Lawyers handle a wide variety of transactions for our business clients, including M&A deals, venture capital financings, and real estate matters, and frequently they aren’t pulled into a deal by the client until a letter of intent (otherwise known as an “LOI”) or term sheet is signed. Clients often have the opinion that the LOI is not binding and so it can be changed when the final deal is done. After all, what can go wrong with a non-binding document? Here’s some food for thought for executives and entrepreneurs who may be negotiating a term sheet or LOI and aren’t sure if they need to consult an attorney during initial negotiations.[1]
Point one: engaging a lawyer to help with your LOI shouldn’t cost too much. LOI’s are a brief statement of the principal terms of the transaction and usually do not involve intense negotiation or lengthy legal documents. And in fact, bringing your attorney into the deal early often reduces the overall cost of the deal by helping think through important issues at the LOI stage before lengthy documents are drafted.
Point two: your leverage may be at its highest point immediately prior to signing the LOI (depending on which side of the deal you’re on). Consider a venture capital financing, for example. If you’re a CFO representing the company looking for funding, then the LOI is your best point to negotiate some key terms that may be important in the deal documents. Of course, many times you’ll think of most of the key business points on your own, but often there are more subtle business points or key legal terms that could have been considered at the LOI stage. After it’s signed, your other potential investors fade away and you’re looking to one venture firm for the crucial money that will help you grow your business. And we all know the golden rule: “he who has the gold makes the rules.” I’ve seen many companies taking venture funding lose time and time again on deal points that were not negotiated at the LOI stage simply because the client needs to have the cash and only has one investor on the hook.
Point three: portions of your LOI should be binding. Most people think of LOIs as non-binding. But often, an LOI includes provisions governing confidentiality, exclusivity in dealing, and other matters that you want to be binding. You don’t want to spend time and expense negotiating towards a deal and have the other party pull the rug out from under you by going to a third-party. So make sure you consider which provisions need to be binding.
Point four: even though the business points in the LOI may not be binding, it’s not viewed well when you attempt to make changes at the deal stage that are covered in the LOI. If you’ve tentatively agreed on X in the LOI, then you don’t look good attempting to change X to Y in the deal documents. So even though it’s a business point and not legally binding (hopefully), you’ll look like a rookie to your new potential business partner when you go back on your prior written word and ask for changes. Lawyers who regularly do the kind of deal you’re involved with can help you think through the LOI and cover points you may have overlooked.
Point five: are you sure the non-binding provisions are not binding? There are numerous reported court cases where a LOI was found to be a legal contract. This could be because either the LOI wasn’t clear that it wasn’t binding or perhaps because subsequent actions transformed an otherwise non-binding LOI into a binding contract.
In short, engaging an attorney at the front end is probably a good idea. You can often get help on the LOI without increasing the total legal spending on the deal and you’ll help avoid some of the problems discussed in this post.
Footnotes
[1] See this post for a discussion on what should be in an LOI when buying a business.
——————————
© 2012 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
Nice post. Great advice. I have only one thing to add, and it is consistent with the spirit and letter of this post. Clients and lawyers always should ask the threshold question of whether they actually need a letter of intent. Sometimes, the process of negotiating the letter of intent wastes the time and energy that could have been spent by the parties working their way toward a mutually beneficial, binding set of deal agreements. Rarely, in my experience, is a letter of intent worth the time and money spent creating it. But different types of practice situations have different norms and demand different approaches. But it’s always a good idea to determine that a letter of intent is necessary or advisable before proceeding.
Thank you for the comment. I completely agree with asking the threshold question about whether an LOI is needed. Definitely true. But I’ve generally had different experience in terms of the usefulness of an LOI. I find LOIs to be worthwhile more often than not. It seems to me that putting pen to paper at an early stage forces you to think through some of the issues that might not have been considered on the front end before significant costs start adding up. So I end up using LOIs on many transactions. Anyway, thank you for your comment and point of view.
You are very welcome.
I meant to mention this in the earlier comment, but (to reinforce many of the points you were making, I recommend that folks read the interesting article that my colleague, Bob Lloyd, wrote on the Texaco/Pennzoil case, an iconic story on this topic: http://trace.tennessee.edu/transactions/vol6/iss2/3/.
And after the Wachovia mess a few years ago, Alston & Bird posted a nice summary presentation on this issue which I find helpful in thinking through the issues. It is available at http://www.acc.com/chapters/socal/upload/ACCA-Presentation-10-15-08-6-1.pdf.
Thanks for doing this great service in promoting the wise use of letters of intent and the retention of lawyers to ensure they are effective for their intended purposes.