Once a buyer and seller have agreed upon the basic terms of a business sale, the buyer normally sends the seller a letter of intent to purchase a business. Letters of intent (LOIs) serve to formalize the purchase process by setting out the terms and conditions of the agreement.
Generally, letters of intent are non binding agreements that give the purchaser an opportunity to take a closer look at the revenues, expenses, and operations of a business before drawing up a formal contract. They show a meeting of the minds, in the sense that letters of intent specify the terms of the purchase and what the buyer needs from the seller in order to perform due diligence. Once the seller signs the LOI and the buyer completes due diligence, the agreement moves to the next stage, which involves drawing up and signing a legally binding contract.
Advantages of an LOI
Depending on the situation, an LOI can be advantageous for both the buyer and the seller. These advantages include:
- Although nonbinding, the letter shows a seller that a buyer has an interest in setting up terms for purchasing the business, particularly if the LOI requires a deposit on the part of the buyer.
- It gives the buyer a chance to perform due diligence by requesting pertinent information from the seller.
- A “no shop” clause for a certain period of time removes a buyer’s worry about competing offers.
- A signed LOI may make it easier for the buyer to arrange financing for the venture, which is a plus for both seller and buyer.
Disadvantages of an LOI
One disadvantage of an LOI is that the document changes the relationship between buyer and seller — the courtship is over and tough negotiations begin. The lack of competition gives the seller an advantage that wasn’t there before the LOI was drawn up.
In addition, the “no shop” clause means the seller cannot shop the business to other possible purchasers. If the deal falls through, this means a loss of time when the business could have been shopped to other potential buyers. One way sellers can protect their interests is to request a deposit that they can expressly use, by the terms of the LOI, to offset expenses incurred during the time the business was off the market.
Basic Provisions of an LOI
You should tailor your letter to reflect the scope of the business. Every business is different and needs different provisions and allowances. Things like inventory, stocks, customer base, liabilities, consulting, and noncompete clauses can greatly affect the nature of your LOI. Basic provisions include:
- Concise details of the structure of the deal, including terms and conditions, exclusivity, and obligations.
- Price and terms, including how much is being paid and who is financing what in terms of independent financing. The letter should specify how much the seller is involved in the financing process.
- Time periods as to when the agreement and contract will be complete. In addition, there should be clauses allowing for the possibility that the negotiations may fall apart.
LOIs should always indicate that they are nonbinding and will be superseded by a legally binding purchase-and-sale contract. To ensure that your LOI is nonbinding, be sure to include provisions that state this in clear and concise terms. As a buyer, you want to make sure you aren’t held to terms and agreements that are not to your advantage.
Stay away from the term “in good faith” in your letter, as it can later be used by the seller to bind you to an agreement. In this event, the seller only needs to ask for reasonable terms to fulfill the “in good faith” criteria. This situation puts the buyer at a distinct disadvantage, so be sure you avoid using this language.