Getting the Letter of Intent Right
A precise letter of intent can help buyers and sellers maximize value from an M&A transaction
Sure glad we got that letter of intent signed – let’s send it to the lawyers to paper the deal.” That common sentiment suggests how the letter of intent, or “LOI” (sometimes also referred to as a “memorandum of understanding” or “MOU,” or “term sheet”), is often misperceived, especially by sellers in an M&A deal. Business parties will often use a letter of intent to confirm only the major business points of a proposed acquisition, such as the purchase price and how it will be paid, provide a period of exclusivity to the buyer, and perhaps address how long representations and warranties will survive.
However, by not addressing in the LOI other critical issues that need to be discussed as transaction negotiations proceed, a seller risks leaving substantial economic value on the table and compromising strategic opportunities. Thus, a seller in a private- company sale transaction is well advised to seek legal and accounting advice in the negotiation and drafting of the LOI.
Not every acquisition transaction has a letter of intent. Instead, the parties sometimes proceed straight to negotiating a definitive purchase agreement. But in transactions of significant size, the more common approach is to have a letter of intent precede the drafting of a purchase agreement. However, the strategic reasons for a letter of intent are very different for the buyer than for the seller. It is generally in the best interest of the buyer to have as short and general a letter of intent as possible, whereas a seller is usually better served by having a more comprehensive LOI.
Unless the seller’s company has unique assets, such as technology, intellectual property, brand, market share or an exclusive territory, the maximum leverage of the seller likely occurs at the time when the letter of intent is being negotiated. The seller’s negotiating strength often will diminish from that point forward. This is because in private-company transactions, most LOIs contain an exclusivity clause, which means the seller will be precluded from speaking to anyone else about a possible sale during the period of exclusivity.
In short, the buyer gets the target company off the market, and other potential buyers may move on to other opportunities. Once it becomes known that the seller has entered into a letter of intent (even if the terms are confidential), if the transaction does not close, the perception may arise that the buyer found something wrong and walked away. True or not, such perceptions can have an adverse impact on the ability of the seller to find a replacement buyer at the same price.
Despite confidentiality clauses, word of the letter of intent can leak out, causing other complications. Employees can get nervous and start seeking other jobs. Customers may become concerned about whether the new owner will increase prices or fail to provide the same level of service. As a result, customers may become more receptive to dealing with the target company’s competitors. A seller can also get emotionally attached to the idea of the sale and begin thinking about ways of spending or investing the proceeds, or, if they are owner-executives, moving on to other activities (including retirement). All of these factors make it harder for a seller to resist demands from the buyer after the letter of intent is signed. The phrase “becoming wedded to the deal” is an apt one.
Sophisticated buyers know this. They want to achieve this point with a seller as quickly as possible and they want to preserve maximum flexibility to draft the purchase agreement in a way that is more slanted to their favor. This is partly achieved by starting with a shorter, more general, LOI. Thus, rather than specifically addressing important topics in the LOI, the buyer’s preference is often to defer the issue by use of convenient stopgap wording in a way that can disadvantage the seller. Leaving an issue to be “as mutually agreed between Buyer and Seller in the definitive purchase agreement” is one such approach. An even more favorable phrase for the buyer is that “the definitive purchase agreement will contain representations, warranties, covenants, indemnification provisions and closing conditions customary for transactions of this nature.”
Using an LOI to maximize seller leverage
If the seller signs such an LOI, without further specifying key points, the effectiveness of the seller’s legal adviser will be significantly constrained. Rather than negotiating for key points when the seller’s negotiating position is more on a par with the buyer’s, the seller’s counsel is faced with doing so when negotiating leverage is declining. For these reasons, a seller is well advised to take the opportunity, before it gives up its optimal bargaining position, to insist on a more comprehensive letter of intent that addresses key transaction points. Here are a few of these key points.
The form of the transaction
If a price for the acquisition of a business is agreed to in the LOI, but the form of the transaction is not, a seller may find itself in a very different situation than it expected. Surprisingly, there are letters of intent that fail to specify this basic point. In general, a seller will want to sell its equity in the target company. The seller usually will have held the equity for a sufficient period to receive more favorable long-term capital gains treatment. The seller will thus have its purchase price reduced by tax only once. The amount it receives for the equity, less the adjusted basis in that equity, will be taxed.
