The role of an LOI in an M&A process

An "LOI" or a Letter of Intent is an important milestone in a deal - representing a high-level meeting of the minds between the buyer and seller regarding what the deal will become.

A great analogy I've heard for this process is that it's like dating before deciding to get married - it's a non-binding agreement that sets out some important parameters and an agreement that both sides will work in good faith to determine whether to close the deal.

Here are a few things to know about an LOI during an M&A process.

What does the LOI cover?

The LOI includes details about the acquisition 'perimeter' (what's getting sold), the purchase price, the deal structure, and the key terms of what will eventually be drafted into the purchase agreement.

Why is the LOI important?

After the LOI is signed, both the buyer and the seller will spend a lot of time, mindshare, and money on due diligence, drafting the deal documents, and negotiations until the deal closes.

So, even though the LOI is "non-binding" meaning that the seller or the buyer can usually walk away with no legal consequences, it's important to get the LOI right.

What happens before an LOI?

Broadly speaking, this is the phase when the vision for the deal gets created.

Prior to an LOI, both the buyer and seller would have spent a good deal of time getting to build a relationship.

The seller would have shared some preliminary information subject to a non-disclosure agreement (NDA), the buyer would have understood the seller's motivations for doing the deal and the seller would have understood what the buyer's vision is for the business.

The buyer should also have formed their internal view on the strategic rationale for the deal, assessed whether there is likely to be a good cultural and commercial fit, identified key deal risks and mitigations, and put together a financial model that values the business (subject to certain assumptions to be validated later).

The seller would have given access to the buyer to certain commercial information, provided the buyer a view into how the seller expects the business to perform on a "stand-alone" basis, and also given the buyer access to seller's management to ask questions.

What should be the spirit of an LOI?

This is very important to get right.

My perspective is that the LOI should address "all the elephants in the room" - cover things that are really important to both sides, as well as bring to the forefront any issues that could potentially kill the deal later on.

If the LOI is written to be too tight and "all-inclusive", it can become an onerous document that can take months to negotiate and kill the deal before it starts - generally because the seller starts doubting the buyer's ability and willingness to execute the rest of the deal smoothly.

If the LOI is written to be too loose and does not bring forth "potential deal killers", both sides will spend a lot of time and money going down rabbit holes in diligence and the purchase agreement but eventually end up backing out of the deal.

Finding the right balance between speed and thoroughness is critical in this phase.

An advisor who has seen multiple situations and can anticipate minefields before they come up is invaluable (both to a buyer and a seller).

Can we skip the LOI and go straight to a purchase agreement?

Yes, but that would be a big mistake.

If there is no "meeting of the minds" (which is what the LOI forces both sides to do), both sides can burn a lot of money, time and effort on a process but get stuck on minor issues while neglecting the truly important ones - and ultimately risk the deal itself.

What are the common clauses in an LOI?

While several of these clauses are often negotiated (with the help of an advisor and lawyers), this list is meant to provide a high-level overview.

Exclusivity: This locks up the seller from talking to other acquirers for a certain period of time while diligence is progressing so that the buyer gets the comfort that the seller is serious about doing the deal

Valuation: This will include the headline price but the devil is in the details - including how the valuation is structured (fixed amount or multiple of EBITDA) and consideration mix (how much of the purchase price is paid in cash at closing vs. earnouts or seller financing)

Financing contingency: Often, financial buyers (or strategic buyers who need to obtain financing) will add a clause about being able to line up the money before committing to close the deal

Due diligence: Buyers will often take all the time they can get to diligence the business so sellers should ensure that the LOI limits this period (typically 45-60 days)

Key management: An LOI will usually outline how the roles of key target's management will work in the acquired organization

Assumptions: An LOI will usually outline some assumptions about the business that the buyer expects to be valid - such as information accuracy, normal levels of working capital, business operating as usual at closing, and no material legal or regulatory issues

What happens after the LOI is signed?

This is when the buyer starts conducting in-depth due diligence on the target's business and speaking with the target's key management.

The seller is typically fielding buyer's diligence requests.

The buyer's lawyers also draft the purchase agreement and both sides start negotiating the agreement, with the intention to sign and close a binding deal

What help does the buyer need during the process?

Most serial acquirers (both private equity or strategic acquirers) have an in-house deal or corporate development team who have the experience of executing dozens of similar deals and can run the process quickly and efficiently. These buyers also have in-house legal teams who can negotiate the deal agreements.

However, buyers are sometimes challenged because they

• don't have the right in-house expertise (or lack the right team that can be both strategic and move at the pace that a deal demands)
• are too busy executing other deals
• or need to run a deal quickly and lack the horsepower to do so

In these cases, buyers hire advisors (to help with commercial or functional diligence), accountants (to conduct financial diligence), and external counsel (lawyers).

What help do sellers need during the process?

For most sellers selling the business is (hopefully) potentially life-changing money and they want to do everything right to ensure they're not leaving money on the table.

Sellers sometimes find the process challenging because

• they're too busy running the business to focus on a sale process
• don't know what to do to prepare for a sale process
• they don't have the experience to field buyer questions at the pace of the deal
• or are afraid of making expensive mistakes that can hurt them later on

Sellers can hire bankers or deal advisors (who can find the right buyers, help with "packaging the business right from a buyer's vantage point", negotiate the deal, or simply run the process keeping the seller's best interests in mind).

What is one key takeaway for the LOI stage?

• For a buyer: While drafting an LOI, think forward about the full process over the long term - due diligence, negotiation, integration, running the target's business for years to come and working with target's management. Investing the right resources and getting executive commitment to doing the deal is crucial.
• For a seller: Remember that once the LOI is signed, the power shifts to the buyer for 6-8 weeks (or longer) since the buyer usually has exclusivity during diligence. Have an advisor read over the LOI and make sure you (the seller) understand what comes ahead.

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