The Pros And Cons Of Letters Of Intent

What are the pros and cons of letters of intent? Business transactions are difficult to negotiate and to make matters worse, the negotiations process can span over weeks and even months in certain cases. So any progress that is made during the negotiations of a deal is worth recording so both parties know that they can move on to the next step. That is where an LOI or Letter Of Intent comes into play. As the name suggests, when parties in a business deal sign this letter, they are showing intent or some level of commitment to keeping the deal going.

While a letter of intent is not a legally binding document, it does however serve as motivation for both the buyer and seller in a deal to keep putting effort into the negotiations process. In some transactions, an LOI may even be considered an essential document, while there are situations when it might not be included altogether. So at the end of the day, the decision of involving an LOI in your business transaction should only be made after careful consideration.

An LOI contains additional sub-agreements and clauses that you should know about before adding an LOI to your business deal. So, if you have only just heard about an LOI and want to learn more about it, then keep reading, this article is for you. You’ll also learn more about the pros and cons of letters of intent.

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What is an LOI used for?

An LOI is mostly used during larger-scale business transactions such as mergers and acquisitions. As well as in fundraising. When the buyers and sellers have agreed on important terms of the transaction. Both parties benefit from a letter of intent, but the seller can really protect their business by involving an LOI in the mix. If the buyer does not agree to the basic terms of an LOI, the seller can take it as a sign of lack of interest, and they can choose not to provide insider information to the buyer.

The terms of a letter of intent may be carried over into the final purchase agreement. A seller’s time spent on negotiating a favorable letter of intent will mean that the favorable terms will eventually get added to the final purchase agreement.

The LOI can also include information about the parties involved in the transaction, as well as the business to be sold. The most important element of a letter of intent is the price the buyer is likely to pay. The sellers have the opportunity to negotiate their desired price when drafting an LOI. So in short, an LOI is highly advantageous for the sellers in more than one way.

However, it is not like the buyers are at a disadvantage if an LOI is brought to the table during the negotiation process. A letter of intent allows the buyers to access key details about the seller’s business. So the buyers can use the LOI to make sure they are investing in the right business.

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What are some key parts of an LOI?

An LOI may not be legally binding in most cases, but that doesn’t mean it can’t contain clauses that hold either party accountable to the law. To better understand whether a letter of intent is worth using during your next business transaction, it is important to know what clauses it may contain. So without further ado, here is a list of all the key components of an LOI. You’ll also develop insights into the pros and cons of letters of intent.

Introduction

This section of the LOI explains the purpose of the document and explains the reasons for its creation. In addition to identifying the parties involved in the transaction, the introduction details the timeframe in which the letter of intent is to be activated.

Additionally, terms that are repeated throughout the letter could be defined in the introduction or description section.

Terms of transaction

The terms of the transaction are another critically important part of a Letter of Intent (LOI). This section contains all the details about the transaction and any terms that have been previously agreed upon by both parties (Buyer and Seller).

The seller also provides the asking price in this section. In any case, the price listed in the LOI may be subject to change during future negotiations.

Also included in the terms of the transaction section is the expected closing date, so both parties have a clear understanding of how long it will take to complete the transaction.

Due diligence

The due diligence section of the LOI is crucial to buyers because it allows them to assess transaction risks.

As part of the due diligence process, the seller permits the buyer to access confidential business information. Additionally, this section indicates how long the buyer may access the information.

Financial details, past performance of the business, pending litigation, and other details are among the information which buyers can obtain through due diligence agreements.

Sub agreements

The letter of intent may be accompanied by Sub agreements or Covenants. An LOI includes a number of sub-agreements that protect the interests of both parties, some of these are:

Non-disclosure agreement

Often included in a letter of intent, an NDA prevents parties from divulging confidential information. Both parties will eventually learn sensitive information about each other that may count as trade secrets. However, once an NDA is signed, both parties become legally bound to not disclose these secrets to outsiders.

An NDA is one of the legally binding parts of a letter of intent.

Non-compete agreement

This type of agreement prevents the parties from directly competing with each other in a particular market. Neither party can use the information they learn from the other to start a new company or to benefit their existing business.

Non-Solicitation agreement

By signing this agreement, both parties agree not to solicit any clients or customers of the other party for business purposes. This clause is there to prevent the other party from taking away key clients from the company.

