The Significance of Signing A Letter of Intent

Signing A 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).  An offer may also consist of a proposed purchase agreement which governs all facets of the transaction and is the formal contract used at closing. If instead the buyer makes an offer by submitting an LOI then both parties should understand what exactly an LOI is as well as the ramifications of having a signed LOI.

Letter of Intent not a Legally Binding Contract 

An LOI is almost never legally binding on either party, and as such either party may pull out of the deal without legal consequences. As such, the buyer always takes a risk when they propose an LOI rather than a proposed 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).  Although not legally binding, the signing of the LOI is critically important to many deals and to a successful closing.

Many Buyers Prefer Submitting an LOI

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. Signing a letter of intent is still very significant because it expresses in writing the framework of the deal, it gives buyers a certain timeframe of exclusivity, and it is the instrument by which buyers and sellers conduct formal due diligence.

An LOI Should Signal End of Negotiations

Having a written and agreed upon framework of the deal via a letter of intent 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). Again, 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.

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 terms that differ from the LOI, then the party who made the changes must be willing to explain why the changes were made. This can be a very difficult hurdle and can kill a deal if one party believes that the other party is acting in bad faith by changing terms that were originally agreed upon.

Consistent and Clear Communication 

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.

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 simply 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 typically needs to have this peace of mind (of exclusivity) in order to be sufficiently motivated to spend 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 with negotiating the purchase agreement.
  • So the seller will also need peace of mind that the buyer has signed a letter of intent, made a deposit, and is serious about closing the deal.

Formal Due Diligence

Signing a 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. Without signing an LOI (or of course a purchase agreement), formal due diligence can not and should not occur. The letter of intent itself should spell out the commencement date of due diligence, and what sort of 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.

Importance of A Written Agreement Before Formal Due Diligence

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 buyer should propose its formal due diligence request list either contemporaneously with the signing of the LOI or within a few days after its signing. However, if there are any unusual requests as to the content of the due diligence request list, they should be spelled out ahead of time in the LOI.

A letter of intent is not typically legally binding, but it does and should 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 engage with outside assistance and to put forth their own efforts in order to complete the deal. It can 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.