Business Valuation
Apr 8, 2023
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This guide explains what letters of intent are in mergers and acquisitions. It also examines some important components in a letter of intent and explains its role in the M&A process. Here are some key takeaways about letters of intent:
A letter of intent (LOI) is an essential document in mergers and acquisitions. It outlines the terms and conditions of the proposed business transaction between two companies and serves as a non-binding agreement that establishes the basis for further negotiations. It is important to consider all aspects of a letter of intent when entering into a merger or acquisition deal to ensure that both parties are on the same page.
A letter of intent provides a number of benefits for both buyers and sellers during a merger or acquisition. For buyers, it allows them to lock down certain key elements of the deal before making any full commitments or investments. This gives them more time to conduct due diligence without having to worry about other potential buyers swooping in during this period.
On the other hand, sellers benefit from using a letter of intent because it sets out clear expectations regarding how they will be compensated upon completion of the deal.
In the M&A process, letters of intent come into play during negotiations. At this point the buyer and seller have met and are both open to doing a deal. Additionally, the buyer has already performed their valuation and a general assessment of the business.
During the negotiations, the two parties will come to a preliminary agreement—agreeing on a purchase price and the terms surrounding the deal. This agreement will be pending the buyers further inspection of the business (called due diligence).
The key to understanding how letters of intent fit into this process is understanding that while both parties are open to doing the deal, the seller still has asymmetric knowledge of their business compared to the buyer. In other words, the seller—having built the business—knows everything about it. The buyer knows far less in comparison. In order to address this asymmetry of information, the buyer and seller sketch out a preliminary deal and a letter of intent is drafted.
This letter of intent is a non-binding commitment, pending the buyer’s due diligence—which is the next phase in the M&A process. After the letter of intent is signed, the buyer will go through a period, usually two to six months, where they inspect the business in more detail. During the due diligence process, they will send a team onsite to inspect the business and observe operations firsthand.
Again, the objective in the due diligence phase is to address the asymmetry of information between the seller and buyer. As the buyer observes operations firsthand, and gains better insight into the deal, they become more and more informed about the business they are buying. To learn more about due diligence, we recommend this guide.
Letters of intent play a role in this process by allowing a preliminary deal to be agreed upon before the due diligence process begins. This will give the prospective buyer a period where they can inspect the business without having to worry about other prospective buyers swooping in. After the due diligence phase there will be a definitive purchase agreement signed and this is how the deal normally closes. However, depending on how the due diligence process goes, the two companies may go back to negotiations after the due diligence phase has been completed.
You can learn more about the M&A process here.
Generally, the idea behind a letter of intent is to formally summarize the key points that have been discussed up until this point to ensure the buyer and the seller are on the same page.
Letters of intent do not need to accomplish what a formal definitive purchase agreement does. That is not the intended purpose of a letter of intent.
A letter of intent should first and foremost include a description of the transaction that is being proposed. Often the potential buyer will mention their intention to structure the deal as an asset purchase or a stock purchase at this stage as well, although this may be revisited after the due diligence phase.
Letters of intent should include other relevant details such as timeframes and the amount of the purchase price. Letters of intent also usually include expectations for how the payment may be made, including the amount of cash and or shares of the acquiring company’s stock that may be used as payment. Also, earnouts are sometimes discussed at this stage, so if there are performance based targets they can be laid out and include what they are dependent upon.
Letters of intent also include statements regarding exclusivity and confidentiality. Confidentiality is always a major concern for sellers in the M&A process. The buyer usually uses a letter of intent, at least in part, to give them a period of exclusivity for the due diligence process. This is designed to prevent competitive offers from being made during the process.
