivity permits the buyer to change the terms and conditions of the deal depending on the due diligence results. They may find additional issues with the company that did not come to light when signing the letter of intent. After the process is complete, buyers may want to renegotiate the pricing.

Conversely, the seller may want to include a contingency clause. The clause allows the seller to opt out of the deal if certain benchmarks are unmet.

For instance, if the due diligence takes longer than expected or the buyer offers a purchase price much lower than the seller’s expectations, the seller should retain the right to negotiate or terminate the LOI. Know that exclusivity clauses are enforceable when expertly crafted.

Exclusivity in Fundraising Deals

To answer the question–is an LOI legally binding, the exclusivity clause in a fundraising LOI is binding. It works similar to an M&A transaction. The key difference is that the clause prevents the owner from reaching out to other investors during the due diligence.

Through the exclusivity clause, the investor can impose certain restrictions on the company, such as marketing certain products and services, serving specific customer categories or geographical locations, or leveraging marketing channels.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend Peter Thiel (see it here), which I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that founders worldwide are using to raise millions below.

Why Entrepreneurs Should Be Cautious of Exclusivity

Whether selling their company or raising capital for it, entrepreneurs and owners should be cautious about accepting the exclusivity clause. This clause dilutes the seller’s negotiating position and puts them at a disadvantage.

By the time the due diligence process is complete, the seller has also invested thousands of dollars and time. They may also have retained the services of attorneys and advisors and are anxious for the deal to go through. The other party is well aware of this expense.

The buyer may take advantage of this situation to push for more favorable purchase terms. Also, know that the exclusivity clause does not prevent the buyer from evaluating other companies as potential acquisitions.

Losing out on the deal has yet another drawback. It may weaken your chances of getting good offers from other buyers who may hesitate to purchase the company. They may have reservations about why the other buyer backed out, further weakening the valuation and your negotiation power.

You’ll examine the language and provisions carefully to ensure they don’t prevent you from taking the deal to other interested parties. That is if the initial offer doesn’t pan out. Also, be aware that geo-political and economic landscapes can change quickly during the exclusivity period.

If the changes favor the target company, it may have a higher valuation. Accordingly, you may want to renegotiate for better terms and conditions. On their part, buyers in an M&A deal may want to secure the purchase at the previous price. That is until they can finalize and sign the purchase agreement.

It is always advisable for the company owner or founder to first draft the clauses in the LOI. They gain an advantage in the negotiations.

Confidentiality

Keep in mind that the LOI and its clauses set the framework for the final terms of the deal. If you ask the question–is an LOI legally binding–the confidentiality clause is undoubtedly enforceable. Both parties agree to keep the details of the deal private even if it falls through.

Sometimes, the deal participants may draw up and sign a formal NDA also. A Memorandum of Understanding (MOU) is another good alternative for the LOI.

Is an LOI Legally Binding?–Other Binding Clauses

An LOI can include other contingencies enforceable in a court of law. For instance, in an M&A deal, the LOI may clearly state that the deal will close only if the buyer successfully raises the required funds.

This clause may also include a pre-determined time frame within which the buyer should have the funds ready. If the financing is not ready on time, the seller can terminate the deal. The LOI can include any other contingencies, prerequisites, and conditions that both parties agree on.

The LOI is only one of the aspects of fundraising that entrepreneurs should learn about. If you need more detailed information about how the process works, check out this video I have created. In this video, I have explained in detail how to raise startup capital for your business.

Legally Binding Clauses to Streamline the Transaction

Although the LOI is not legally binding, including certain binding clauses can ensure that the deal goes through smoothly. Here are some suggested clauses to include:

Define What Constitutes the Company Assets and Purchase Price

The LOI should clearly specify how the working capital is calculated in an M&A transaction. Both parties should be clear on whether it is included in the purchase price. This factor is crucial since the buyer will want assurance that the company will have adequate liquidity to continue operating.

Calculating working capital is a complex process requiring professional expertise. Once the deal closes, the buyer adds up the actual available working capital. Next, they compare it with the estimate the seller presented. The final purchase price reflects any adjustments made.

Sellers often make the mistake of defining a price range in the LOI, for instance, between $35M and $50M. More often than not, after the due diligence, the lower limit becomes the final offer. To avoid unpleasant surprises, working out the correct language to define the limit is advisable.

Including earnouts as part of the purchase price is quickly becoming a preferred negotiation strategy. Before committing to this structure, sellers should be clear on the terms, such as the EBITDA or revenues.

The buyer may want to change the earnout terms after the due diligence process, arguing that the projections are overestimated. Adding a binding clause in the LOI can prevent this situation.

Escrow Conditions

An LOI specifically mentions the payment terms and how the purchase price is calculated. Sellers in an M&A should also specify the payment amount placed in escrow. And, the timeline and criteria for releasing it to the company owner.

Clarifying this issue when drafting the LOI eliminates the confusion when the deal is about to close. Negotiating escrow when drafting the purchase agreement often leads to disagreements that both parties want to avoid.

Transition and Integration

A seamless transition to the buyer and integration with the acquiring company can make or break the deal. Both parties in an M&A can include specific binding clauses that outline how to structure them.

They must also discuss the terms under which the seller stays as a consultant and the time frame for their tenure.

The Takeaway–Is an LOI Legally Binding?

According to the law, an LOI is not legally binding. However, certain clauses in the LOI can be enforceable in a court of law which expects them to act in good faith. Dealmakers can include clear and precise language defining the contingencies and criteria for enforcing the clauses.

The parties drafting the LOI typically have the upper hand in the negotiations and set the tone for the final agreement. In addition to binding clauses, the LOI can highlight and address specific issues that can potentially derail the deal.

This is why having expert legal advisors on board is crucial to ensuring the deal reaches a successful conclusion. This factor holds for an M&A transaction or a fundraising contract.

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