LOI Cheat Sheet: Key Focus Areas

When it comes to mergers and acquisitions (M&A), the Letter of Intent (LOI) serves as a critical preliminary agreement between the buyer and seller. It outlines the key points of the potential transaction, setting the stage for further negotiations and due diligence. In this blog post, we will delve into the essential elements of an LOI and explore why ironing out important details at this stage can significantly impact the success of the deal. From purchase price and deal structure to confirmatory process considerations and other crucial terms, we'll examine the factors that can shape the outcome of an M&A transaction.

1. The Importance of the Purchase Price and Adjustments

The purchase price is a defining element outlined in an LOI. However, when evaluating the price, its level is not the sole factor to consider. Although not precisely defined in an LOI, net working capital adjustments can lead to substantial fluctuations in the final price received upon the deal’s closure. The methodology used to calculate net working capital is often outlined which typically provides an overview of which current asset and liability accounts are included in the calculation. Although usually included in net working capital, buyers will evaluate the timing and cost to service the deferred revenue and sometimes make the argument that the account should be treated as indebtedness. Overall, a comprehensive analysis of this component is vital to fully grasp the financial implications of the LOI.

2. Navigating the Deal Structure

In an LOI, it is important to specify whether the proposed transaction will be structured as an asset sale or an equity sale. In a stock purchase, the buyer acquires all or most the company’s outstanding shares, whereas in an asset purchase, the buyer selectively chooses specific assets and liabilities they wish to acquire from the target company. This decision has significant implications for both the buyer and the seller. By evaluating tax implications, legal requirements, liabilities, and financial impact, parties can align their interests, negotiate favorable terms, and streamline due diligence. A well-informed decision at this stage sets the foundation for a successful and mutually beneficial transaction.

3. Consideration Matters

Consideration refers to the form in which the buyer will pay for the acquisition. It can include various components such as cash on close, equity of the acquiring company, equity rollover (i.e., legacy shareholders retaining some equity of the target company post-transaction), and earnout (i.e., future payouts earned based on achieving performance targets over time). Every type of consideration serves its own purposes; notably, equity is frequently employed to motivate key employees after the transaction, while earnouts are used to address valuation disparities between the buyer and seller. Balancing these considerations is crucial, as they can impact the timing, certainty, and overall value received by shareholders.

Another important variable with respect to consideration is the amount of leverage used to finance the acquisition. Financial sponsors, in particular, often employ a higher level of debt than strategic buyers. Debt can offer various advantages, including boosting returns for equity holders through reduced capital requirements and the tax efficiency of interest expenses. However, it also introduces potential downsides, such as restricting business operations (i.e., via covenants, mandatory principal / interest payments) and increasing overall business risk.

Beyond the benefits and drawbacks associated with the use of leverage, there exist other sources of risk from proposed financing sources. These include the structure (i.e., interest rate, maturity, repayment schedule, etc.), terms and conditions (i.e., covenants, collateral, etc.), reliability of the funds (i.e., track record of the institution providing the funds), and the broader economic state (i.e., interest rate movement, industry cyclicality, etc.).

To make well-informed decisions regarding Letters of Intent, it is vital to consider the form of consideration along with the sources of the funds.

4. Confirmatory Process Considerations

Two major confirmatory process components are commonly outlined in an LOI: the exclusivity period length and due diligence (DD). Typically spanning from 45 to 60 days, the exclusivity period demands that the seller refrains from engaging with or soliciting other potential buyers, focusing solely on negotiations with the selected party. For the seller, shorter exclusivity periods are generally preferable as they maintain a sense of urgency with the buyer and reduce the risk of ‘black swan’ events disrupting the deal. Exclusivity periods occasionally come with an auto-renewal clause which extends its length so long as both parties are working in good faith towards a close.

Confirmatory due diligence is a critical aspect of the M&A process, entailing a thorough examination and analysis of the entire selling business. The LOI often outlines, at a high level, the specific streams of remaining DD, any outstanding DD items that are critical to closing, and any anticipated regulatory approvals. Confirmatory due diligence often encompasses financial, tax, operational, legal, human resource, etc. aspects of the business. The remaining diligence required can significantly impact the certainty of the deal's closure, making it vital to carefully evaluate this element when considering multiple LOIs.

5. Management and Employee Considerations

The LOI should address key terms that impact management and other employees of the target company. These may include negotiating renewed employment agreements, outlining plans for employees post-transaction, and presenting future incentives (i.e., option pools, profit sharing, etc.). Addressing these concerns is essential for both parties. From the buyer's perspective, it supports talent retention and facilitates integration, while for the seller, it provides reassurance for continued involvement post-merger and highlights potential rewards based on strong performance.

6. Indemnity Escrow Considerations

In a purchase agreement, the seller typically provides representations and warranties (R&W) concerning various aspects of the target company’s business, including its financial condition, assets, liabilities, contracts, intellectual property, compliance with laws and regulations, tax matters, etc. There are two primary types of R&Ws: fundamental and general. Fundamental R&Ws are core to any transaction and cover basic areas such as company ownership, the authority to execute a transaction, compliance with legal obligations, and taxes, etc. On the other hand, general R&Ws cover an important, but broader range of topics including corporate existence, the accuracy of financial statements, and material contract validity, etc. Typically, it is market-practice for fundamental R&Ws to have a survival period equal to the statute of limitations or seven years and general R&Ws to have a survival period between 12 and 18 months.

A portion of the purchase price will often be withheld in an indemnity escrow to protect the buyer against breaches of the representations and warranties. The amount, currency, and term of the escrow are typically defined in an LOI. The size of the escrow often ranges between 10% and 15% with the lower end being more seller friendly. Indemnity escrow features can have significant implications for the legal exposure of the selling company’s shareholders and cash received on close – it must be carefully considered.

7. Other Critical Factors

Another layer of protection with respect to representations and warranties can be purchased through representation and warranty insurance (RWI). It protects both the buyer and seller from potential financial losses arising from breaches of these representations and warranties. When negotiating the LOI, parties often address the inclusion of RWI, including considerations of who will bear the cost and the overall expense. RWI can play a vital role during the closing process as it helps mitigate risks for both parties, expedites the confirmatory process by reducing the need for lengthy indemnification negotiations, and minimizes the requirement for excessive escrow amounts.

Lastly, governing law is frequently addressed in an LOI, and while it is often consistent with the jurisdiction agreed upon at the NDA phase, other crucial factors must also be taken into account and may warrant a revision. These factors include familiarity with the laws of the selected jurisdiction, the presence of a well-established body of M&A law, and predictability in contract interpretation and enforcement. Some commonly favoured jurisdictions for M&A transactions are Delaware, New York, California, Texas, Ontario, and Quebec.

A well-crafted Letter of Intent sets the stage for a successful M&A transaction by outlining the key terms and conditions for both the buyer and seller. Ironing out essential details at this stage, such as the purchase price, deal structure, consideration, and confirmatory process, can significantly impact the outcome of the deal. Additionally, addressing management and employee concerns, along with other critical factors like R&W and governing law, contributes to a smoother and more efficient transaction process. By understanding the importance of these elements and carefully negotiating them in the LOI, parties can lay the groundwork for a mutually beneficial M&A deal.