Closing conditions:

In order to close a deal, both parties must fulfill certain conditions set forth in the Letter of Intent. Both parties must work together to come up with closing conditions that protect their interests.

Final agreement-related statement

As mentioned earlier, in most cases letters of intent are not legally binding, and they are used for documenting negotiations. In other words, an LOI is not a final agreement, and the deal is considered final after a separate final written agreement is signed.

An LOI must also include a statement stating that the LOI is not a final agreement in order to keep it from being regarded as one. Otherwise, any party might argue that the conditions agreed upon in an LOI are the final word on the deal.

When enforcing the LOI, the language of the letter holds paramount importance in order to ensure the agreement doesn’t sound like a final agreement. It should be carefully worded.

Governing law

Whenever an LOI is drafted as a legally binding document, it is important to specify which laws apply to it. It is critical to mention the state law that governs the letter of intent since it is governed by the law of the state in which it was drawn up.

The governing laws are applied to the party that fails to adhere to the legally binding terms and conditions. The lack of a legal specification can make it difficult to determine what laws apply to the LOI in case of a breach.

Now keep in mind that the components of an LOI that we have stated above are not required to be a part of each and every LOI. In addition, there are many other components that can be added to an LOI to make it more effective. So it is best to work with a lawyer when drafting an LOI to make sure the LOI is drafted in your best interest. An expert attorney will also help you understand the pros and cons of letters of intent.

Not understanding how the letter of intent works is only one of the common mistakes entrepreneurs make when fundraising. For more information about the typical pitfalls to avoid, check out this video I have created.

What are some pros and cons of letters of intent?

Now coming to the major question that most companies and business owners have on their minds when they are asked to sign an LOI. Just like any other agreement in a business deal, signing an LOI is also going to carry some advantages but may also put you at a disadvantage.

So without further ado here are some pros and cons of signing an LOI:

Pros of signing an LOI:

An LOI allows both parties to save time and money

Since an LOI can be created as non legally binding, it allows both the buyer and seller to negotiate the terms of the deal such as sale price, closing date, and how the deal will be materialized without worrying about entering a formal commitment.

The negotiation process would normally get dragged along longer than it should if both parties are trying to avoid committing to the deal. However, once the legally binding aspect is taken out of the equation, the negotiation process can move much faster saving time and finances.

LOI can help address the elephant in the room

Every business transaction has some fundamental disagreements that often result in the demise of the deal. These issues should be addressed earlier on so that they don’t snowball into bigger issues down the road.

When both parties sign an LOI and the agreed-upon terms are listed down, it also pinpoints any matters that are a cause of disagreement.

Once the dust has settled and both the buyer and seller know the causes of disagreements, they can either choose to find common ground or end negotiations if they can’t resolve the issues.

Builds trust between both parties

Even simple agreements between the buyer and the seller can create confidence between them. The mutual trust built by forming an LOI can translate to a successful transaction later on.

Cons of signing an LOI:

You can end up in a legally binding agreement

While most companies consider an LOI as a harmless non-binding agreement, something as simple as using the wrong legal language when creating them can make them legally binding. So you could sign the LOI believing you’re only documenting the conditions, but you’re actually legally obligated to obey and abide by them.

Sends out the wrong message

Entering into an LOI can send out the wrong message to your customers, shareholders, partners, and other stakeholders. They may take the signing of an LOI as a sign that your company is not doing well which is why you are trying to get rid of it.

This can have a negative impact on your company’s reputation and can also reduce the trust of stakeholders in your company.

An LOI may prove counterintuitive

This is less common but still a possible con of entering an LOI. Companies that are trying to get acquired often enter an LOI with one potential buyer to show other interested parties that they are in fact worth acquiring.

This practice might get the sellers some higher offers but the buyer ends up getting used as a way to get better offers from the seller.

So there you have it–the pros and cons of letters of intent. While using an LOI definitely has many benefits, it can also turn into a problem for either the buyer or seller in some cases. However, the best way to avoid using an LOI incorrectly is to hire the services of an attorney. Legal experts can assess your individual case and help you determine whether entering into an LOI is a good idea or not.

Conclusion

In most cases using an LOI has more benefits than disadvantages. If you want to get the most out of an LOI and avoid the downsides we discussed in this article, the key is to construct it carefully and only utilize it for its intended purpose, with professional legal help. Make sure to understand the pros and cons of letters of intent before using them.

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