When in the process of negotiating an asset or share sale, or any other complex commercial transaction, various key documents will need to be drafted, including a letter of intent.
In this guide, we explain what letters of intent are, how they are used and the legal considerations involved.
What is letter of intent?
A letter of intent is a document used to declare a preliminary commitment to doing business. Also known as letters of potential interest, memoranda of understanding, heads of agreement or heads of terms, a letter of intent can be used to outline the terms of a proposed commercial transaction, as agreed in principle between the parties during the course of negotiations. In a nutshell, the letter of intent formalises the intent of both parties and any associated terms.
Prior to drafting the principal sales agreement, there is no strict legal requirement for the parties to provide a letter of intent or to agree to heads of terms. However, by setting out the key provisions for the proposed transaction, and the basic framework of the final contract, this can help to facilitate substantive negotiations and provide a timescale for completion.
A letter of intent is typically in a letter format. This type of format is appropriate where the intentions or reasons of the parties are to be recorded, providing a context for the transaction. However, the parties could also opt to use a heads of terms style document instead, setting out a summary of the preliminary terms, organised in the same order that the points might flow in the final contract. Either way, both documents will provide the basis for a full draft agreement.
When are letters of intent used?
Corporate entities use letters of intent for a range of reasons. They may be used simply to signal that the entities are negotiating an agreement, such as a merger. However, letters of intent are most commonly used to outline the broad strokes of a deal before resolving the finer points and finalising the details. Ultimately, the aim of any letter of intent is to disclose the nature of a proposed deal and to clarify the key points involved.
Letters of intent are commonly entered into once preliminary terms have been agreed and before commencement of detailed due diligence, although they can be used at any time, where negotiations do not need to be completed for this type of document to be drawn up.
In most cases, the purpose of the letter of intent is to document the fact that a deal is in the process of being discussed, and the progress made to date, outlining the timetable and obligations of the parties during the course of negotiations. It can also be used as an aide-memoir of what has been agreed, for the next round of negotiations, especially if discussions take place over time.
Examples of types of commercial transactions where letters of intent are commonly used include asset sales, share sales and joint venture arrangements. A letter of intent can be especially useful where several different people within the business are involved in discussing interrelated matters, and there needs to be a record that pulls together all those different threads, or where the parties need to satisfy a potential investor or lender of their intentions. The parties may even produce a series of letters, especially when negotiations are prolonged.
Are letters of intent legally binding?
A letter of intent is a document that records the intentions of the parties who are considering entering into a legally enforceable agreement. Whilst the content of the letter is evidence of serious intent, and has strong moral force, this does not usually legally compel the parties to conclude the deal on either the terms set out within that document, or even at all.
By itself, therefore, a letter of intent is not normally legally binding, and is not a substitute for a final contract. To be legally binding, among other things, both parties must intend to be bound, where the basic premise of the letter of intent is to outline the key matters agreed by the parties and record negotiations to date, without holding either party to its terms.
It is not until the parties sign a formal contract that any negotiations will be solidified into a legally binding agreement. However, as a precautionary measure, letters of intent should always start with the words ‘Subject to contract and without prejudice’. The expression ‘subject to contract’ records that none of the content is contractually binding, unless it is placed in another agreement. The ‘without prejudice’ part is simply a statement that the contents of the letter are not necessarily the parties last words on the matters outlined.
Legal implications of using letters of intent
A letter of intent is not an actual contract, but rather written confirmation of the main terms agreed in principle between the parties. However, in addition to laying the groundwork for a proposed transaction, it can be used as a framework for preliminary legally enforceable agreements that may need to be entered into before any further discussions can take place.
The fact of negotiations can give rise to a number of commercial risks, especially around privacy, as well as potentially significant abortive costs associated with management time and instructing professional advisors. To protect the parties when engaging in negotiations, a letter of intent will therefore often set out the framework for the following agreements:
- a confidentiality agreement: also known as a non-disclosure agreement, this will ensure that there are legally enforceable obligations around disclosure of discussions to third parties
- an exclusivity agreement: preventing the seller from soliciting an offer from, or negotiating with, any other party over a specified timeframe, locking out other prospective buyers and protecting the existing potential buyer from being outbid by a third party
- a non-solicitation agreement: preventing the parties from poaching each other’s employees, suppliers, customers or clients during the course of negotiations.
These types of agreement can be attached separately to a letter of intent for signing, or set out as clauses within the letter of intent itself, either as a premise upon which to agree the finer detail of each agreement or expressed as legally binding.
