Term Sheets or Letters of Intent (LOIs) are commonly used in the buying or selling of businesses or other key contractual relationships.
The purpose of LOIs are to clearly state the principal terms that the parties have agreed to as part of the deal and represent the intent of the parties to pursue the contemplated transaction. Typically, LOIs are non-binding in terms of requiring the parties to close the deal and are commonly entered into at the beginning of the transaction prior to detailed due diligence and preparation of definitive purchase documents. The framework put into place with the LOI is then used to form the definitive purchase documents needed to close the deal.
Reasons to Use LOIs
- Identify early on (prior to expending transaction costs) what terms are mutually agreed upon and which key terms may be deal breakers;
- Focus negotiations on key terms;
- Increase commitment and deal stability;
- Outline binding obligations such as exclusivity for negotiations, payment of costs and confidentiality concerns;
- Obtain 3rd party approvals; and
- Enhance mutual understanding of deal terms for parties that have varying degrees of sophistication.
Reasons Not to Use LOIs
- The cost of negotiation and preparation of the LOI may be unnecessary or undesirable if the deal is easily understandable;
- Negotiation of the LOI can slow deal momentum;
- Improperly drafted LOIs may create unintended binding obligations to negotiate and close the deal.
- LOIs may inadvertently create a duty to negotiate in good faith which could eliminate the ability of a party to walk away if there is a change of mind.
- The LOI may weaken the negotiating position if the party later seeks to change the terms.
While LOIs are typically non-binding, there are commonly certain terms within the document that are binding on the parties. The binding provisions typically relate to the exclusivity of negotiations, confidentiality of information during due diligence and the allocation of costs and expenses incurred during transaction. To avoid unintended binding obligations, the parties should clearly state which sections are binding and which are non-binding.
Even if the LOI is non-binding, parties may be obligated to negotiate in good faith. The language in the LOI is important to clarify this issue. Accordingly, careful drafting is necessary to avoid unintentionally creating a duty of good faith negotiation when such may not be desired.
LOIs are common and generally accepted in acquisition deals, but there are a number of important issues to consider. LOIs serve a distinct purpose and deserve attention by the parties so that the purpose is achieved without the risk of the unintended circumstances discussed above.
