In the first of a two-part series, we dissect the Letter of Intent – the next step in the process to acquiring a business. For Part 2, click here or download the full guide using this link:
Congratulations – you have set up your Search Fund or secured funding and now you have identified a target business to acquire! What’s next?
As we continue to witness an increase in Entrepreneurship Through Acquisition (“ETA”) activity in the UK and European markets, and following on from our article on An introduction to Search Funds, this article looks to continue our Searcher-focused article series and discusses the next step in the process to acquiring your business – the Letter of Intent (“LOI”).
What is an LOI?
Also referred to as a “Term Sheet”, the LOI is a non-binding indicative offer that outlines the key commercial terms of a deal. It formalises the understanding between the buyer and the seller(s) and provides a basis from which the formal transaction documents can be negotiated.
Why is it important to get an LOI right?
If prepared correctly, an LOI can significantly increase the ease of negotiations and generally aid the acquisition process. Conversely, a badly drafted LOI can lead to protracted negotiations, higher advisor costs and a greater chance of a deal becoming delayed or even aborting. Additionally, the preparation and negotiation of the LOI itself can help to identify and address any potential dealbreakers for either party.
A good LOI should be based on a solid understanding of the business being acquired and an awareness of some of the issues that will need to be negotiated during the process. This can only be obtained by undertaking some initial due diligence on the target business and, ideally, having high-level discussions (at the very least) with the seller(s) and / or the target business’ management team.
A bad LOI, meanwhile, can entrench negotiations to the detriment of the deal. Agreeing terms from the offset can be beneficial if such agreement is based on a sound understanding. However, issues can crop up during due diligence that may require you to row back on certain terms that were deemed to be agreed in the LOI. Although not legally binding, doing so may cause tensions to fray and reduce your standing and trustworthiness in the eyes of the seller(s).
When should I enter into an LOI?
As stated above, you should seek to enter into in an LOI once you are comfortable that you wish to proceed with the acquisition of the target business. Although not legally binding, the LOI demonstrates that the parties are serious about entering into a formal agreement and represents the formalisation of such commitment.
Generally, LOIs will grant a buyer a right of exclusivity that enables them to proceed with more in-depth due diligence on the target business safe in the knowledge that they will not be wasting time and costs in the event that someone else comes in with an offer that is more attractive to the seller(s). Accordingly, the LOI should be entered into once you are ready to proceed with more rigorous due diligence following initial investigations into and discussions with the target business.
Is it legally binding?
In general, an LOI is not legally binding – it is more of an “agreement to agree”, and care should be taken to ensure that the LOI is not drafted so as to bind you to its terms. If you entered into an LOI that states a purchase price and you spot an issue in your due diligence that reduces the value of the business, a well drafted LOI will ensure that you are not prevented from negotiating with the seller(s) on price.
That said, certain terms within the LOI should be drafted so it is clear that they are legally binding. In particular, we would expect clauses relating to Confidentiality and Exclusivity to be legally binding. Each of these will be considered in further detail below.
How long/detailed should it be?
There is no hard and fast rule. In general, an LOI needs to have enough detail that provides clarity as to what has been commercially agreed. An LOI that is too detailed may prove to be too rigid and limit your negotiation power going forward. A nice middle ground setting out the key terms in reasonable detail is the best starting point from which the lawyers can prepare the transaction documents.
Think of it like planning a road trip: you don’t want to set off without plotting your route, but equally you don’t want to hamstring yourself by setting out a rigid itinerary that prevents you from taking an alternative route in the event of road closures.
Next time
In our next article, we will set out some of the key items that must be included in your LOI with some hints and tips to help you prepare that perfect LOI.
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