Detailed Letters of Intent (LOIs) Make Closings More Likely
Different Approaches to Letters of Intent
There are two basic approaches to LOIs. One is to prioritize speed and get an LOI executed as soon as possible. According to this school, only the outlines of the deal terms need to be included since everything will get sorted out later. This is more common among buyers who have already been spurned by sellers and can be part of a spray-and-pray type acquisition strategy of sending a large number of LOIs and hoping that one or more sellers accepts the offer. Once the deal is under exclusivity (and often only once the deal is under exclusivity), the buyer will conduct meaningful diligence and see if the target business is worth buying. Then the buyer hires an attorney to paper the transaction after rounds of trading and retrading with the seller.
The other approach is to add a lot of substance to the LOI, to the point that entire sentences and even paragraphs can be copied and pasted into the purchase agreement. This produces a slightly longer document, takes more work, and usually requires serious negotiation between the parties and sending multiple redlines back and forth. All of the critical deal points are addressed and since everything has been agreed to in principle, there is hardly any for either party to retrade at the eleventh hour. And if there does need to be a change to deal terms based on the findings in diligence, then there can be something to point to in the LOI itself as to why that change is necessary.
If you want to close, you should opt for a more detailed LOI.
Why You Should Prefer More Detail in Your LOI
Now we’re going to describe the reasons why it is worth the time and effort to hammer out a detailed LOI if you are serious about closing your transaction.
Is a Framework Agreement in Place?
The single most important reason why a detailed LOI is better is that a detailed LOI makes it more likely that buyer and seller actually have an agreement. This sounds basic, even trivial, but it isn’t. There are multiple examples of people bringing a signed LOI to us, us asking some basic questions about deal terms, and it being clear that there isn’t actually a deal in place. In any transaction there are two overarching things that must be negotiated, namely price and terms. Most people intuit the need to agree on the price and even the most basic LOI will state the purchase price. As more sophisticated parties know, however, it is the terms that make or break a deal. There can be a myriad of terms in a transaction, all of which can be of major importance: How much money is paid at closing? What contingencies are there for the payment of any deferred compensation? Is the seller going to remain with the business after closing? In solid LOIs, these big picture terms questions are addressed. When these questions aren’t addressed, there is a real possibility that both buyer and seller will later come to realize that they were never in agreement on a transaction and that both have only wasted time in working towards a deal that was never actually on the table.
Psychological Anchoring
As a legal matter, the only binding terms in most LOIs are the confidentiality and exclusivity provisions. As a practical matter, this is not true. People become attached to whatever is in the LOI no matter what disclaimers are placed on those terms. This is especially true when it comes to numbers. Any deviation between the terms in the LOI and the terms in the purchase agreement will require an explanation since people are “anchored” to what the LOI says. Such explanations can and do arise during the diligence process and there are steps that can be taken in the LOI itself to make those conversations easier, but people who are unprepared for this reality and rely solely on LOI terms being “non-binding” as the basis for retrading lose deals over their indiscretion.
Deal Momentum
Time kills deals. The longer the period between signing the LOI and signing the purchase agreement, the greater the likelihood that the transaction dies—the business falters while the seller is focused on the transaction, the buyer finds something else, the seller decides not to sell, etc. Having a more detailed LOI means reaching an agreement in principle on more issues earlier in the process. Since those items have already been addressed, diligence shifts to an exercise in confirming what was already agreed to instead of creating the basis for negotiation and only smaller details are left that need to be negotiated to reach the final version of the purchase agreement and reduces the number of landmines that must be navigated to consummate a transaction.
Reduced Legal Costs
This point is closely linked with maintaining deal momentum. The more detailed the LOI is, the less room there is for lawyers to insert things into the purchase agreement that can cause problems or even kill a deal entirely. If someone tries to introduce new terms, then the counterparty can look to the LOI, point to what was already agreed to, and asked what has changed that would warrant a deviation. This dynamic reduces the amount of back-and-forth between attorneys during purchase agreement negotiations and saves much more time and money than what is expended to create a detailed LOI, even with attorney help, in the first instance.
Special Seller Considerations
Sellers have the most leverage before they sign the LOI. Before signing an LOI, sellers can play potential buyers off of each other (within the limits of confidentiality), negotiate with multiple potential buyers simultaneously, and focus on the deal terms that matter most to them with each of those potential buyers. Upon signing an LOI, this ability goes away. The power of exclusivity is a real thing. Sellers should appreciate this dynamic and work to get detailed acquisition proposals from the different potential buyers before committing to any particular buyer. The more detailed the LOI, the fewer things can cause problems later in the deal process.
On a slight but related tangent, if a business goes back onto the market after having already been under LOI then every other potential buyer is going to ask why. Even if the transaction fell apart because the old buyer failed to secure financing, something entirely outside of the seller’s control, the seller will still have to explain what happened.
Special Buyer Considerations
After reading the previous section, buyers may be wary of sending a detailed LOI out of fear of ceding leverage to the seller. Any such fears are misplaced, though, as there are reasons why buyers should want to send more detailed LOIs also. In the case of any good business on the market, there are going to be multiple interested buyers. This means there is going to be competition between buyers to get the deal, and buyers can compete along several metrics. The most obvious is price, but also terms can be an important comparison. Sometimes, even above the importance of terms, is the seller’s confidence that a particular buyer knows what they are doing and will actually be able to close on the transaction. By sending a detailed LOI, buyers communicate that they have taken the time to evaluate the business and are serious about acquiring it. When there are multiple competitive offers, this can make all the difference.
Hire an Attorney Before Signing an LOI
There is a lot of conflicting information floating around the internet on the subject of when to involve an attorney in the process of buying or selling a business. Some say to delay hiring an attorney as long as possible. These people opine that there is no need to incur legal costs until you know a deal is going to happen, that lawyers will only slow things down, that lawyers aren’t real dealmakers anyway so there’s no value add. These voices are at best misguided. If you’re serious about closing on a transaction, you should have an experienced attorney early in the process. As a rule of thumb, drafting and negotiating the letter of intent (LOI) is the perfect time to bring in an attorney.
Why is this? First, when you hire an attorney that attorney represents you and only you. Your attorney even has fiduciary obligations to act in your best interests, something that is not always the case for other advisors. Second, the terms of the LOI are going to be the starting point for the terms in the purchase agreement. It’s worth having someone intimately familiar with purchase agreements review the LOI with you so that you understand what it really says.
Benefits of Working with Barlow & Williams
You’ll be hard-pressed to find any attorneys with more knowledge and experience in lower middle market transactions, particularly in our core focus of digital businesses (SaaS, Ecommerce, Content, and Agencies), but also in more traditional brick-and-mortar business. We guide our clients, both buyers and sellers, through the whole lifecycle of the transaction. We know which terms matter and which ones don’t; we know how to structure a transaction to minimize risks and maximize returns. This is what we do.
We also understand our clients’ concerns. The most common reason people wait to hire an attorney is the fear of broken deal costs. Our flat-fee pricing model meets this fear head-on. When you work with Barlow & Williams, you know your maximum legal cost from the outset. And if there is a broken deal (or even two) along the way to a successful transaction, you don’t pay us any additional amount.
If you are buying or selling a business, we will gladly guide you through the process to a successful transaction. Reach out to us at info@barlowwilliams.law and we will schedule a meeting to discuss your goals and how to achieve them.