Letters of Intent: Getting on the Same Page
In the world of mergers and acquisitions, a letter of intent may be considered the equivalent of an old-fashioned courtship. Two companies are interested in a relationship (whether buying, selling or merging). They have exchanged the initial pleasantries and learned the other is interested. It appears to be a good match. What now?
Just as a new couple typically does not want to rush into marital vows before learning more about their potential mate, companies that are contemplating a merger or acquisition want to find out more before they take the plunge. After all, aside from wanting to avoid a poor match, making things official costs money. No one wants to make a large investment just to call things off before (or on) the big day.
In the M&A context, a letter of intent is designed to provide an outline of the essential terms under which two (or more) parties are willing to proceed with negotiating a definitive agreement, such as a merger agreement, purchase agreement, etc. Letters of intent generally are not binding contracts (though they may include a few binding provisions). The goal is not to obligate the other party to specific terms, but instead to ensure both parties have the same understanding of the most important terms of the proposed transaction, i.e., the deal breakers, and to assist the parties with negotiating the details.
Common Letter of Intent Terms
Pricing – First and foremost, letters of intent will typically discuss pricing. In cash deals, this may mean identifying the specific dollar amount to be paid or a formula that will be used to come up with that dollar amount. In stock transactions, the consideration may be an exchange rate indicating how many shares of the acquirer’s stock that the target’s shareholders will receive for each share of the target they currently hold. These formulas and exchange rates may include both cash and stock and can get complicated, so a letter of intent is useful to ensure there is a meeting of the minds.
Exclusivity – Another important term to consider is whether the seller/target will agree to work exclusively with the buyer/acquirer toward a formal agreement, or whether the seller is free to continue to shop around. In a perfect world for a seller, it can engage several suitors and create a bidding war, whereas the buyer, of course, wants exclusivity for a time so as not to have to compete with other bids.
Binding Terms – The exclusivity or nonexclusivity provision of a letter of intent is one of the few terms to which the parties agree to be contractually bound. Similarly, other terms that govern the parties’ actions prior to the execution of a definitive agreement may also be binding. For example, the letter of intent is likely to bind the parties with respect to confidentiality requirements, as well as the responsibility each party must bear for negotiation expenses. In some cases, letters of intent also include a binding provision that grants the buyer, under specified conditions, the right to perform due diligence on the operations of the seller, and obligates the seller to make the company’s premises, employees, and books and records available to the buyer.
Timing – Sometimes, one or both parties have specific dates by which they want definitive agreements signed and the transaction to close. Other times, the parties generally agree to move forward and leave timing open to later discussion. While timing provisions are typically not made binding, they can be effective in setting each party’s expectations and prompting the parties to work diligently toward transaction milestones.
Regulatory Issues – Timing is of specific interest in regulated industries such as banking because the regulatory approval process prevents parties from agreeing to sign definitive agreements and close on the transaction on the same date. Instead, after signing definitive agreements, but before closing on the transaction, banking organizations must obtain regulatory approval from their primary federal regulators and, for state-chartered banks, state regulators. Generally, the definitive agreements will provide for the acquiring party (and, if necessary, the selling party) to submit regulatory applications within a certain number of days after the definitive agreements are signed. Typically, bank regulators then have 30-60 calendar days (depending on the regulator and the structure of the transaction) to consider the applications. Only after all necessary regulatory approvals have been obtained may the transactions be completed.
In the banking industry, these unique timing issues and the need for various regulatory approvals are generally addressed in some form within letters of intent. Also, the letters of intent will often specify that any transaction is contingent upon receipt of all necessary regulatory approvals, as well as all required corporate approvals, such as those of the parties’ shareholders.
Other Essential Terms – Sometimes, the value of a potential transaction to a particular acquirer may be contingent upon the occurrence or nonoccurrence of certain events. For example, the acquirer may want to enter into a transaction with the target only if certain key employees of the target agree to stay on following closing. In other cases, the acquirer may be interested in the target only if it first divests itself of certain assets, such as substandard loans. In these cases, it can be beneficial to address these requirements in the letter of intent in order to avoid surprises.
Intent Not to Be Bound – In all cases, a letter of intent should expressly state that the parties do not intend to be bound by the terms of the document (except with respect to any binding provisions). Failure to include such a disclaimer could result in a court finding that the document is binding on the parties.
While most of a letter of intent tends to be nonbinding, parties generally take care in deciding what terms to include and how specific to be. The reason for such careful consideration is that these documents not only set the tone for future negotiations, but signing the document signifies the parties’ comfort level with its terms and raises expectations that those terms will not be significantly modified or abandoned.
During the course of negotiations, the parties may often refer to the letter of intent in negotiating agreement terms. If a party advocates for agreement terms that contradict terms included in the letter of intent, the other party will be quick to point out the discrepancy and may even question the deviating party’s motives, intentions or ethics. In short, acting contrary to the terms of a letter of intent may not land a party in court, but it can jeopardize a deal or at least strain negotiations.
Of course, a letter of intent is not the only way to pave the road to negotiations. For instance, the parties may opt to prepare a term sheet, which similarly sets forth the principal deal terms but does not include any binding terms and is not in letter form. The parties may or may not sign the term sheet, but similar to a letter of intent, it will serve as the basis for formal negotiations toward a definitive agreement. Whether signed or unsigned, term sheets should also include language stating that the parties do not intend to be bound by the document.
Whatever form it takes, having a written understanding of the principal terms of a potential transaction before proceeding with detailed negotiations can help the parties avoid spending time and money dealing with misunderstandings.
When contemplating an M&A transaction, the parties can establish a clear picture of their goals and expectations by negotiating a letter of intent. This will give the parties comfort that they have found the right partner and can move toward a more permanent relationship.