A Look at the Letter of Intent

1. Introduction

In the dynamic world of business, where transactions can range from simple agreements to complex mergers and acquisitions, the need for clear, structured communication between parties is of the essence. One of the key instruments facilitating such clarity is the Letter of Intent (“LOI”). Though often perceived as a non-binding preliminary step, an LOI plays a vital role in setting the stage for successful negotiations and eventual agreements.

The importance of a LOI cannot be overstated. It provides a framework that helps to clarify the intentions of the parties, mitigate risks, and demonstrate a serious commitment to the transaction but it can also be used for negotiation tactics. Content, structure and enforceability of a LOI often differ across jurisdictions. Drafting an effective LOI therefore requires careful consideration of several key elements. The purpose and scope of the LOI must be clearly defined, specifying the parties involved, the nature of the transaction, the key terms and conditions. It is also essential to distinguish between binding and non-binding provisions, ensuring that both parties understand which aspects of the LOI carry legal weight.

This article aims to explain the fundamentals of a LOI, its significance in a transaction, and the potential consequences of its mishandling. It should be noted that specific rules regulate LOIs in public procurement processes. 

2. The Purpose of the LOI

A LOI is essentially a document that outlines the preliminary understanding and intentions of the parties involved before they enter into a binding contract. It serves as a roadmap, guiding the parties through the intricate process of negotiation and helping to ensure that both sides are aligned on the fundamental aspects of the proposed transaction. While it is not a legally binding document in its entirety, certain provisions within an LOI, such as confidentiality and exclusivity clauses, can carry legal weight.

A LOI is often drafted and agreed upon in the early stages of the transaction, often before a due diligence has been carried out. A LOI provides the parties with an opportunity to agree on, for example, estimated purchase price, purchase price mechanism, commercial terms, exclusivity, negotiation period and so forth. Even if a proper drafted LOI includes understandings between the parties that are not intended to be binding between them, stating certain terms and targets often make the parties feel more at ease in going forward with the process, thus increasing the chances of a successful deal.

Since the LOI is used to clarify the intentions of each party, it ensures that both sides are aligned on the key terms and conditions of the prospective deal. As such, the LOI is a tool to help avoid misunderstandings and foster a cooperative negotiation process. Furthermore, by outlining the basic terms and conditions, it provides a framework for detailed negotiations, serving as a reference point to guide the parties through the transaction. While an LOI helps create a stable negotiation phase, it will also act as a risk mitigation tool by identifying potential deal-breakers early on in the negotiation process. By addressing these issues promptly, the parties can determine whether they remain deal-breakers after appropriate actions have been taken. This approach helps to avoid investing time and resources in a transaction that may ultimately fail.

3. Key Components of an LOI

While the specific content of an LOI varies depending on the transaction, several key components are typically included:

Introduction and Purpose: The LOI usually begins with an introduction that outlines the purpose of the document and identifies the parties involved in the transaction. This section sets the context for the agreement and provides a brief overview of the intended transaction.

Transaction Structure: This section details the proposed structure of the transaction, whether it is a share purchase, asset purchase, merger, or another form of acquisition. It may also specify whether the transaction will be paid in cash, shares, or a combination of both. The structure of the transaction can have significant tax and legal implications, so it is crucial to outline this early on.

Purchase Price and Consideration: The LOI outlines the proposed purchase price and the form of consideration. This section may also include information on any earn-outs, escrows, or other contingent payments. Earn-outs are additional payments contingent on the target company achieving certain performance milestones post-closing, while escrows are funds held back to cover potential indemnity claims.

Due Diligence: This section specifies the scope and timeline for due diligence, including the areas to be investigated and the responsibilities of each party. Due diligence typically covers financial, legal and tax due diligence but may also e.g., include IT, HR and ESG. The LOI may also outline the process for addressing any issues uncovered during due diligence.

Conditions to Closing: The LOI may outline certain conditions that must be met before the transaction can close, such as regulatory approvals, financing, or the absence of material adverse changes. A LOI often include requirements that such conditions shall be included in a final SPA. These conditions outlines important aspects for each party at an early stage to increase deal certainty.

Exclusivity: If applicable, the LOI may include an exclusivity clause, preventing the seller from soliciting or negotiating with other potential buyers for a specified period. This exclusivity period allows the buyer to focus on due diligence and final negotiations without the risk of competing offers. Penalty clauses are often connected to the exclusivity clause for deterrent purposes. 

Confidentiality: A confidentiality clause ensures that any information exchanged during negotiations remains confidential and is not disclosed to third parties. This is critical for protecting sensitive business information and maintaining the integrity of the negotiation process. In most transactions a non-disclosure agreement has already been entered into between the parties (please see our previous article about NDAs for further information), and the confidentiality clause therefore links to such agreement to avoid duplication or conflicting terms. 

Non-Binding Nature: Most LOIs include a statement that the document is non-binding, except for certain provisions such as confidentiality, exclusivity and agreed penalty clauses. This allows both parties to walk away from the deal if they cannot agree on final terms. 

Termination: The LOI may specify the conditions under which the document can be terminated, such as the expiration of the exclusivity period or the failure to reach a definitive agreement within a certain timeframe. The parties´ liabilities or no liabilities shall also be clarified in case the LOI is terminated. This provides a clear exit strategy if the negotiations do not progress as expected. 

4. What if it Goes Wrong?

Since the LOI is generally intended to serve more as a framework to guide the parties rather than a binding agreement, there are risks involved when drafting and entering into the agreement. One risk is that the document in its entirety may inadvertently become binding, which is rarely the intention of the parties involved. It is of the utmost importance that the LOI explicitly stipulates that a binding agreement between the parties shall not arise until the parties have concluded a final agreement. If this is not clearly stated, the principles of offer and acceptance may otherwise lead to a contract being deemed to have arisen at a very early stage. The binding parts of the LOI shall therefore be stated as exceptions to this main principle and not the other way around. 

Another issue which may arise is the misinterpretation of the intent detailed in the document. Should the language used in the LOI be ambiguous or unclear, it may lead to different interpretations, causing confusion and disputes. Hence, the language included in the document must be chosen carefully in order to mitigate the risk of unnecessary misunderstandings and a stalled negotiation process.

In order to mitigate the risk that a prospective buyer uses the exclusivity period to reduce interest from other potential buyers, it should be considered to minimize the exclusivity period and consider including a penalty clause for any extension request by the buyer. From a buyer perspective it shall be carefully assessed if the suggested exclusivity time is reasonable or perhaps used by the seller to hasten the negotiation process. Finally, since the LOI outlines the obligations of each party, it fosters trust between them. Though not a fully legally binding contract, a LOI may create a morally binding agreement, making it difficult to retract commitments. Therefore, it is imperative to thoroughly consider the content before signing.

5. Summary

As concluded in this article, we recommend all parties entering into negotiations to consider the benefits of a LOI for the overall transaction process. While it sets the stage for detailed negotiations, it also helps mitigate risks by clarifying intentions and identifying potential deal-breakers early in the process. However, due to the potential for misinterpretation and the moral obligations it may create, it is crucial to approach the drafting of an LOI with diligence and precision. By ensuring that the terms are clear, the language is unambiguous, and the intentions are aligned, parties can foster a trusting and cooperative negotiation environment. It also increases deal certainty if addressing crucial matters early in a negotiation process which results in lower advisory costs. In conclusion, investing some time and effort into drafting a thorough LOI can save considerable time and money in a transaction process.

Authors: Maria Lilliestierna, Martin Tenselius and Ludwig
Engström