WebExtra! How to move from letter of intent to M&A success

Five steps for completing the deal

Craig Chason

As any experienced deal maker will tell you, signing a letter of intent offers no guarantee to sellers that an acquisition will be completed. In fact, the percentage of transactions that move from a letter of intent to actual signing of a definitive acquisition agreement appears to be declining. Consequently, prudent sellers need to protect themselves from transactions that slip away after the letter of intent is signed.

Letters of intent are just that ? they are intended to memorialize the parties' current intentions with regard to both price and other material terms of a transaction and commit the parties to negotiate a transaction based on these terms. While letters of intent are generally nonbinding in nature, historically the parties are almost honor-bound to adhere to the terms unless they can demonstrate that one or more of the assumptions underlying the pricing of the transaction is flawed. The level of due diligence that precedes a letter of intent will vary from transaction to transaction, but typically a significant amount of buyer due diligence will occur between the signing of the letter of intent and the actual signing of the purchase agreement.

The buyer's due diligence team will include lawyers, accountants and outside consultants. Consequently, before the buyer commits time and resources to this process, the buyer will want a commitment from the sellers that binds them to negotiate exclusively with the buyer for some agreed upon time, typically 30 - 90 days. This provision, often referred to as a "no-shop" or "lock-up" agreement, is the one binding provision included in most letters of intent. The no-shop provision effectively takes a potential seller out of the market for the agreed upon period and significantly shifts the negotiating leverage toward the buyer.

The red-hot government M&A market of the past several years has stoked intense competition among buyers looking for good potential targets. Much of this is done within the context of an auction or limited auction in which buyers compete on the basis of price and non-price terms. Buyers have put great emphasis on signing a letter of intent with sellers as soon as possible to exclude other potential acquirers. A by-product of this rush to get a no shop in place is that buyers sometimes will not have done enough upfront due diligence to really understand the business. This increases the likelihood that the buyer will want to renegotiate the price or other terms after the letter of intent is signed? a point when sellers have lost much of the leverage they had during the original auction process.

To guard against this type of breakdown, a seller must negotiate a letter of intent that aligns the seller's and buyer's expectations and points both parties toward a successful negotiation of the definitive purchase agreement. Here are five points you should consider:

Buyer Reputation. Not all buyers are equal. Check on the potential buyer's reputation for signing a definitive purchase agreement and consummating the transaction once a letter of intent is signed. It's difficult to check, but try to get a sense of how stringently the buyer adheres to the terms of letter of intent in negotiating the definitive agreement.

Due Diligence. Require the buyer or universe of potential buyers to perform substantive due diligence that puts them in a position to understand the business and underlying financial information. This means, for instance, providing buyers with contract-by-contract revenue numbers if a meaningful portion of your business is generated from restricted work, even showing them that the restricted work is more profitable than the unrestricted work if that is the case.

No Shop. Not all no-shop provisions are the same. The duration of the no shop should be consistent with getting the transaction done in a timely manner. Long no-shop provisions are not advantageous to sellers. The buyer may find another transaction that diverts its attention or that it even likes better?and it is very difficult to get a buyer to agree not to look at other deals. Consider adding a provision that requires the buyer to recommit upon the seller's request to the deal terms contained in the letter of intent and allows the seller to kick out the no-shop provision if the buyer is unable to confirm that the terms have not changed.

Material Terms. The easiest definitive purchase agreements to negotiate are those in which the letter of intent included a comprehensive outline of the material terms. Things such as purchase price holdbacks and escrows, indemnity obligations and a clear understanding of the non-compete and employee retentions requirements and closing conditions are important to understanding what the letter of intent represents.

Agreements to Agree. Some letters of intent will leave open terms and conditions as basic as the transaction structure. Significant tax dollars can be at risk, for instance, if the letter of intent does not clearly reflect whether the transaction contemplates a straight stock sale or a stock sale with a section 338(H)(10) election, which effectively treats the transaction as an asset sale for tax purposes, or how the compensation charges generated from the cancellation/ buyback of seller options is reflected in the working capital calculation that is typically included in most deals.

Because potential buyers are always anxious to obtain no-shop protection, letters of intent tend to be negotiated in a super-charged environment. Sellers that follow these steps and slow the process down just a little will have a higher probability of getting the transaction closed?and that, after all, is the goal.

Craig Chason is partner with ShawPittman LLP, McLean, Va., specializing in mergers and acquisitions. He can be reached at craig.chason@shawpittman.com.

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