However, if the form of the transaction is not specified, many buyers will seek to acquire not the equity of the target company, but rather only its assets and selected liabilities. Why? Although a detailed tax analysis is beyond the scope of this article, as a general rule, if the buyer acquires assets, it receives a step-up in basis on those assets. Subject to certain exceptions, liabilities not assumed in the deal are left behind with the seller, so the buyer may have lower post-closing risk of third-party claims. The target company is taxed on the gain between the purchase price of the assets sold minus the adjusted basis in those assets. But in order to get the money out of the target to the shareholders, some form of dividend must be made, which is then taxable income to the shareholders, and likely at a higher tax rate. Thus, there can be two levels of tax (and perhaps at higher rates, too) in an asset structure, as opposed to one level of tax at more favorable rates in a stock purchase transaction structure.
Holdout equity holders
Even if the form of the transaction is specified in the LOI as the acquisition of all of the equity, but not specified further, an important topic may still be left unresolved. If a buyer is willing to acquire the target company through the purchase of equity, the buyer generally insists on all of the equity being sold to it. The buyer does not want to deal with holdout minority shareholders. This is not a problem if either (a) the shareholders have a proper shareholders’ agreement among them that addresses this situation or (b) there is only one shareholder or a very few, all of whom are committed to sell.
But what about the situation where there is a minority shareholder, perhaps no longer actively engaged? For discussion purposes, assume he has a 5 percent interest in the company. The buyer does not wish to purchase 95 percent; it wishes to purchase 100 percent. The minority shareholder will know this. Because the minority shareholder may not have that much to lose (by having only a 5 percent interest), he may decide that he doesn’t have as much to gain either. So, the 5 percent shareholder could demand an additional payment to sell his shares, and, in the absence of a proper shareholders’ agreement, he may have every right to take that position. You do not want to be dealing with this situation after a definitive purchase agreement has been fully negotiated and you are just trying to obtain signatures in order to close. The better time to deal with it is at the letter of intent stage by specifying a merger structure if possible.
Indemnification for breach of representations and warranties
Just how long will the seller be responsible for standing behind the representations and warranties and any related claims? In terms of the classic bell curve, a representation-and-warranty survival period between six months and three years is arguably under the curve and, thus, within “market.” Of course, a buyer can be expected to push for the longer period. This survival period should be determined in the LOI.
At the same time, buyers often want an even longer period, sometimes in perpetuity or for the length of the relevant statute of limitations, for certain “fundamental” representations. For a seller, the best time to quantify (and limit) what will be on that list of fundamental representations is likely during the negotiation of the letter of intent.
Claims by the buyer for indemnification are often subject to a “basket,” which provides that an indemnifying party does not have an obligation to indemnify until the amount of the indemnified party’s losses exceed a certain agreed amount. Many letters of intent say there will be a basket and the amount of the basket (for example, a specified sum or a percentage of the purchase price). But a buyer typically prefers that nothing else be said on this topic. Once again, the buyer wants the LOI signed, and it wants to preserve its negotiating flexibility.
Here is where a seller often leaves real money on the table. Although these baskets go by several different names (including “tipping,” “pour-over” and “dollar one” baskets), a buyer prefers a basket that functions like this: Assume a basket of $500,000. At $480,000 of claims, the buyer receives nothing. But if the buyer gets to $500,000 in claims, then it is indemnified for the entire $500,000. Thus, the buyer’s asserting $20,000 of additional claims becomes a $500,000 benefit. On the other hand, a seller will want a basket that functions like a true deductible – $499,999 of buyer claims yields the buyer no recovery, while $500,000 of claims yields the buyer $1.00.
That’s quite a difference.
For a seller, the letter of intent often provides the point of maximum negotiating leverage to insert a few phrases or sentences that can make a material difference in the overall transaction. Experienced professional advisers have a highly useful role to perform, and a wise seller will take full advantage of this important opportunity to maximize its strategic transaction position and thereby put more dollars in its pocket.