What is a Letter of Intent (LOI)?
- Bryan Ducharme
- 30 minutes ago
- 7 min read
In a business sale process, the Letter of Intent (LOI) is a non-binding agreement that defines the high-level terms of an offer to acquire a company. LOIs are more detailed than the Indications of Interest (IOI) collected earlier in the sale process.
An effective LOI sets buyer and seller expectations for the drafting of additional, detailed legal documents that come later in the acquisition process. The LOI reduces the possibility of a negotiation impasse that could threaten the deal later, during due diligence. A Merger and Acquisition Advisor (M&A advisor) may solicit LOIs from several potential buyers simultaneously, to secure the most favorable overall terms for the seller, but only one LOI is ultimately accepted . The potential buyer whose LOI is accepted by the seller is only the preliminary winner of the bidding process, because a period of intensive due diligence and legal drafting follows. If problems surface during due diligence or if the buyer and seller can’t agree on legal details, the LOI may be terminated by either party.
Basic Letter of Intent (LOI) Terms
An effective Letter of Intent addresses all of these basic terms:
Stock Sale or Asset Sale?
The LOI identifies whether the buyer will be acquiring the assets of the company (an “asset sale”) or the stock of the company (a “stock sale”). This deal structure is fundamental to the tax treatment of the sale and the seller’s after-tax proceeds. As such, it heavily influences the legal drafting process.
Total Purchase Price and Currency.
The purchase price and currency are the most obvious terms described in an LOI. An LOI will include the buyer’s proposed compensation to the seller, which may include an amount of cash at closing and other forms of payment, and possibly contingent or post-closing considerations (e.g. seller’s notes, earnouts, rollover equity or stock swaps). These are typically defined at a high level. For example, if there is a seller’s note involved, then the dollar amount, term, amortization schedule, interest rates and security (e.g. collateral or personal guarantee) are stated.
Included and Excluded Assets and Liabilities.
The LOI provides guidance on which assets are being purchased and how certain liabilities may be treated. For example, the LOI may state that the offer is “Cash Free / Debt Free”, meaning that cash is retained by the seller and the seller is responsible for settling outstanding debts at or before the closing. Included assets may list plant, property & equipment, customer lists, and any intangibles. The seller may want to exclude specific assets such as a company car, personal furnishings, artwork, etc. To the extent that those assets were included in the company financials presented to potential buyers, now is the time to set expectations about what the seller plans to keep after the sale.
Working Capital.
Included assets may also encompass targeted Net Working Capital, often defined as an average of AR plus Inventory less trade AP over a specified period. A seller’s outcome can be greatly impacted by Net Working Capital amounts, and the treatment of these assets can vary greatly by industry. When purchased assets include Net Working Capital, it is important that the process for determining the targeted amount and true-up process are defined in a manner that allows them to be carried over to the Asset/Stock Purchase Agreement with little modification.
Exclusivity.
The reason an LOI is signed with only one potential buyer is that most buyers will insist on a period of exclusivity while they conduct due diligence. Buyers invest substantial time and money in the due diligence and legal drafting process, and they want assurance that the seller is no longer negotiating with other buyers.
Note that the overall Letter of Intent may be “non-binding”, but the exclusivity terms are often specifically made legally binding. Again, the buyer wants assurance that the company is off the market while they are investing heavily in due diligence.
Buyers often ask for 90 days or more of exclusivity, but sellers need to be careful. If the deal falls apart, the seller will want to quickly engage the other bidders. That can’t happen if the legally binding exclusivity period is still in effect. For example, if the LOI calls for a 90-day exclusivity period, but the buyer demands a purchase price reduction after 30 days of due diligence, the seller is in a difficult position. If the seller refuses to agree to a purchase price reduction, the deal may be effectively dead, but the buyer can prevent the seller’s team from negotiating with other possible buyers until the remaining exclusivity period has expired.
What happens to selling owners?
The LOI should outline what is expected from the selling owner(s), including how long they are expected to remain with the company after the close, and the compensation they will receive. The LOI should outline the terms of any non-compete or non-solicitation agreement that owners will be expected to sign at closing as well. These details are often overlooked in LOIs and they can create unnecessary conflict when they are introduced late in the process of drafting legal agreements.
