We have presented several webcasts in the past few months and in all of them there have been questions about the use and value of a Letter of Intent (LOI) — in our process this is typically a non-binding agreement that signifies agreement in principle on the core deal points and agreement to negotiate in earnest on all remaining items. Some brokers advise to skip the LOI and go straight to the purchase agreement and an LOI is not typically used in the market at large. So, why do we advocate the use of an LOI when purchasing a business?
In our experience, an LOI is a critical component in structuring a win-win transaction. We use them on virtually every deal. Here are the main benefits we see:
- More efficient use of time
- Proceeding with a clear understanding and agreement in principle
- Trigger point for taking the next steps
More efficient use of time: Some people feel an LOI puts the cart before the horse. We find exactly the opposite to be true. If you were to go to an unknown area, would you want a map of the area? Well that is exactly what the LOI is: a map of the major deal points. In today’s busy world, it is important to be sure two parties are going down the same road and in the same direction before spending too much time working out all the details of a transaction.
Proceeding with a clear understanding and agreement in principle: The key elements of the LOI should be negotiated beforehand and can be used as a guideline to prepare the purchase agreement. It should state that, if all information during due diligence confirms what was represented, that the buyer intends to complete the purchase under certain conditions. The key elements should include:
- All parties to the transaction
- Type of deal structure
- Payment structure
- Transition plan
- Closing date
- Contingencies (i.e. due diligence, financing, etc.)
- And identify other items to be negotiated.
Trigger point for taking next steps: In addition to setting the key elements of the deal, the LOI is also a trigger point for critical milestones during process. Those trigger points are:
- For the seller to remove the practice from the market and focus on the single buyer.
- For the buyer and seller to begin conducting their due diligence. With agreement in principle on the main terms the seller will have more comfort in opening the books and sharing client information and the buyer will have more comfort in providing financial information.
- For the buyer to pursue financing. The financing process takes times and banks require either an LOI or purchase agreement as part of the loan package. So an accepted LOI is a critical component to securing financing.
We have a saying in our firm that smooth transactions make successful transitions. Basically, if two parties cannot agree on the elements of the LOI, they will probably have a hard time negotiating while dealing with the minutiae of the purchase agreement. Normally, once the key points of the deal are negotiated up front, the rest of the transaction tends to work much more smoothly.