A letter of intent (LOI) or term sheet tends to be the first substantive document for an M&A transaction. It outlines the key terms and mutual understanding between a buyer and seller while they progress through due diligence and work towards negotiating, preparing, and executing a definitive agreement. The key components of an LOI are generally the proposed purchase price, transaction structure, fundamental business points, timeline, and expenses. While generally non-binding, it’s common for parties to include certain binding provisions such as exclusivity and confidentiality.

Non-Binding LOIs

Non-binding LOIs in M&A transactions can present pitfalls. They lack enforceability, and either party can walk away at any time. This uncertainty may discourage serious commitment, result in a loss of deal momentum, and allow one party to use the LOI as leverage against other potential buyers or sellers. Without a standalone non-disclosure agreement, the absence of enforceable exclusivity or confidentiality clauses can also expose sensitive information to competitors or the public. Overall, while non-binding LOIs offer flexibility, they can create strategic and legal vulnerabilities.

Binding LOIs

Binding LOIs are legally binding in their entirety for both parties. Since LOIs are drafted during the early stages of a negotiation, binding LOIs may prove to be problematic down the road after due diligence reveals unanticipated risks and liabilities. Binding LOIs are often drafted broadly, and once executed, parties will be bound to all terms within it, no matter how unfavorable it may be for one of the parties. Conversely, if key terms are left vague or framed as agreements to agree, there is a risk that some terms may be deemed unenforceable due to lack of certainty.

In some cases, a party may request a deposit upon execution of a binding LOI. It is essential that the terms governing the deposit are clearly defined and fully understood by both sides. Without proper business and legal due diligence on the target company, sellers should be particularly cautious about agreeing to any binding LOI involving a deposit in the M&A context.

Hybrid LOIs

While LOIs are generally non-binding, parties often include certain binding provisions to provide greater confidence as they invest time and resources into due diligence, negotiations, and drafting the definitive agreement. These hybrid LOIs strike a balance between commitment and flexibility, offering both parties peace of mind during the negotiation process. Two of the most common binding provisions in hybrid LOIs are exclusivity clauses and confidentiality clauses.

Exclusivity

Exclusivity clauses ensure that both the buyer and seller agree to negotiate solely with each other for a defined period, usually long enough to finalize due diligence, confirm valuation, and agree on final terms. They help foster good faith negotiations and reduce the risk of parallel discussions with other parties, helping to maintain deal momentum.

Confidentiality

Confidentiality clauses protect sensitive information exchanged during the negotiation process. They prevent either party from disclosing proprietary or non-public information to third parties, which is especially important in competitive industries, such as the technology industry. These clauses help build trust and reduce the risk of reputational or strategic harm.

Other Beneficial Clauses in LOIs

In addition to exclusivity and confidentiality, certain other provisions can help structure an LOI by reducing legal costs and facilitating a more efficient negotiation process.

Indemnities

Indemnity clauses help allocate and limit risks, such as tax obligations or legal liabilities, between the parties early on in the process, which can streamline the drafting of the definitive agreement. For example, a seller may wish to fast-track negotiation by inserting indemnity provisions in the LOI, such as liability caps, baskets, and survival periods. Conversely, certain sellers, such as private equity, may insist that representations and warranties insurance be used as an alternative to standard indemnity provisions.

Valuation Range

Including the valuation range or multiple, such as EBITDA or adjusted EBITDA, can be highly beneficial in setting expectations early in the negotiation process. This valuation can then be validated during the legal and financial due diligence phase, helping to either confirm the proposed price or support adjustments.

Ancillary Agreements

LOIs will benefit from setting out expectations in terms of material agreements required on closing. Depending on whether a transaction is structured as a 100% buy-out, majority acquisition, leveraged buy-out, management buy-out, or other, parties will benefit from discussing these key terms early in the process. Including such agreements in the LOI helps ensure alignment on post-closing arrangements, particularly in transactions where existing management will remain involved.

Conclusion

The LOI plays a critical role in setting the tone and structure for a successful and efficient M&A transaction. Whether non-binding, binding, or hybrid, the LOI serves as a foundational document that outlines key deal terms and expectations. While non-binding LOIs offer flexibility, they can introduce uncertainty and risk if not carefully managed. Binding LOIs, on the other hand, may create unintended obligations if entered into prematurely. Hybrid LOIs strike a practical balance by incorporating select binding provisions, such as exclusivity and confidentiality, that protect both parties during the negotiation process. Ultimately, a well-crafted LOI can streamline negotiations, build trust, and lay the groundwork for a smooth path to closing.

For guidance on your next transaction, contact Cozen O’Connor’s M&A team to ensure your deal is structured for success.