by Chris Way

Opportunity lies before you. After months of searching, shmoozing, networking, and planning, you have found a business enterprise worth taking over. Maybe it offers a new line of business for your company. Maybe it expands your team and customer base opening up new expertise, more people power, and more cross selling opportunities. Maybe it’s a perfect passive investment. And maybe it’s the thing you’ve been waiting for that allows you to leave your 9 to 5, and finally explore your business ideas.

Your reasons are your own. But the opportunity awaits. An important question lies ahead; now that you’ve found this opportunity, what comes next?

Meet the Letter of Intent

A letter of intent (also known as an LOI or Term Sheet) lays out a proposed deal’s structure in a single written document. This provides everyone a singular reference point and summation of all the negotiations. Rather than digging through weeks or months of emails,  everyone can see what the sides are proposing, and is able to clearly evaluate if this is worth their time in moving forward. A letter of intent saves everyone from a true nightmare scenario. Imagine spending months pouring over financial statements, contracts, and employment records, participating in meeting after meeting, and reading and revising a few drafts of a purchase agreement, only to find out after all of that, that you and your counterparty actually don’t agree on some pretty important terms. The term sheet saves both sides time and expense by giving you a summary of the major pieces of your deal, allowing you to collectively decide to move forward, before you get to the finer points.

Even though they are preliminary documents, and generally non-binding (see below), they are fiercely negotiated. This makes sense. Once something is offered it can be difficult to pull back from it later in the deal process. A letter of intent sets important anchoring points for the final agreement that can be hard to pull back from without good reason.

What Do I Include in a Letter of Intent?

A great LOI should focus on key terms, the key terms being whatever is most important to you. That being said, I find four topics to be the most important for a great LOI.

One, who pays what to whom in exchange for what. Businesspeople often think of these terms as the whole deal. It’s like what you think of if you think you have a “simple” contract. I have cash, you have a business, I will give you said cash in exchange for said business. Simple. Not quite. A Term Sheet needs to hit a few more things.

Two, the basic ground rules of the transaction. These are things like estimated timelines, closing conditions, and basic assumptions about shared facts that make this a reasonable deal to proceed with for both sides. Here we want to establish a set of shared expectations about how we will work together to close this deal.

Three, we cover the deal breakers. These are things are so important to us, and potentially to the other side, that we wouldn’t want to surprise someone with them. These are things that could be major sticking points. Because each side may feel strongly about them, it’s better if we talk about them now rather than save them for further down in the negotiating process when we’ve spent more time and money.

Finally, we handle terms that protect the negotiating process. These are things like confidentiality agreements, exclusivity, and agreements preventing big changes to the business during the purchase negotiations.

Binding Letters of Intent

Because a letter of intent is simply a tool of negotiations, it generally does not create any binding obligation. Courts have recognized that participation in negotiations does not create a binding agreement even if the parties agree to all the terms proposed. There must be intent to create a contract and be bound, rather than the parties merely agreeing that a given set of negotiated terms and provisions is the most attractive structure of a deal. There may be several letters involved in the course of contract negotiations, and the last letter in time may not be perfectly reflected in the final agreement.

So how then do letters of intent become binding?

1. The parties expressly intend the letter to be binding. OK, if you know what you’re getting yourself into and mean to do this.
2. The parties implied it was binding. Oops.

Keeping Letters of Intent Non-Binding

Generally, a binding letter of intent arises when the document contains clear, complete, and unambiguous terms on the issues covered in the document.

The most common species of binding letter of intent is probably, The Fully Binding Preliminary Agreement. This results when the parties have agreed on every issue that could be negotiated including the intent to be bound. These letters of intent are considered complete contracts and are preliminary only in the sense that the parties intend to write a more elaborate final contract in the future. Courts treat this second stage as merely desirable to the parties, instead of necessary. A good way to think about these letters/term sheets is that they are similar to oral contracts. The lack of a formalized agreement does not mean that an agreement was not reached.

The second unintentionally binding letter, The Binding Preliminary Commitment, results when instead of reaching a final agreement (as in the previous type of binding LOI) the parties make certain commitments to negotiate in good faith. This can generally mean that a party has promised not to renounce or walk away from the proposed contract, abandon the negotiations or demand conditions that vary from the letter of intent. Here the implication arises that the parties have entered into a complete and binding agreement. This can be difficult to extract yourself from.

There are two simple steps you can follow to keep yourself from implying either through text in your letter or the actions following your letter that the letter of intent or term sheet is binding.

Step 1- Words

Do NOT state or imply the letter is binding anywhere in the text of the letter, and Do NOT state or imply that there is any commitment to negotiate in good faith. Avoid using terms like “the parties agree”, “[Party 1] offers”, “[Party 1] promises”, “[Party 2] accepts” and never ever say anything like “[Party 1] and [Party 2], intending to be legally bound, hereby agree as follows….”. The more complete the letter’s terms are the more careful you should be NOT to use in words or actions that imply a binding agreement. You SHOULD include in the letter clear language that each party has the right to terminate negotiations in its sole discretion.

Step 2- Action

Do NOT perform any act included as a term in the letter of intent. Complete or partial performance of the letter’s terms is a significant factor showing that the parties intended the letter to be a binding contract. You should also stop your opposing party from any performance that you become aware of.

DO treat the letter of intent as though it is not binding. Include within the letter a clear expression that the letter is non-binding and that negotiations may be terminated at either party’s discretion when you create the letter. Don’t tell the other party that they will be breaching if they don’t do something. Remind everyone that the letter is not binding by referencing its non-binding nature in your communications with the opposing side, particularly email since it’s written.

Is a Binding Letter of Intent Ever a Good Idea?

My personal preference is to avoid binding letters of intent. At such an early stage of negotiations, there are simply too many things you don’t know to commit to a transaction. Remember, a business purchase (or sale) generally follows a specific sequence:

1. The parties find each other;
2. They have some preliminary planning and discussions to see if they’re a good fit for each other;
3. They enter an LOI;
4. They engage in due diligence; and finally
5. They enter a final purchase agreement with closing to follow.

At the LOI stage all that you know about the business is what you’ve learned in Stage 2. At that point, you simply won’t have received enough information or have been able to properly test it for accuracy or completeness to know that this is the deal you want to be bound to.

That being said, there can be situations where you feel a binding letter of intent is the best move. For example, you may have determined that there is some factor at play that makes this deal worthwhile regardless of what the due diligence reveals. That is a question of your risk tolerance and a series of financial and business measures that are beyond this article. However, if you find yourself in a situation where you want a binding LOI, just remember this.

There’s no such thing as a binding letter of intent; you’re entering a contract. Treat it that way. Make sure the key terms are structured to serve your interests as written, because though you may be able to add additional terms in a later agreement, you will have already agreed to what is in your letter.

Buying or selling a business is an incredible opportunity. While the goal might seem simple, to acquire a business enterprise in the best possible terms, the path to reach that goal is anything but. Don’t go it alone. When you have the opportunity to buy (or sell) a business, the team at Way Law is ready to help!