The Letter of Intent, referred to in this article as an “LOI” but sometimes also referred to as a “Memorandum of Understanding” or MOU or even simply a “Term Sheet”, is a document that in many ways defies definition but can be a very important element of proper deal management and is often times the genesis of either a successful or failed undertaking. There is no particular “template” although for those familiar with the document certain trends are incorporated into different forms of the document. Almost any transaction (including without limitation, buying or selling a business; contemplating a joint venture or distribution arrangement; negotiating a commercial lease; looking to secure debt financing; or undertaking an equity offering) can, will or very often should start with some form of LOI.
At its most basic, the LOI sets out in non-legalize (the alternative to the precise and considered language of lawyers) the intent of the parties involved in a proposed transaction, the parameters of certain material deal terms and a pathway to documenting and finally consummating a transaction. It is uncommon, at least in many small and medium business transactions, that lawyers are there in the room the first time two or more parties meet to discuss a potential business arrangement. More common, business people will initiate conversations directly and typically come to some high level understanding as to the type of transaction proposed, the main terms and conditions of the proposed transaction and the pathway to implementing the proposed transaction. That high level understanding is then communicated to lawyers (or should be) to draft the appropriate agreements, ensure compliance with applicable laws and attend to all regulatory and legal formalities. If done properly, the preparation of an at least somewhat well-considered and drafted LOI will align all of the party’s expectations before engaging in significant expense; provide a clear outline for lawyers and other service providers to move forward – which ultimately saves time and money and will be the springboard to an effective and efficient conclusion to any transaction.
However, a word of warning is justified. Just as a well-considered and drafted LOI will greatly improve the prospects of success, a poorly considered and drafted LOI may prove the nail in the coffin, so to speak, of your business ambitions. Unless you are a seasoned business or leasing professional, an underwriter or a bank loan officer (and even in some cases even if you are any of those), I would strongly suggest that before signing anything, lawyers for the respective parties have an opportunity to review and comment, or better yet draft, the LOI.
With that in mind, here are five items that you should consider before you speak to, or with, your lawyer.
1. Binding or Non-binding. While many articles on this topic often simply assume that an LOI is a non-binding document, the case law produced from the many unfortunate disputes over this assumption suggest otherwise. In fact, an LOI can (sometimes despite its title – for example, cases have turned on the use of the phrase “Memorandum of Understanding” and “Memorandum of Agreement”) be determined to represent the entire, binding statement of terms agreed by the parties; or be determined in whole or in part to simply be a statement of intent to enter into binding legal obligations in the future. Courts generally have asked whether the LOI includes all of the essential provisions to be incorporated in a definitive document and/or whether those provisions are sufficiently detailed and clear so that the contract is not void for vagueness or uncertainty – a fundamental element of contract law. Similarly Courts will often go to some length to determine if the parties to the document intended to be bound immediately upon signing the LOI, even if it is clear that a more definitive agreement was intended to embody the precise terms of the initial agreement, or did the parties intend to defer all or part of their respective legal obligations until a definitive agreement was settled, signed and delivered. You may wish, or intend, to have an entirely non-binding document. Indeed, you may be seeking to document a binding deal. More likely, or at least in most LOI’s I have prepared, your intent is to include certain pre-closing obligations that are to be binding and relied upon by one party or other in consideration of undertaking further expense to progress a deal (for example confidentiality, due diligence or a temporary exclusivity clause or standstill); while having a number of provisions intended to be non-binding and outlined only to confirm an understanding and facilitate preparation of a definitive agreement. Careful and clear drafting is vital to ensure the intent or the parties is clear and that those items intended to be non-binding are interpreted consistently to be non-binding and that those intended to be binding meet all the requirements under applicable contract law to ensure enforceability.
2. Who Should Sign An LOI. I see this issue most often in two circumstances. The first is the individual who signs an LOI, perhaps for example to lease a store front, with the intent to form a new corporation which would undertake and assume any legal obligations in that LOI. The second is the individual or entity that enters into an LOI, perhaps for example to purchase a business, with the wrong parties on the other side capable of facilitating completion of the proposed transaction. In the first instance it can be a shock, particularly to an individual, that the other party does not wish or intend to permit that individual to transfer the legal obligation to newly established corporate party in whole or in part and therefore intends to hold that individual responsible for any binding obligations or costs set out in the LOI or use the situation to terminate the LOI. In the second instance it can become an unfortunate and sometimes costly oversight to learn that you cannot necessarily agree to purchase all of the outstanding shares of a company, for example, by coming to some agreement with the company itself (the shares are the property of the shareholders, not the company). It may be a simple matter of timing, or drafting, but in any case some thought should be given as to who signs the LOI and who is intended to consummate the proposed transaction.
