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.
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 options and 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
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.
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.
For common mistakes by sellers in acquisitions, see 22 Mistakes Made by Sellers in M&A Transactions.
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.
Binding vs. Non-Binding Terms of the Letter of Intent
The letter of intent will typically state that it is non-binding, except for certain designated provisions. Usually at this stage in the acquisition process, neither the buyer nor the seller are willing to be bound to conclude a transaction. Further, the letter of intent does not contain all the terms that should be agreed upon in an acquisition.
Nevertheless, certain provisions are typically designated as binding such as:
- Confidentiality - The letter of intent and its terms should be agreed to be confidential and typically subject to the non-disclosure agreement between the parties.
- Exclusivity - The scope and terms for exclusivity granted to the buyer.
- Expenses – Statement that the parties each bear their own expenses or, in some instances, whether one party (usually the buyer) will cover some of the other party’s expenses.
- Conduct of the Business – Buyers sometimes insist that sellers agree to operate the selling company’s business only in the ordinary course and refrain from certain material actions.
- Dispute Resolution - The parties sometimes agree that any disputes surrounding the letter of intent would be resolved exclusively by confidential binding arbitration.
The letter of intent should clearly state which portions are binding and which are not. Lack of clarity on this point might allow a court to enforce (or refuse to enforce) a provision contrary to the intent of the parties.
Exclusivity for the Buyer/No Shop
The buyer will typically insist on a binding exclusivity/no shop period where the seller and its officers, directors, representatives, advisors, employees, stockholders, and affiliates may not engage in any discussions or negotiations with, provide information to, or enter into agreements with any other prospective buyer. The seller is also precluded from “shopping” the buyer’s bid or the company. The exclusivity provision will also typically require the seller to immediately terminate any other sale discussions. The buyer will also ask that it be notified of any inquiry or offers from other potential buyers during the exclusivity period, and the terms thereof (including the identity of the third party).
The seller will want to keep the exclusivity period short (for example, 7-14 days) and the buyer will typically want longer (for example, 30-60 days). The seller should insist on a sentence that allows it to terminate the exclusivity period early if the buyer subsequently proposes a lower price or materially worse terms, or if the seller believes in good faith that the parties are not making sufficient progress on finalizing a deal or the buyer is not keeping up with the time table agreed to by the parties (discussed below). The buyer will, of course, resist giving the seller a basis to terminate exclusivity early since the buyer will begin spending substantial resources on conducting due diligence and preparing documentation. In many instances, the compromise will be an exclusivity period somewhat shorter than the buyer desires.
In rare instances, such as a possible merger of equals transaction, both parties will agree to exclusivity.
Price for the Acquisition
The price for the deal is obviously the key issue, but the letter of intent should make clear:
- Whether the price will be paid all cash up front.
- If stock is to be part or all of the consideration offered by the buyer, the terms of the stock (common or preferred), liquidation preferences, dividend rights, redemption rights, voting and board rights, restrictions on transferability (if any), and registration rights.
- If a promissory note is to be part of the buyer’s consideration, what the interest and principal payments will be, whether the promissory note will be secured or unsecured, whether the note will be guaranteed by a third party, what the key events of default will be, and the right to accelerate payment of the note upon a breach by the buyer.
- Whether the company will be “debt free and cash free” at the closing or whether the buyer will assume various indebtedness.
- Whether there will be a working capital adjustment and how working capital will be calculated. This is ultimately just an adjustment up or down to the purchase price. The buyer may argue that it should get the business with a “normalized working capital” and the seller will argue that if there is a working capital adjustment clause, the target working capital should be zero. This working capital mechanism, if not properly drafted, could result in a significant adjustment in the final purchase price to the detriment and surprise of the adversely affected party.
- If part of the consideration is an earnout, how the earnout will work, milestones to be met (such as revenues or EBITDA and over what period of time), what payments are to be made if milestones are met, what protections will be offered the seller to enhance the likelihood of the earnout being paid, information and inspection rights, etc. Earnouts tend be the source of frequent disputes and sometimes litigation. Precision in drafting these provisions and agreeing on suitable dispute resolution processes are essential.
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Timeline for the Acquisition
Sometimes it is useful to set forth in the letter of intent dates by which the parties expect various matters to be completed, such as:
- When the online data room (the virtual room where the seller’s key documents and contracts are housed) will be made available to buyer.
- When the first draft of the acquisition agreement and exhibits will be presented by one party and when first comments will be provided
- When due diligence is to be completed by the buyer
- The expected signing date of the acquisition agreement
- The expected closing date
Limitations of Liability/Indemnification
In private company acquisitions, the seller typically indemnifies the buyer for breaches of representations made in the acquisition contract. Indemnification effectively adjusts the purchase price downwards and therefore the terms of indemnification are almost always the subject of lengthy negotiations.
The seller (and its stockholders), well aware that their bargaining leverage will decline once the letter of intent is signed, frequently will insist that the letter of intent set forth limitations on the scope of this indemnification obligation. In contrast, buyers will typically resist, asserting that negotiation of the terms of indemnification should be deferred to the negotiation of the entire acquisition agreement, at which time the buyer will be much better informed about the seller’s business and liabilities. Although market practice today is to specify the size of an indemnification escrow and the extent to which it might be the sole source of recovery for buyer indemnification claims, it is sometimes difficult for sellers to obtain in the letter of intent additional limitations on its (or its stockholders’) indemnification obligations.
In some deals, the seller with leverage can take the position that the deal should be structured like a public company type deal—that there is no escrow and that representations, warranties, and covenants expire at the closing. An escrow in private company acquisitions is used to secure the seller’s indemnification by placing an agreed amount of the cash purchase price into an escrow. The seller will argue that if the buyer wants additional protections, it can do so through its own careful due diligence and by obtaining the protections afforded by M&A representation and warranties insurance.
