An LOI can be a robust tool for enabling collaborations. Business transactions involve a lot of back and forth before the parties involved can come to an agreement. Since business deals require valuable time and effort, all parties involved in a transaction may want to make sure that there is at least a basic agreement in place before they commit more effort to negotiations.
That is where LOI or Letter Of Intent comes in, it is a non-binding agreement that shows that both parties have an intent to finalize the deal. Sellers often insist on an LOI to be signed before they disclose their business details to the potential seller to make sure any information they share with the buyer is protected. An LOI is still a very basic level agreement, and it doesn’t guarantee the completion of a deal. However, it helps reassure both parties that there is at least an agreement in place that covers the fundamental terms of the deal. So if you are buying or selling a business, it is important to use an LOI to make sure you and the other party aren’t wasting their time and effort.
With that said, an LOI needs to be drafted properly and should contain all the basic elements to be effective. So if you want to know what an LOI is and how you can draft one for your business transaction, then this article is for you.
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What is an LOI?
An LOI may also be called a letter of understanding, a memorandum of agreement, or a memorandum of understanding. The reason it is called a letter of intent is that it is usually drafted and presented in a letter format.
It is a non legally binding agreement, which means it can’t bind either party to the terms and conditions listed in it. However, it is still an effective agreement to increase the likelihood of a successful business transaction. The letter of intent is going to contain the basic terms and conditions for the agreement. However, it may have other agreements within itself, such as confidentiality agreements and a non-compete agreement.
An LOI comes into play when the negotiations between the buyer and seller have reached an agreement on the important terms of the merger or acquisition. While an LOI is beneficial for both parties, it is especially important for the party selling their business. A letter of intent ensures that sellers are not obliged to provide insider information for the due diligence process to a buyer who refuses to accept the basic terms.
Even as you’re trying to understand how to draft the LOI, you should also know what is a term sheet. Check out this video I have created explaining how that’s done. It will help you with insights into the LOI.
How does an LOI work?
An LOI contains all of the information either party needs about a deal to make an informed decision about whether the deal is worth it or not. As mentioned above, an LOI can allow sellers to only disclose business details to buyers that sign an LOI with them and show interest in moving forward with the deal. The way a letter of intent (LOI) works for buyers is that it may often be used to obtain a buyer’s right of first refusal. This means that the seller can’t sell the business to a third party without negotiating the deal with the buyer that signed an LOI with them.
A letter of intent is also essential for buyers because the agreement gives buyers the go-ahead to start the due diligence process on the seller. Once an LOI is signed, the seller often gives the buyer exclusive access to insider information about their business, so the buyer can verify the authenticity of the seller’s claims. While most LOIs are not legally binding, some may work as legally binding agreements if they are drafted as such. So both parties need to be careful about any legally binding provisions that may bind them once the letter of intent is signed.
What is included in an LOI?
Every business transaction may require a unique LOI to be drafted, so the components of a letter of intent may vary as per the scope and requirements of the transaction. However, several components are used in most, if not all, letters of intent, so without further ado, here are the most commonly used components of a letter of intent.
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The description, also known as the introduction section of an LOI will discuss the reason behind the creation of the document. This section also identifies the parties involved in the transaction and the timeframe for activation of the letter. The terms that are repeated throughout the letter may also be defined in the description or introduction section.
Terms of transaction
Terms of the transaction are another key part of an LOI, and this section contains all the details about the deal and any terms that both parties (buyer and seller) have previously agreed upon. This section also contains the asking price that the seller expects. However, the asking price stated in the LOI is not definitive as it might change as a result of future negotiations. In addition, the terms of the transaction section can also mention the expected deadline for the transaction to complete, so both parties have a timeline for closing the deal.
Due diligence is an important part of the LOI for buyers because it is meant to grant permission to buyers to assess risks associated with the transaction. The due diligence section involves permission from the seller that allows buyers to access confidential business details about the business. Moreover, this section also specifies how long the information may remain accessible to the buyer. The information that buyers get access to with the help of the due diligence agreement includes financial details, past performance of the business, and any pending litigation among other details.
Covenants are sub-agreements that are a part of most business agreements, and an LOI is no exception. The convents are meant to protect the interests of both parties, and some common convents that are a part of an LOI include the following.
