(Don’t) Fill in the Blank
The Inventor’s Dilemma
First and Foremost
Crossing the Line
Not Business as Usual
Negotiating a merger or acquisition can be a delicate process. Some believe that involving experts, such as attorneys, in the letters of intent (LOI) negotiation process can damage the relationship between the seller and the buyer and inhibit the development of trust. I couldn’t disagree more. Such advice is ill-advised and can result in adverse financial and legal consequences—particularly for a seller—in an M&A transaction.
I agree that, at the time the LOI is being negotiated, the parties are still early in the process and in the “dating phase” of the relationship. Both parties need to appear eager and flexible and do what they can to establish trust and not appear overly concerned with details, tax and legal issues, or unnecessary legalese.
However, the reality is that the LOI is a critically important component of any M&A transaction. In my experience, neither party to a proposed M&A transaction—and particularly the seller—should ever enter into an LOI without input from competent and experienced legal, tax, accounting and financial advisors, and doing so is often a very costly mistake.
A Non-binding Agreement?
The main purpose of an LOI in an M&A transaction is to force the parties to identify and consider early in the process the critical and fundamental deal terms and conditions, before either party expends a substantial amount of time, money, effort or resources pursuing a transaction when no basic agreement regarding the fundamental terms and conditions has been reached.
Clients and prospective clients routinely say to me, “the LOI isn’t important because it’s a non-binding agreement.” However, that notion is fatally flawed and can be a very dangerous trap to fall into for three reasons.
First, while it’s true that LOIs for M&A transactions are almost always non-binding agreements, a few very important, but often seemingly innocuous, provisions are routinely made binding. Included among the provisions that are almost always binding are exclusivity/no shop, confidentiality, payment of expenses, termination, and governing law and jurisdiction. Not understanding and appreciating the operational, financial and legal consequences of each binding provision can result in substantial liability, especially for the seller.
Second, critically important and financially significant provisions can—and almost always should—be negotiated into an LOI on the front end of any M&A transaction. It’s a common occurrence for buyers to be in such a hurry to get an LOI signed that they fail to focus on the critical tax, financial, accounting and legal consequences.
Third, while it’s true that the non-binding provisions of an LOI are not legally binding, as a practical matter a significant amount of moral commitment attaches to those provisions. I routinely point out to opposing counsel certain non-binding provisions as evidence of the parties’ thinking, intent and understanding at the time the LOI was executed.
Unwittingly agreeing to certain provisions in an LOI can result in substantial adverse tax and financial consequences for the seller of a business. About a year ago, a prospective client called about possibly retaining me to represent the three owners in connection with the simultaneous sale of two affiliated companies. I didn’t hear anything from the sellers for about two months, when they called back to retain me to represent them on the sale.
They then dropped a bombshell and told me they had signed the LOI the day before—without the assistance of any professional advisors. The client told me that the buyer (a large New York-based private equity fund) told them not to worry about the LOI because “it isn’t a binding agreement.” Unfortunately, my client accepted that notion and signed the LOI without any input or review from its advisors.
After reading the LOI and running some numbers on the deal, we determined that the three owners would pay almost $5 million in unnecessary taxes on the transaction (almost 4 percent of the $130 million sale price). We further determined that through a restructuring of the two companies being sold, we could save the sellers most of that $5 million with little or no tax impact on the buyer.
I advised the client to allow me to go back to the buyer’s counsel and re-negotiate the LOI. After several weeks of difficult and time-consuming negotiations, we were able to agree to a much more fair, reasonable, and customary LOI and deal structure.
The seller’s leverage in an M&A transaction almost always is at its maximum on the day the LOI is signed and declines precipitously thereafter. Once an LOI is executed, the seller will be subject to certain binding provisions that will take the seller “off the market,” including an exclusivity/no shop provision prohibiting the seller from discussing any possible transaction with anyone other than the other party to the LOI.
Therefore, the LOI negotiation phase is when professional advisors should be involved and critical deal issues identified and addressed—particularly those that will have a substantial tax and financial impact on the seller.
Thomas R. Taylor is a corporate and M&A lawyer and shareholder in the Salt Lake City office of Durham Jones & Pinegar, P.C.