Do I Need a Letter of Intent?
Most of the deals I close do not use a Letter of Intent (LOI), Term Sheet, or Summary of Terms (different terms for legal documents that have the same purposes). Technically, the law does not require you to use an LOI, but here are some things to consider when determining whether to do so:
Do you want to take the business off the market? If you are the buyer, you want the seller to stop shopping its business and take it off the market, at least for a period of time, to protect you from losing the deal or getting into a bidding war with other potential buyers. Sometimes this provision in the LOI is called a "No Shop," "Exclusivity," or "Non-Negotiation" provision. This type of provision is one of the few provisions in an LOI that should be binding on the parties.
Do you want time to conduct due diligence before you sign a purchase agreement? The LOI should set up a period of time (e.g., 30 to 90 days) during which the business will stay off the market and allow the buyer to conduct detailed due diligence.
Do you need confidentiality protection? If the buyer and seller don't already have a separate, signed confidentiality agreement, the LOI should contain a provision that requires the buyer to protect the confidentiality of the seller's information disclosed during due diligence. This type of provision is also one of the few provisions in an LOI that should be binding on the parties.
Do you want to make sure the seller continues to operate its business in the normal course? There is a risk that a seller will wind down its business, whether intentionally or unintentionally, once it has found a potential buyer. For example, the seller might stop ordering inventory, stop pursuing prospective customers, and let employees go without replacing them, which would damage the value and future operations of the business. An LOI should contain a provision that requires the seller to continue to operate its business in the normal course. This type of provision is also one of the few provisions in an LOI that should be binding on the parties.
Do you want to negotiate any sticky terms and conditions before spending the time and energy to draft a purchase agreement? Negotiating key issues at the LOI stage of a transaction might help the seller and the buyer resolve those issues or terminate discussions before spending a lot of time and energy on the deal.
Do you want a roadmap for drafting the purchase agreement and other closing documents? An LOI will give the lawyers working on the purchase agreement and other closing documents an outline of the key terms and conditions of the transaction. The LOI can avoid additional negotiation when draft legal documents are inconsistent with the LOI because the parties can simply point the lawyers to the LOI.
Is a broker involved? My experience is that broker-lead deals tend to be more formal. I believe brokers encourage LOIs so that the buyer and seller feel that they have taken the first step to being legally bound to do the deal (even though most of the provisions of the LOI are non-binding).
How much is the proposed purchase price? I have observed that the lower the purchase price, the less likely the buyer and seller are to use an LOI. Parties in smaller deals tend to rely on the trust they have in each other, rather than spending the time, effort, and legal fees on negotiating and drafting an LOI. They just jump right to negotiating and drafting the purchase agreement.
Do you want to create the feeling that the parties are engaged? Most all the provisions in an LOI are non-binding. Nevertheless, I believe signing an LOI creates a psychological feeling that the parties are now obligated to move forward with the deal until the deal is terminated (e.g., because contingencies aren't met) or closing occurs.
Does the lender require an LOI? If the buyer is getting a loan to pay part of the purchase price, its lender might require an LOI as part of the underwriting process. The lender wants to have some comfort that the buyer has the exclusive right to buy the business before spending time, energy, and money on underwriting the loan. The LOI will also provide the lender with the basic terms of the deal, which the lender will need for underwriting.
Do the buyer and seller trust each other? A high degree of trust might be a good reason for not having an LOI (unless you want some of the benefits of the binding provisions of an LOI). A low degree of trust is probably a good reason for having an LOI.
You can contact me at firstname.lastname@example.org if you have any questions about LOIs or need help determining whether you should use one, and, if so, what it should contain.