Home Guides Mergers & Acquisitions in the US Preacquisition Agreements Letters of Intent

Letters of Intent

A letter of intent (LOI), also known as a memorandum of understanding (MOU), is an acknowledgement of two parties’ intent to pursue a mutually agreeable deal.  LOIs frequently outline the broad terms of a deal, although not the details.

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Advantages & Disadvantages of LOIs

Advantages
  • Demonstrates common understanding of and agreement on major deal points
  • Provides insight into likely areas of disagreement and potential deal impediments
  • Usually leads to smoother, quicker and more organized negotiations

 

Disadvantages
  •  Letters of intent are not legally binding – either party is free to back out of the agreement, or ignore it entirely. 
  • Letters of intent frequently become public to the markets, customers, competitors and employees once they are signed.  Premature disclosure may have a negative impact on stock price, customer relationships and employee morale.  This is an especially important consideration for the Target.
  • Some feel that letters of intent reduce negotiating leverage, because significant deal terms are off the table once the LOI is signed.  Deal leverage is usually highest for the Target early in the process when it may have other suitors and the taint of a failed deal is very low.  Deal leverage is usually highest for the Buyer late in the process when other suitors have been excluded from the process and the Target faces the risk of being seen as tainted if a Buyer backs out of the deal at the last minute.

 

Public companies face conflicting issues when deciding whether or not to use a letter of intent. 

  • News of an acquisition of any size influence the stock price of both the acquirer and especially of the target.  This consideration leads companies to want to enter LOIs as late as possible, as LOIs inevitably become public.
  • Disclosure requirements for public companies require material or potentially material transactions to be disclosed as soon as they occur.  This consideration leads companies to want to enter LOIs as early as possible, before the deal becomes public.
  • LOIs establish expectations with investors as to the size and terms of a potential deal, thereby committing the parties to a particular course of action and limiting future options.  This consideration leads companies to want to enter LOIs as seldom as possible, thereby limiting the publicity of a failed deal.
  • LOIs set parameters for a transaction and help establish major deal terms, thereby limiting areas of argument and increasing the likelihood of a deal closing successfully.  This consideration leads companies to want to enter LOIs as often as possible.

 

Materiality Test

In evaluating whether a public company is required to disclose an LOI, US law applies a materiality test to the transaction.  A materiality test requires that an LOI be disclosed if knowledge of the LOI (and therefore the underlying deal and deal terms) is likely to influence an investor’s investment decision; if knowledge of the LOI is not likely to influence an investment decision, it is not required to be disclosed. 

As a practical matter, public companies rarely enter into LOIs.  Instead, they usually create a comprehensive term sheet with no price included.  This practice allows the parties to take the position that the transaction is not yet material (because the most important term, the price, has not yet been established). 

 

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