- Non-disclosure agreement: A NDA is a common agreement included in an LOI, and this agreement prevents either party from disclosing confidential information learned during the negotiations process.
- Non-compete agreement: A non-compete agreement prevents both parties from directly competing with one another in the same market. This agreement prevents either party from learning information from the other and using it to start a business of their own.
- Non-Solicitation Agreement: This agreement prevents either party from soliciting the other party’s clients or customers.
An LOI sets some conditions that must be fulfilled by both parties in order to close the deal. The deal is ready to close when all of the closing requirements are fulfilled, and funds are exchanged.
Final agreement-related statement
An LOI is usually non legally binding, and they are used to document the progress of negotiations and the terms that both parties have agreed upon. This means a letter of intent is not a final agreement, the deal will only be considered final once a separate written agreement is in place.
However, in order to make sure an LOI is not considered as a final agreement, it is essential to include a statement related to the final agreement that clearly states that the LOI is in fact not a final agreement. The language of the LOI is also taken into account when it comes to enforcing it as a final agreement. So the language of the agreement should be carefully chosen to make sure it doesn’t read like it is a final agreement.
These are just some of the very basic components of an LOI, and both parties may choose to add further sections to the letter to improve its effectiveness.
Considerations when drafting an LOI
An LOI should contain all of the components mentioned above at the very least. However, when it comes to drafting an LOI, it is important that you create each section of the letter properly. Here is how you can draft the basic sections of an LOI.
Describe the transaction in detail
The description/introduction section should be crafted with care. You should clearly mention the objectives of the deal and make sure both parties agree to what the expected outcome of the deal is.
Specify the asking price
When the business transaction involves money, it is essential to have an asking price in the LOI. This will make sure that both parties understand the asking price and any other value that is being exchanged.
Timing and closing date
Closing of the deal requires fulfillment of certain conditions at the same time, it is important that your LOI contains an expected closing date to add a timeline to the negotiations process. Doing this will make sure that both parties can set the pace to close the deal by the agreed-upon date.
If you are not sure if you have the legal and professional expertise in-house to draft an LOI for your business transaction, is it best to seek help from an advisor and attorney to help you draft the agreement.
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What are the advantages and disadvantages of using an LOI?
An LOI is generally a part of the business transaction process, even though it is not required. It is important to know the pros and cons of using an LOI for your transaction to know whether to use it or not. So without further ado, here are some advantages and disadvantages of using an LOI.
Advantages of an LOI: Some advantages of using LOI for your business transactions include:
- Specifying terms of the transaction: A LOI helps document everything by recording the purchase price closing date and other terms of the transaction. So by using an LOI, you can maintain a record of the agreements reached during the negotiation process. This helps save time for both parties and keeps the deal moving in the right direction.
- Pointing out any issues that need to be resolved: A LOI contains the terms that have been agreed upon by both parties, at the same time it puts the spotlight on any disagreements that are preventing the deal from moving forward.
By pointing out the major issues that have put the transaction on hold, an LOI can motivate both parties to resolve them to speed up the transaction.
- Creates a sense of commitment: Even though an LOI is not a legally binding agreement, it still creates a sense of commitment for both parties towards the terms of the agreement. So, if both parties sign an LOI, it serves as a sign that both parties are committed to closing the deal.
- Serves as a draft for final documentation: A LOI can also be used as a guide for both parties regarding how the closing documents will need to be created. So by creating an LOI, both parties can get a glimpse of what the final documentation will look like.
Disadvantages of an LOI: Despite having its advantages, an LOI also comes with a fair share of disadvantages, which are as follows:
- An LOI can be legally binding: As we have discussed in the previous section, you should always add a statement about the LOI not being the final document. Not to mention, the language of the LOI should be selected carefully to prevent it from being considered a legal document.
With that said, if the LOI is not drafted professionally, it may well become legally binding.
- Can cause panic among stakeholders: Signing an LOI may send the wrong message to your company’s stakeholders such as vendors and employees as they may think you are selling the business. This panic can eventually harm your business if the purpose of an LOI is not properly communicated among stakeholders.
An LOI is the first step in an M&A deal and offers benefits for both the buyer and the seller. Now that you know all the components of an LOI and the key considerations for drafting this document, you can better utilize a letter of intent in your own transactions.
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