What happens to employees?
The LOI should also outline the buyer’s intentions for the current staff. Ultimately, the buyer can do whatever they want with the staff after they buy the business, but sellers generally look for some commitment to retain the staff for a minimum period. For example, one of Venture 7 Advisors’ clients insisted that the buyer agree to maintain the headquarters operation in the existing location for at least two years. Defining this commitment in the LOI was just as important to the seller as the total purchase price.
Due diligence plan
The LOI includes an expected due diligence duration (typically 90 days) and an outline of the type of due diligence the buyer expects to undertake. In reality, due diligence often takes longer than expected and the buyer often expands the scope of due diligence, especially if a potential risk is uncovered in the process. The example LOI below represents a typical due diligence scope.
Advanced LOI Terms
The terms below are often left out of LOI negotiations for expedience, but that can lead to risky disagreements later in the process. The seller’s negotiating leverage is highest when several buyers are competing to win the deal, so working through these issues in the LOI is generally in the seller’s best interest.
Indemnification Limits
A definitive agreement to sell a business will include several pages of seller representations and warrantees which are basically promises that the seller makes to the buyer. They range from fundamental representations like “I own this business and I have the authority to sell it,” to “The company financials are accurate” and “The business is in compliance with all environmental laws”. The seller agrees to indemnify (protect) the buyer from liability should any of the representations and warrantees prove to be false.
The limits of the seller’s indemnification can vary widely. Some buyers expect sellers to provide unlimited indemnification. That means that the seller might actually have to pay the buyer more than the business purchase price if something big goes wrong after the sale. For example, if an expensive environmental violation is discovered or if a simmering employee issue turns into a costly lawsuit. Obviously, sellers want to limit their financial exposure to these risks after the sale.
Negotiation of indemnification limits is often left for the final stages of the due diligence process, but that is a mistake. As stated earlier, the seller’s negotiating leverage is highest before a LOI is signed. For this reason, indemnification limits should be outlined in the LOI. They may be renegotiated during due diligence, especially if the buyer discovers a risk that troubles them, but setting basic indemnification expectations in the LOI avoids difficult negotiations that might sink a deal deep into the process.
Escrow Terms
One of the ways that buyers protect themselves from post-closing risks is by insisting that a portion of the purchase price be held in escrow to settle any claims against the representations and warrantees. Escrowing seller funds is customary, but the amount of the escrow and the length of time it is held can vary widely. These issues typically come up late in the legal drafting process when the seller is deeply invested in the sale process, which weakens their negotiating position.
Purchase Price Allocation (asset sale only)
In an asset sale, the buyer will need to assign values to each asset purchased for the IRS. One of the reasons buyers generally prefer an asset sale is that they can depreciate the physical assets they acquire, and amortize the intangible assets (e.g. goodwill), which shields future profits from taxation. And since physical assets can generally be depreciated faster than intangible assets, the buyer has an interest in placing high values on physical assets and a relatively low value on intangible assets.
The challenge for sellers is that if physical assets are allocated a higher value than their current book value, any gain on those assets will be taxed at higher ordinary income tax rates. For example, suppose one of the assets being sold is a CNC machine tool that originally cost the seller $1 million and has been depreciated down to $100,000. If the buyer assigns that machine a value of $500,000 in the purchase price allocation, then the seller will pay income tax on the $400,000 gain. This is called depreciation recapture, and it can substantially reduce a seller’s after-tax proceeds. The way to avoid this tax trap is to negotiate a favorable purchase price allocation with the buyer and document that agreement in the LOI. In a stock sale, the seller’s gains are taxed as capital gains and there is no purchase price allocation to worry about.
About Venture 7 Advisors:
Venture 7 Advisors is a team of merger and acquisition advisors who assist the owners of small and mid-sized companies to plan and complete the sale of their business. We find the best buyer to meet each business owner’s financial and legacy goals. We represent clients in consumer products, distribution, manufacturing, B2B services, construction, telecommunications, and eCommerce from offices in Burlington, Vermont, the Hudson Valley, New York, and Western Massachusetts.
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Bryan Ducharme
Managing Partner
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