Indemnification obligations may limited in a variety of ways, such as:
- The seller should prepare a full and thorough disclosure schedule laying out all required disclosures under the acquisition agreement to reduce the risk that the buyer will seek indemnification for breach of the seller’s representations and warranties.
- The seller should seek a short-term limited escrow (5%-10% of the purchase price for 9-12 months) to be the exclusive recourse for breach of the seller’s representations and warranties. Of course, buyers will seek larger escrows and longer time periods. Although it has become common for the parties to an acquisition to agree to allow the buyer to seek recovery beyond the escrow (or after it has been disbursed) for breaches of certain “fundamental representations,” in every negotiation the seller should carefully consider insisting that the buyer’s recourse for indemnification be limited to the escrow.
- The seller will want “fundamental representations” to only consist of those relating to due authorization, due organization, and enforceability of the acquisition agreement. However, some buyers will argue that representations around capitalization, tax matters, intellectual property matters, and fees owed to advisors also fall in the bucket of “fundamental representations.” Sellers strongly resist such a provision.
- The seller should make sure that survival periods for breaches of general representations and warranties are no longer than the term of the escrow, except with respect to “fundamental representations.”
- To the extent that indemnification may be required by the selling stockholders under the acquisition agreement, that indemnification should be “several” (i.e., pro rata) and not “joint and several” liability (which would make any single stockholder liable for all of the losses alleged by a buyer). In addition, the seller should insist that no indemnifying stockholder be liable for more than the amount of sale proceeds actually received by the indemnifying stockholder.
- Other limitations that are negotiated include the dollar threshold before indemnity is required, caps on the indemnity, exclusions or carve outs from the indemnity, limitations on what types of losses a buyer may recover, and the extent to which a buyer’s knowledge of an inaccuracy in the seller’s representations bars indemnification.
Representations and Warranties
The letter of intent will typically not include a detailed listing of the seller’s representations and warranties. But if the seller desires to have certain materiality or knowledge qualifiers for particular representations and warranties, it may be best to negotiate these in the letter of intent. For example, the seller may want to state that any representations and warranties concerning intellectual property infringement issues be limited by a knowledge qualifier.
To the extent there are any key employee issues for the seller or buyer, it may be prudent to address these in the letter of intent. Such issues could include:
- Whether the buyer will assume the seller’s unvested employee stock options (and whether that assumption is a deduction of the purchase price).
- The types of compensation and benefits to be made available to seller’s employees by buyer.
- The hiring of any key executives, the key terms of employment, and the extent to which the closing of the acquisition is conditioned upon such key employees entering into employment agreements with the buyer.
Conditions to Closing of the Acquisition
The seller will want to set forth key conditions to closing (and ideally will want the letter of intent to set forth the only conditions to closing). That way, the seller will have a better understanding of the likelihood of a closing.
The typical closing conditions that a seller will allow for the benefit of the buyer include:
- The truth and accuracy, in all material respects, of its representations and warranties in the acquisition agreement.
- The compliance by the seller of its covenants in the acquisition agreement, in all material respects.
- The obtaining of any necessary governmental consents (such as Hart-Scott-Rodino Antitrust approvals).
The buyer may also insist on the following closing conditions, among others:
- The obtaining of consents that may be required from third parties under key contracts, that may be triggered by the acquisition.
- Absence of any litigation seeking to enjoin the transaction or any litigation material to the seller.
- The execution of employment agreements with key executives of seller.
- The execution of non-compete and non-solicitation agreements by the stockholders (venture capital and institutional investors almost never agree to these).
- No material adverse change in the business of seller between signing of the acquisition agreement and closing (the seller will insist on various exclusions to this condition).
- The obtaining of financing (sellers will strongly resist this as a closing condition, arguing it introduces too much uncertainty and is outside of the seller’s control).
- Delivery of audited financial statements of the seller to enable the buyer, if the buyer is a public company, to comply with its securities law reporting obligations.
- Delivery by the seller of the consent to the acquisition by the holders of a very high percentage of the seller’s outstanding equity and delivery by such stockholders of support agreements waiving dissenters’ rights, agreeing to keep company and transaction related information confidential, and agreeing not to sell their stock except to the buyer.
It is desirable for the letter of intent to set forth how and where resolution of disputes will happen, both under the letter of intent and under the acquisition agreement.
My preference is for a confidential binding arbitration/provision, under the JAMS commercial arbitration rules in existence at the commencement of the arbitration, before one arbitrator chosen by JAMS. In deals involving international parties, international arbitration firms (such as the International Chamber of Commerce) should be considered for this purpose.
Such an arbitration provision allows for faster and more cost-effective resolution of disputes than litigation. Litigation can be extremely costly and last for many years during any appeal process.
Among the issues to be considered with respect to an arbitration provision are the number of arbitrators, the location of the arbitration, the scope of discovery, the time period for resolution, and who will bear the fees and expenses of the arbitrator. I also typically prefer a provision that states that each party will pay its own legal fees and costs, and 50% of the arbitrator’s fees.
A well-drafted letter of intent can increase the likelihood of an acquisition successfully closing, on optimal terms. To see some sample letters of intent, check out the Forms and Agreements section of AllBusiness.com.
See all of Richard D. Harroch’s articles on AllBusiness.com.
Copyright © Richard D. Harroch
About Richard Harroch
Richard Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on investing in Internet and Digital Media companies. He is the author of several books on startups and entrepreneurship. He was also the founder of several Internet companies. He is the co-author of Poker for Dummies and a Wall Street Journal bestselling book on small businesses. He was also a corporate partner at the law firm of Orrick, Herrington & Sutcliffe, with experience in startups, mergers and acquisitions, strategic alliances, and venture capital.