In acquisitions of privately held companies, a letter of intent/term sheet is often entered into by both parties. The purpose of the letter of intent is to ensure there is a “meeting of the minds” on price and key terms before the parties expend significant resources and legal fees in pursuing an acquisition, and before sellers agree to grant exclusivity to buyers.
The purpose of this article is to explore the key issues in negotiating and drafting an acquisition letter of intent.
Step n°1 |
What Is Typically Included in a Letter of Intent?
A letter of intent can be short or long, depending on the dynamics of the negotiations and the desires of the parties. Here are the types of items that can be included in a letter of intent, a number of which are discussed in greater detail later in this article:
Price/Consideration—Will it be all cash, all or part stock, earnout, or promissory note?
Adjustments to the purchase price—Will it be a cash-free/debt-free deal? A working capital calculation and adjustment mechanism? Treatment of severance costs and transaction fees and expenses?
Transaction structure— Will it be an asset purchase, purchase of all outstanding shares, or a merger?
Expected timeline for due diligence and negotiating the deal
Any escrow to secure the seller’s indemnification obligations, how long the escrow will last, and for what items the escrow will be the buyer’s sole remedy for claims
Exclusivity for the prospective buyer—How long will exclusivity last? When can the seller terminate exclusivity early?
Access to the employees, books, and records of the seller for the benefit of the buyer as part of its due diligence process
Scope of key representations and warranties of the seller (will some key reps be subject to qualification by a “materiality” or “knowledge” standard?) and survival period
Whether any portion of the consideration received by key employees will be paid out over time post-closing for purposes of retaining these employees
How seller employee optionsand equity held by employees will be treated (will they be assumed by the buyer or terminated?) and whether these are in addition to the purchase price
Activities prohibited by the seller pending closing
Whether any third-party consents to seller’s key contracts will be required or sought, as a consequence of the acquisition
The confidentiality obligations of the parties concerning the transaction (and ideally a non-disclosure agreement will already be in place by the parties)
How seller’s employees will be hired/treated by the buyer
Continuing indemnification obligations of the buyer for seller’s officers, directors, employees, and stockholders, pursuant to any existing Indemnification
Agreements or charter provisions
Conditions to closing the transaction, both for buyer and seller
Whether any non-compete/non-solicit agreements will be required
Indemnification obligations by the selling stockholders and the limits and exclusions from such indemnification provisions
How and when the acquisition agreement can be terminated
How disputes will be handled and in what jurisdiction
Step n°2 |
Short-Form vs. Long-Form Letter of Intent
Long-form letters of intent are more comprehensive and legally constructed, and designed to reach a meeting of the minds on many of the key terms of a potential deal. The key advantages of a long-form letter of intent are:
Issues that can be deal breakers are identified early on and resolved, before spending significant legal fees and management resources for both the buyer and seller.
Resolution of significant issues early on can make the process of reaching a definitive acquisition agreement easier and more efficient, with resulting savings in time and legal fees.
If an important issue surfaces as insurmountable, for sellers it is better to learn that early, rather than learn about it when the seller is in exclusivity and a termination of discussions at that point could be more damaging or difficult for the seller.
The primary disadvantage of a long-form letter of intent is that it may bog down the momentum of getting a deal done, as the parties deal with too many difficult issues early on. It may also result in the breakdown of the negotiations that could have been avoided if certain issues had been deferred.
A short-form of letter of intent will usually only address the price and perhaps a few key terms (such as any escrow holdback for seller’s indemnification protection, length of escrow, and the exclusivity/no shop right for the buyer) and has the advantage of being quicker to negotiate than a long-form letter of intent. The obvious disadvantage is that it leaves many important issues to be resolved later on.
Step n°3 |
The Selling Company’s Perspective
From the perspective of the selling company, it will typically want the letter of intent to be as detailed as possible on the key issues of the deal. The reason is that once a letter of intent has been signed and an exclusivity negotiating period has been granted to a buyer, the leverage in the negotiations will swing to the buyer.
Therefore, the seller will often want to have a complete picture of the price and deal terms before it is locked up and precluded from talking to other potential buyers. And the more detailed the letter of intent, the more likely that a definitive acquisition agreement can be negotiated successfully. The best time to get key concessions from a buyer is when the buyer believes there are competing bidders and where it does not have exclusivity.
Step n°4 |
The Buyer’s Perspective
From the buyer’s perspective, especially where the buyer has considerable negotiating leverage, it will favor a short-form letter of intent which includes a long period of exclusivity in order for it to finish its due diligence and negotiate a definitive merger or acquisition agreement. The buyer typically will argue that it can’t agree to some of the key terms of the deal in the letter of intent until it completes its due diligence. (The seller will dispute that argument—the buyer can agree to key terms, but if problems arise in its due diligence, it is always free to renegotiate any provision.)
In some situations, it is in the buyer’s interest to also have a detailed letter of intent to avoid spending lots of management resources and legal fees on a deal that might not get consummated.
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