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A letter of intent (LOI) is an essential step in the merger and acquisition (M&A) process, yet its exact purpose and content might be widely unknown. Furthermore, there are several popular misconceptions about these agreements and exactly what their role is in the process of selling a company.

Essentially, a letter of intent is what it sounds like — an agreement between parties that lays out the structure of the deal and the intent of both parties to follow through with it. There are several key sections in a basic LOI, which are outlined below.

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The first section is the purchase price and payment structure, and as the name suggests, it outlines the dollar amount to be received for the sale of the firm. Furthermore, it must include how this number was calculated, which is typically an EBITDA multiple. (For smaller deals, this can be fixed assets plus a goodwill number.) EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and gives an accurate picture of a firm’s profitability. There should be specific detail about how payment will be made. Such details can include the timing of payment, the percentage of the payment made, and the sources of capital. They are:

1) Cash: The buyer has enough liquid capital and buys the company outright;

2) Seller Financing: The seller lends the buyer cash to buy the business and charges interest;

3) Earnout: After an initial cash payment, the buyer will make additional payments to the seller if the business achieves agreed-upon milestones such as profitability or revenue growth;

This section can also include the specific assets to be sold, liabilities that are incurred, and a clause for an escrow fund. The escrow fund sets aside a predetermined percentage of the purchase price at the time of closing, to be held in reserve for up to two years. This gives the buyer something to make claims against if misrepresentation occurs. It also provides guidelines for the valuation of inventory that is currently held by the seller. This is an essential step for small or mid-size businesses because inventory represents a substantial portion of the value of the company. Such a valuation is usually based on how recently inventory items have been sold.

The next section contains the assumptions related to the purchase price. This includes terms that are assumed by the buyer about the seller and the company. An example of this is that the purchase agreement will contain typical industry terms and conditions, or that the sellers will sign a non-compete agreement.

Employee and management incentives are the next section and are in place to make sure the buyer and seller agree on the future role of employees. This section can include terms guaranteeing employment and consistent compensation for employees after the sale of the company. It can include terms about incentivizing management to stay on board after the sale and continue to perform.

The next section is the definitive agreement, and this has some more information about the asset purchase agreement. This section also restates that the purchase agreement will contain all of the necessary indemnifications. Finally, this includes a clause that ensures that all shareholders in the seller company will exercise their rights individually and not collectively.

Next, there is a section on the real estate that is involved in the transaction. This can differ significantly between deals. If the physical property is being sold that will be outlined, and if there will be a rental agreement that will be mentioned as well. Real estate can represent a very large portion of the assets in a business, so it is important to outline how it is going to be handled in the deal from the start.

The next section outlines due diligence timing and closing. It provides provisions for when the due diligence will be completed by the buyer, how long it will take, and to what extent the seller must participate in it. A target date for closing the deal is named to establish a timeline.

The following section is titled seller approval and consent, and it establishes that the seller has all the internal and external approvals necessary to go forward with the transaction. Also, it states that the seller does not anticipate any legal or regulatory complexities to arise.

Next, we have transaction expenses. This section covers how the payment of legal and transactional fees will be made. Typically, each party will bear its own legal expenses and split the cost of the escrow agent.

Next, there is a section relating to exclusivity and non-solicitation. In this section, the seller agrees not to contract any third party concerning the transaction for the life of the deal. In this section there is typically a clause that prevents the seller from attempting to hire employees away from the seller at any time during the process or after the deal has been completed.

A letter of intent is a non-binding agreement that is used to express the collective wishes of all parties within a deal and can be subject to termination by either party at any time, with the exception of a few sections. The clauses related to exclusivity, transaction expenses, and the choice of state law are legally binding once the agreement has been signed. This is the case because we must balance the need to protect the monetary interests of the seller with the freedom to walk from the deal. Since most of the agreement is non-binding and the agreement is entered into willingly there is an expectation of good faith between the parties that they will be forthcoming with all pertinent information in the creation of this document.

As outlined above, the LOI is of paramount importance in the M&A process in order to maintain expectations and good faith between parties.

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