A letter of intent (LOI) is an initial, non-binding agreement between the parties in a proposed business deal. The LOI establishes the aspects of the deal the parties agree on, shows the parties are committed to making a final deal, and clears the way for a later, binding agreement called a definitive agreement.
What Is a Letter of Intent?
An LOI is a starting point between two parties that are negotiating a business transaction, such as a sale or purchase, a merger, or a joint venture. A letter of intent clarifies the intentions of those involved in the deal and the major provisions that still must be agreed upon.
Though some of the provisions of the letter may be binding, the overall letter is not intended to be binding to both parties. The letter should state which parts of the agreement are binding while making it clear the letter is not a definitive agreement. If one of the parties fails to fulfill a binding part of the agreement, they may be responsible for damages to the other party.1
Either party can walk away at any point during the negotiation process based on new information that's discovered or a lack of agreement on a particular point.
- Alternate names: Letter of understanding, memorandum of agreement, memorandum of understanding
- Acronym: LOI
How Does a Letter of Intent Work?
The LOI describes what detailed information is necessary for the parties to make an informed decision about the deal. The letter may also be used to give the buyer the "right of first refusal." That means the seller may not reach a definitive agreement to sell itself or its subsidiary (or whatever the agreement is about) to another entity before it reaches such an agreement with this buyer.2
In addition to setting the stage for a possible final agreement, the letter of intent typically enables the buyer to begin its formal due diligence. The buyer is given complete access to the seller's financial accounts and other important company records, including information on customers, to verify everything the seller has told it is accurate.3
At this point in the negotiations, the parties probably won't want to get too specific. The KISS principle—"keep it short and simple"—is likely good advice when creating an LOI.
Some letters of intent have been found to be binding because the parties included provisions that were too detailed, which gave the LOIs the appearance of being final agreements.1
Components of a Letter of Intent
The exact structure of a letter of intent depends on the specific type of business deal involved, but it often includes several sections that outline the proposed deal in at least basic terms.
The introduction of an LOI will include a statement of the purpose of the document. It also states the date upon which the document becomes effective. Various terms used in the document might also be identified and defined here.
Identification of Parties
The buyer and seller or the parties in the merger or joint venture are described completely so there's no possibility of confusion.
Transaction and Timing
This section includes a general description of the transaction, including the type of business deal that will be entered into. It can also include a purchase price, although this point may still be under negotiation. The parties may want to set some deadlines to ensure the process moves along reasonably quickly while still allowing for the possibility of extensions if both parties agree.
A contingency is something that must happen before something else happens. Common contingencies in business deals include the securing of financing by the buyer and the approval of boards of directors and/or a government agency. The parties may also agree on which state's laws will cover the final agreement between them.1
A deadline should be set for this process used by the buyer and—more often in the case of a joint venture—sometimes the seller to go over the deal with a fine-toothed comb. The process involves checking records, verifying tax and legal documents, searching for unknown liabilities or pending litigation, and asking lots of questions.
The LOI should state that all entities in a position to provide information during the due diligence process will cooperate in good faith.4
Covenants and Other Binding Agreements
Most business deals include sub-agreements called restrictive covenants. If one party doesn't abide by them, it can damage the other party. You might want to include some or all of these agreements in your letter of intent, but they're not required.
A non-compete agreement protects one party in the deal, usually the seller, from competition by the other party. For example, if the prospective buyer learns information about the seller's business or its customers and then starts a business using that information, this competition would be potentially damaging to the seller.
A non-disclosure or confidentiality agreement prevents one party from revealing information about the other party gained in the due diligence process.
A non-solicitation agreement protects one party against the other party soliciting employees or customers during or after the due diligence process.
Exclusive dealing language states that neither party will negotiate with other potential buyers or sellers for a certain period of time.
A section devoted to expenses and costs typically states that each party will pay for its own expenses incurred during the process. These costs might include legal and accountant fees, costs for documents, and travel costs.
If a deal is very simple, a letter of intent could be created using a template found online. However, it's almost always preferable to hire an experienced attorney to create the document.
The parties should select a closing date and include in the LOI language saying the parties agree to abandon the deal if it isn't finalized by that day.
The parties should sign and date copies of the letter of intent after they have agreed to its terms, and all parties should receive a copy.
The signing should be witnessed by a third party, preferably a notary republic.1
Alternatives to a Letter of Intent
A term sheet is sometimes used as a synonym for an LOI, but it typically differs in that it's just a list of terms for the deal rather than a fully fleshed-out letter. 5
An indication of interest (IOI) or expression of interest (EOI) is an informal, non-binding letter stating an interest in carrying out a transaction. If an IOI is part of a deal negotiation, it would precede an LOI.
An IOI is most often sent by a proposed buyer to a company it's interested in acquiring. The IOI may include a purchase price range—expressed in dollars or as a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA)—and might provide some information on the buyer's sources of funding.6
- A letter of intent is a non-binding agreement between the parties in a proposed business deal: an acquisition, merger, or joint venture.
- It may lead to a binding agreement called a definitive agreement.
- Some of the provisions in the LOI may be binding to the parties, and the LOI should make it clear which ones are and which ones aren't.