Legal Services for Startups & Savvy Businesses in Colorado

Letters of Intent – The Most Valuable Non-Binding Legal Agreement You’ll Ever Sign

Letter of Intent

To the untrained eye, letters of intent may seem like the least important part of a business agreement. After all, they’re usually non-binding. And many people equate non-binding with inconsequential.

But nothing could be further from the truth. In a deal where the parties sign a letter of intent, letters of intent are where nearly all of the critical negotiations take place. And thus it could be argued that it’s the most important part of the negotiation. Yet many buyers and sellers whip together a hasty and ill-conceived letter of intent, thinking that their lawyers can always go through and get things right later.

If you’re a venture capitalist who has done a thousand deals, you probably know what you need to put on the back of a napkin to protect your interests. If this is one of your first few rodeos, this approach might end up with you getting mauled by a large animal.

For those unfamiliar with the typical steps of a business acquisition, this is how things usually play out: One business (a buyer) is looking to acquire another (a seller). The buyer puts out feelers to see if the seller is interested. If the potential seller is interested in exploring a sale, the seller will begin negotiations with the initial buyer, work with an M&A broker to explore other buyers, or work on their own to see what price the market will bear.

However the seller proceeds, when things start to get serious, the potential buyer and the potential seller start to negotiate the key terms of the transaction. Usually, the parties do this with a non-binding legal document called a “letter of intent” or a “term sheet.”

The idea behind a letter of intent (aka, LOI) is simple: absent surprises in due diligence or unexpected and unforeseen circumstances, these will be the high-level terms of the deal. When the parties sign the LOI, unless someone was confused or misinformed about something, the structure of the deal is done. The LOI and the closing are for due diligence, fleshing out nuances, and ironing out legal details. It’s not a time for renegotiating key terms without justification.

To be clear, the LOI almost always locks in what’s being sold, for how much, and how and when the payment is due (for instance, is it all cash by a certain date, or a promissory note payable at a specific interest rate over a longer period of time).

This means that the LOI is not just a placeholder document. It’s the deal. Unless something happens in the due diligence phase that changes negotiation dynamics, you’re likely stuck with what you have in the LOI. It doesn’t matter if the LOI is on the back of a napkin or formal legal letterhead. Most strong negotiators will refuse to negotiate any term that’s already been agreed to in an LOI.

What’s more, the whole “non-binding” thing isn’t as cut-and-dried as it sounds. While the concept of a letter of intent may seem risk free, it isn’t. Every legal contract in Colorado and in most other states include what’s called an “implied duty of good faith.” Even if you sign a letter of intent that may appear on the surface to be non-binding, unless the letter of intent expressly disclaims the duty of good faith, you have to proceed in the negotiations, you guessed it, in good faith. That implies that unless the other side does not live up to its side of the bargain, you could be in big trouble if you just change your mind because you’re having second thoughts.

One major reason parties bother with the letter of intent is to nail down key terms and to formalize the seriousness of their intent. After the signing of an LOI, each party typically incurs significant legal, accounting, and other expenses during the due diligence phase. This is a time-consuming and potentially disruptive process for any business. If one party gets cold feet and backs out for no good reason, even with a non-binding LOI, the other party may have a claim against them for breach of the duty of good faith.

This is why it is critical to make sure that the LOI is drafted in such a way as to reflect the level of seriousness of the parties.

Subtle distinctions matter in an LOI. This is particularly true for a novice seller or buyer, who lacks the experience from dozens of sales/acquisitions to know what to look for, what is legally important, and what could go wrong otherwise. Slight language tweaks, in terms of how the deal is structured, in terms of who pays what costs, and in terms of which laws will apply, can make an enormous difference. Even if the top-line dollar amount of the deal doesn’t change, cumulatively, the classification and structure of the deal can shift who gets paid what by 50% or more. Depending on how liabilities are treated and who is responsible for dealing with them after the transaction, sometimes a subtle language change can shift liabilities that exceed the value of the transaction itself.

And that’s why you shouldn’t be fooled by the notion that an LOI is just a non-binding legal document. Given the brevity of a typical letter of intent, compared to how much depends on it, word-for-word, an LOI may be the most valuable legal document you’ll ever sign.

Tags: , ,

Leave a Comment

Leave a Reply

Your email address will not be published.




Top