Letter of Intent in M&A Transactions

published on 23 February 2024 | reading time approx. 4 minutes

Right at the start of a planned M&A transaction, buyers and sellers have certain ideas about how the deal should proceed and which aspects they consider important in this process. A Letter of Intent (LoI) is often concluded in order to identify such key issues at an early stage, to determine the planned structure of the transaction and to give a psychological push to the transaction. Since the LoI is a non-binding declaration of intent, it generally has no binding legal effect.

This raises the question about what precautions should be taken at an early stage of the planned M&A deal for the transaction, but also for the case of a failure of the transaction. This article addresses the most important points.

Why do you need a Letter of Intent?

The primary purpose of a LoI is to enable the parties to clearly communicate their intentions and expectations regarding the planned M&A transaction. This helps determine a starting point for the upcoming negotiations. The parties can include their key issues in the LoI and set a framework for the content and process of the transaction.

Furthermore, by signing the LoI, both the seller and the buyer show their serious interest in carrying out the transaction and set the tone for the rest of the process. This can prove particularly useful once the M&A process is underway, especially after due diligence has been completed and when negotiating the transaction documents. Experience has shown that negotiations between the parties may be sometimes tough and the parties may get the impression that the positions are entrenched. In such situations, the LoI might give a helping hand by serving as an anchor and common basis that the parties can refer to and rely on.

The content of the Letter of Intent

The parties decide on their own how detailed or comprehensive the declaration of intent should be. Although the LoI is not legally binding in the M&A deal, it still has a de facto binding effect, and thus its importance should not be underestimated. The key elements of the LoI are as follows:

Commercial cornerstones:

The LoI should set out those commercial points on which the parties have already agreed. This includes the object of the purchase and the type of transaction (e.g. share deal, asset deal) on the one hand, and the purchase price or the method on the basis of which the purchase price is determined, including the purchase price mechanism (e.g. locked box/closing accounts), on the other.

Road Map

It is often difficult to assess which issues need to be negotiated between the parties and to what extent, especially before the due diligence is carried out. In addition, the deal teams are often under considerable time pressure. To document a schedule that is as consistent as possible, to avoid unnecessary delays and for better resource planning, it is helpful to record the expected steps up to the transaction closing.

Confidentiality and exclusivity

Confidentiality can be agreed in a separate NDA. Often, however, the LoI already contains a corresponding provision. Also the fact that the seller shall not conduct negotiations with another potential buyer is often already stated in the LoI.

The binding effect of the Letter of Intent

As a rule, the LoI is not legally binding. An exception is recommended for clauses on confidentiality and exclusivity. It is advisable to set out in the LoI which clauses are legally binding and which are not. This helps avoid liability risks in the event that contract negotiations should fail.

In purely factual terms, however, the LoI can certainly be said to have a certain binding effect. This is because by signing the Letter of Intent, the parties have expressed their readiness to cooperate in order to finalise the transaction – under the conditions set out and agreed from the outset.

Experience has shown that the Letter of Intent is often used as an argument in negotiations in the transaction process if one party deviates from its original commitments. The documentation of intentions then serves as a valuable tool to manage the negotiation process and avoid misunderstandings.

If it does come to a an abortion of negotiations

In the event that – for whatever reason – the transaction process is cancelled, protective mechanisms can be incorporated in the LoI from the perspective of the prospective buyer:

Due diligence requirement

The due diligence process may reveal aspects and issues that give rise to unexpected risks. If such "red flags" come up, it is quite possible that the potential buyer will want to back away from the transaction. In order to prevent the seller from asserting pre-contractual claims for damages in such a case, the parties condition the conclusion of the transaction on the completion of satisfactory due diligence.

Break-Up Fee

An M&A transaction process may involve high costs for the parties. Therefore, the parties may be interested in agreeing a break-up fee in the LoI in order to minimise the economic risk of wasted expenditure. This is a kind of contractual penalty agreed for the event that the seller is unilaterally responsible for breaking off the contract negotiations. If the reasons for the cancellation are attributable to the buyer, this is referred to as a "reverse break-up fee". According to case law, the amount of compensation must not be set so high that it would create a de facto obligation to conclude a contract. In such a case, the LoI would have to be notarised. The parties should keep this in mind when negotiating the LoI.

Conclusion

Carefully drafting and understanding the LOI can facilitate a smooth transition from expressing the declaration of intent to concluding a final deal. As the Letter of Intent is crucial for the successful transaction process and for the content of the transaction documentation, due attention should therefore be paid to the drafting of the Letter of Intent, if necessary with the assistance of professional M&A advisers or transaction lawyers.