3. Hard Coded or “To Be Determined”. In certain circumstances, and certainly with particular transactions, not all elements of a proposed transaction are or have been conclusively determined. Asset sale or share sale? Amalgamation or arrangement? Debt securities or equity securities? Consideration should be made as to whether it makes sense to describe the proposed deal structure early, or permit the parties to propose a deal structure after due diligence is completed and more comprehensive legal and accounting advice has been obtained. Often one deal structure has, on balance, more favourable implications for one party over the other. Accepting to pursue a particular deal structure in a LOI, only to propose the deal structure be changed once legal and accounting advisers tell you there is a better way (for you) to pursue the transaction, likely will not sit well with the other party and can jeopardize the deal, increase costs significantly and result in unintended litigation. However the law around “agreements to agree” or, more particularly, obligations to negotiate open items in “good faith” are evolving. Years ago it was clear advice that agreements to agree in most Canadian jurisdictions, unlike many U.S. jurisdictions, were not enforceable and implied obligations to negotiate in good faith were non-existent. Recent trends in Canadian courts suggest at least to me a growing acceptance of good faith in commercial dealings. Again, drafting a clear and considered LOI is important.
4. To Break (Fee) or Not to Break (Fee). Parties will incur costs (either actual financial cost on due diligence, legal and accounting advice; or opportunity cost in terms of missed opportunities to pursue other transactions or the distraction of management and other staff to facilitate due diligence instead of pursuing business) as part of any precursor to a proposed transaction. The problem with a non-binding LOI is that one party or the other can, too easily, walk away leaving the other with a pile of sunk financial and/or opportunity costs. This issue can be significantly more material in circumstances where one party is on, or close to on, the financial ropes. It is not uncommon for a strategic purchaser to stretch a due diligence process and pile financial and opportunity cost on a weakened target, only to walk away at some point and re-emerge with an alternative – and often significantly less remunerative – offer. Break fees are often difficult to negotiate, particularly in smaller transactions, but are very common in almost all public company merger and acquisition transactions. In certain circumstances, and certainly with particular transactions, considering some degree of compensation to the party left behind if a party walks away or if a party discovers a material misrepresentation in the status of a target or its assets that initiated the whole pursuit of a particular transaction seems reasonable. However, take care as to how any break fee is characterized, calculated, drafted and ultimately to be collected.
5. Extraordinary Expectations or Demands. Nothing torpedoes the documentation of a transaction and the good faith cooperation of the parties like an extraordinary expectation or demand made either in the midst of finalizing standard transaction documents or, worse still, contained unexpectedly in documents prepared by one party. If there is a need or anticipated desire for inclusion of provisions often controversial to one party or the other – like non-refundable deposits; indemnities; non-competes; exclusivity; rights of first refusal; change of control payments or other related party compensation; or frankly a break fee – my suggestion is to be brave and discuss these issues thoroughly at the negotiation stage and have them reflected in the LOI. Making unanticipated, unique and/or controversial proposals or demands mid-transaction increases substantially the chance of total deal failure, increased deal costs and the probability of unintended litigation.
If I am not at the table during the initial negotiations of a proposed transaction, I take significant comfort in receiving a considered, well drafted LOI signed by both parties – particularly if I at least drafted or had an opportunity to review and discuss a draft of the LOI. Concerns about any cost in engaging legal counsel earlier should, in my view, be disregarded. Simply put, the cost savings in terms of drafting transaction documents; constraining transaction parties or their respective legal counsel from pursuing new demands or alternative directions mid-process; and/or mitigating the bad faith perceptions common when transactions are negotiated on the fly are well and truly worth the investment.
Endeavor Law can assist entrepreneurs and business owners, as well as their consultants and advisers, in negotiating, drafting or reviewing letters of intent and other pre-transaction documents. Endeavor Law will always seek to provide competitive pricing for any legal services requested and is pleased to discuss fee arrangements that suit any potential client.
Does not constitute legal or other advice and must not be used as a substitute for legal advice from a qualified legal professional in your jurisdiction who has been fully informed of your specific circumstances. Information may not be up-dated subsequent to its initial publication and may therefore be out of date at the time it is read or viewed. Always consult a qualified legal professional in your jurisdiction.