Letter of Intent
At some point in the process of selling a business, a buyer may submit an offer via a Letter of Intent (frequently referred to as an LOI). A Letter of Intent is not the governable purchase agreement of a deal but rather should be viewed as its formal framework. The asset or stock purchase agreement governs all facets of the transaction and is the formal contract used at closing. Both buyers and sellers of businesses should understand the role of an LOI in a business deal, as well as the legal and practical ramifications of agreeing to a Letter of Intent.
Letter of Intent not Legally Binding
An LOI is almost never legally binding on either party, and either party may almost always pull out of a LOI without legal consequences. As such, both parties to an LOI take the risk that the other party may simply change their mind after accepting an LOI. This differs from a purchase agreement which is legally binding. Typically, the LOI covers the essential points of the deal (such as the price, terms, closing date, non-compete clause, and any other critical terms of the deal). Although not legally binding, the signing of the LOI is still important to many deals and to a successful closing.
Letter of Intent Should End Negotiations
- Buyers frequently prefer submitting an LOI rather than a proposed purchase agreement for the simple reason that an attorney is typically not used or needed when proposing an LOI.
- Most buyers do incur attorney costs when proposing a purchase agreement which definitively covers every aspect of the deal.
- Signing a letter of intent is still very significant because it expresses a written framework of the deal, gives buyers a certain timeframe of exclusivity, and it sets out the terms of the formal due diligence.
- Critically, a LOI letter should signal the end of negotiations over the critical aspects of the deal (such as price, terms, the non-compete clause, and post-closing transitional-related matters).
- Even though the LOI is not legally binding, it does bind the parties as a practical matter to what is agreed upon in the LOI.
- Both parties should understand the ramifications of changing critical terms of the deal.
- While it is true that discoveries during the formal due diligence period (after the LOI is signed) may give a buyer valid reasons for changing the LOI’s terms, the parties must have consistent and clear communication about any potential pitfalls of the deal.
- An experienced business broker that facilitates clear and consistent communication between the parties is the real glue that holds a deal together.
Selling A Salon As An Example
For example, let us assume that a buyer wants to make an offer on a beauty salon being offered for sale by submitting an LOI. If both parties agree in the LOI that the seller shall give 60 days of free training to the buyer after the closing, then the purchase contract should also reflect this critical term. If the purchase contract has training terms that differ from the LOI, then the party who made the changes must explain why the changes were made. This can be a very difficult hurdle and may kill a deal if one party believes that the other party is acting in bad faith by changing terms that were originally agreed upon.
LOI May Give Buyer Exclusivity
- The second critical component of signing a LOI is the exclusivity given to a buyer – typically for 30 -60 days.
- Exclusivity means that the seller is prohibited from signing another deal with another buyer during the exclusivity period.
- A buyer must give a negotiable deposit in order to secure an exclusivity period.
- A seller should want as short an exclusivity period as possible because one never knows what other buyer may emerge.
- A buyer in contrast needs to have some assurances of exclusivity and security prior to spending the resources necessary on an accountant to assist with formal due diligence and on a lawyer to help draft the proposed purchase agreement.
- This outside assistance can frequently amount to several thousand dollars.
- Conversely, the seller will also have to spend resources on their accountant in answering the due diligence request list and on a lawyer to help negotiate the purchase agreement.
- So the seller must be persuaded that a buyer is serious about closing the deal
Formal Due Diligence
The letter of intent is the typical instrument governing the formal due diligence process. The formal due diligence phase is when the buyer asks for and receives any and all available financials and company information about the business. Without signing an LOI (or a purchase agreement), formal due diligence can not and should not occur. The letter of intent itself should spell out the commencement date of formal due diligence, and what information the buyer will require during the formal due diligence process. It should also give a timeline as to when due diligence will be completed, and lay out the contingencies to close. In practical terms, a seller will not (and should not) engage in the formal due diligence process absent an agreed upon letter of intent or an agreed upon purchase agreement.
A letter of intent is not typically legally binding, but it still should practically bind the parties to the framework of the deal. A signed LOI gives both the buyer and the seller the peace of mind and confidence to incur transactional costs and put forth their own effort to complete a deal. An LOI may serve as the foundation of a successful closing and should be viewed as such by both buyer and seller.
Give Martin at Five Star Business Brokers of Palm Beach County a call today with questions about valuing your business and how to steer the sale of your business to a successful conclusion.