In connection with the sale of a business, an owner may hear conflicting opinions regarding the use of a letter of intent. First, I’ll define what I mean by “letter of intent.” Sometimes one will hear it referred to as a term sheet or a memorandum of understanding. Regardless of what the letter of intent (LOI) is called, it is a written document that contains a number of unenforceable, preliminary understandings of the parties and a few enforceable provisions.
Is a Letter of Intent Absolutely Necessary?
There is no hard and fast rule that the buyer and seller must execute a letter of intent. A properly drafted letter of intent will set out the key business points in a deal. The LOI can be valuable as a memo regarding what the seller and the buyer have discussed and how the deal will proceed.
I strongly suggest that the parties execute an LOI for a number of reasons. The first and most important reason is that an LOI insures that the buyer and seller are on the same page; that they are communicating with and understanding each other with respect to the terms of the deal. That is, at least as to certain critical terms, the buyer and seller have reached an agreement in principle.
The second reason why it’s important to sign a properly drafted LOI is to promote efficiency. It’s much more efficient to draft the definitive agreement if the parties have already agreed to core deal points. Conversely, it is extremely inefficient if they have not agreed to deal terms and the attorneys are drafting an agreement that will be rejected by the seller or the buyer.
The third good reason for signing an LOI is that even though the LOI is not an enforceable contract, it does represent something like a handshake. It represents the good faith path a deal will follow. This makes it more difficult for the parties to later “re-trade” on specific deal points. The final definitive terms may depart from the terms set out in the LOI, but the reason will be less likely due to memory failure or initial misunderstanding between the parties. From a seller’s perspective, having an LOI is especially recommended when there may be a long period between the first discussions and the anticipated closing date or completion of the definitive agreement.
Finally, signing an LOI is a way to protect oneself. Potential buyers will need to learn about the seller’s business to determine whether they have an interest in pursuing a deal. An LOI may contain the terms of an NDA or supplement the existing NDA.
Contents of a Letter of Intent
The contents of an LOI can be vague—just an expression of interest by a potential buyer—or extremely specific and set out a lot of the key terms and conditions of a possible transaction. The type of LOI use will need to be customized for each specific deal. Some key terms typically found in an LOI are:
Negotiation of an LOI shows that the buyer is serious. A detailed LOI lets the parties make a moral commitment to the deal before either side wastes the other’s time. Sellers want to know more about the buyer and get a chance to size him up. Is he serious or just kicking the tires? Or worse, is he nosing around to steal customer lists and other trade secrets? If the LOI says the buyer will pay a million dollars for the business, the seller will want to know where the buyer is getting the money. They want to know when he expects to close, how much due diligence he wants to do, and things like that. The LOI gets the ball rolling and gives the seller a reference point if the buyer comes back and makes an offer that is significantly different than what is set out in the LOI.
An LOI may have a couple of contractually binding sections. It may contain provisions that prevent the buyer from stealing confidential information and it may grant the buyer a period of exclusivity during which he is the only party with whom the seller can negotiate. Otherwise, an LOI should clearly state that the LOI is an expression of intent only and that entering into a definitive purchase agreement is a condition to selling the company.
Typically, an LOI will recite the structure of the transaction-deal structure. The goal of a business sale is to put the purchase price in the pocket of the seller and control of the company in the hands of the buyer. The method employed to accomplish that task is often referred to as the deal form or deal structure. There are three basic deal forms: stock purchase, asset purchase, and merger. From the standpoint of transferring a business, none of the three basic forms is better than the other two. Each form will allow the seller to be paid the negotiated value of the business and allow the buyer to take control. There are multitudes of variations of each.
The structure of the transaction depends upon many factors including the nature of the business, the needs of the buyer and the seller, and many other issues, not the least of which is the tax treatment afforded the deal. This is a very basic overview of deal structure intended to throw some light on the subject for letter of intent purposes.
In a stock purchase, the shareholders of the target company transfer all of their shares of stock to a buyer for cash or other consideration. The buyer takes the target company with its liabilities intact, and the title to the assets of said company remains unchanged. For a stock purchase to work, all of the shareholders of the target company may have to agree to sell their stock. Upon the sale and transfer of target company stock, ownership is transferred under principles of state corporate law because the buyer becomes the sole shareholder of the target company with all the rights, duties, and powers that the selling shareholders previously had. In other words, the buyer steps into the shoes of the previous shareholders, and all the previous assets and liabilities of the company remain with the company.
Generally speaking, a stock sale is probably the least complicated of the three types of deal structures. A stock sale can be taxable to the seller at the time of the transaction or taxes can be deferred if structured properly and certain requirements are met.
In an asset purchase, the target company sells certain assets to the buyer. The buyer may also assume certain liabilities of the target company, although it doesn’t have to and may want to intentionally avoid certain liabilities. During the purchase, the buyer can “pick and choose” certain assets and liabilities of the target company instead of taking everything, as in a stock purchase.
An asset sale does not result in a change of ownership of the target company. After the assets have been sold, however, the principal shareholders of the target company will usually liquidate or dissolve the company and distribute the cash received from the sale of the assets.
An asset sale requires the target company to convey each piece of property or asset to the buyer to the extent such assets can be assigned. Sometimes certain business assets cannot be transferred, like a lease or franchise agreement, without the consent of a third party. The inability to obtain such third party consents may preclude structuring a deal as an asset sale.
A merger is a creature of state corporate law. Mergers involve a vote of the shareholders, which results in the merging of one corporate entity into or with another corporate entity. If the deal is structured as a merger, the target company shareholders will surrender their stock in exchange for stock or cash or other consideration. After the merger, the target company shareholders will no longer own shares of the target company. The target company will either be merged into the buyer’s company or a subsidiary of the buyer’s company or vice-versa.
Choosing the Deal Structure
There is no “best” way to structure a deal, but it’s important to know the different options. What may be best for the seller may not be what the buyer wants. Similarly, the deal structure proposed by the buyer may have some disadvantages for the seller. It is critical to understand the distinctions between the various types of deal structure before proposing one or accepting the other party’s proposal on deal structure.
Ultimately, the contents of the LOI, including the choice of structure, depend on a lot of issues, including the type of business, the state law in which a business is incorporated, and tax treatment. Rather than delegating the determination of these to a business broker, the best thing a business owner can do to effectively draft an LOI and choose the correct deal structure is to involve a lawyer and an accountant.
Not only will they be able to provide expert advice, they will also help ensure the smooth sale of a business and protect sellers against potential legal pitfalls.
Reprinted with permission. This article was summarized from SELLING YOUR BUSINESS: HOW TO SELL A BUSINESS IN GOOD AND BAD TIMES by J. Scott Hunter and Matthew Wiese (BusinessZone Press © 2010).
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