However, a confidentiality or non-disclosure agreement will often be put in place in advance of any letter of intent, and prior to any negotiations taking place, to pre-empt what might be discussed. A non-disclosure agreement should always be entered into very early on in any negotiations. This is because the process of investigation undertaken by a buyer, known as due diligence, involves disclosure by the seller of significant amounts of commercially sensitive information about their business. A properly drafted non-disclosure agreement will help to prevent the buyer from taking unfair advantage of that information, using it for their own gain.
A non-disclosure agreement can also work both ways, where there is an obligation on either party not to disclose certain information during pre-contractual negotiations. Bilateral non-disclosure agreements are commonly used in mergers and acquisitions, where both sides will be sharing confidential aspects of their respective businesses. Equally, a bilateral agreement can be used where both parties are keen to keep quiet that they are negotiating in connection with a possible sale, especially when it comes to the corporate workforce or competitors.
How should a letter of intent be drafted?
In many corporate transactions, the legal work will be driven by the buyer, where letters of intent are generally drafted by or on behalf of the buyer, to be sent to the seller for review. However, either party can produce a letter of intent, or series of letters, setting out the preliminary terms agreed at that stage, in as much or as little detail as they choose.
A letter of intent is not intended to be an exhaustive document, but rather designed to record the parties intentions and provide a blueprint for the transaction, where the level of detail to be included is down to the parties. By adding clear and cogent detail to the letter of intent should mean there is less to negotiate in the principal agreement, while too much detail may delay a deal, duplicating work when it comes to drafting the long form documents.
The general rule of thumb is that the letter of intent should include enough detail to clarify the key points of legal and commercial principle, and provide a clear basis on which the parties can proceed to a more detailed and definitive agreement. It is important that the parties do not get bogged down in too much detail when drafting a letter of intent, as this can lead to protracted negotiations and higher costs before the sale process has even properly begun. In contrast, a well-defined letter of intent can be used to help focus the parties minds and highlight any major issues that are not yet agreed, reducing time and costs in the long run.
Given the largely non-binding nature of letters of intent, it is often tempting not to instruct lawyers at this stage to draft the necessary content. However, by having professional input from the outset, this can help to create clarity, providing a clear basis on which to proceed. Importantly, letters of intent can also occasionally have legal force, even if unintended, where care must be taken when drafting this document. The legal effect of a letter of intent depends on its construction, where expert and strong non-legally binding language must be used.
What should a letter of intent include?
A letter of intent will typically cover a range of issues, although every document will need to be tailored to the proposed transaction in question. There is no required layout or structure, and can be as formal or informal as the parties like, although the key points should include:
- the names and details of the parties to the deal
- a description and key details about the proposed transaction
- the provisional sale price, if agreed, and any pricing structure, ie; how this will be paid
any confidentiality, exclusivity or other legally binding pre-contract provisions - the preliminary agreed terms of the principal agreement
- the scope of the due diligence process
- any warranties and indemnities in relation to risks and liabilities
- the key obligations of both parties during the course of negotiations, including responsibility for drafting the principal agreement and other transaction documents
- any pre-conditions or contingencies that must be met prior to signing the contract, such as the production of critical documents, completion of the due diligence process, or obtaining regulatory approvals or third party consents, for example, from shareholders
- any post-completion restrictive covenants, such as for the seller not to compete with the buyer for a specified period of time within a set geographical area upon completion
- the law and jurisdiction that will govern the principal agreement
- a timetable and target completion date, where if the deal has not been concluded after the closing date passes, then the letter of intent should be considered terminated.
Letters of intent will often include a preamble, recording the parties intentions and expectations, providing a context within which the preliminary terms can be reviewed and reassessed. The document should also include a declaration of legal effect, clarifying the non-legally binding nature of the letter of intent and, where relevant, those clauses which are intended to be legally enforceable, for example, any confidentiality or exclusivity provisions.
Finally, where relevant, it can be useful to provide a written rationale or explanation of a particular stance taken on certain issues, for example, where a party is unable to do otherwise because of regulations or commitments to third parties. This can then serve as a useful reminder of where negotiations are at and any obstacles that may still need to be overcome.
Legal disclaimer
The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal advice, nor is it a complete or authoritative statement of the law, and should not be treated as such. Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission. Before acting on any of the information contained herein, expert legal advice should be sought.
Author
Gill Laing is a qualified Legal Researcher & Analyst with niche specialisms in Law, Tax, Human Resources, Immigration & Employment Law.
Gill is a Multiple Business Owner and the Managing Director of Prof Services - a Marketing Agency for the Professional Services Sector.
