Tips re Letters of Intent

by Scott Edward Walker on December 8th, 2010

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat (one of my favorite websites for entrepreneurs).  Below is a longer, more comprehensive version.  Please shoot me any questions you may have in the comments section (or via the “Ask Scott Any Question” link if you prefer confidential treatment).  Many thanks, Scott

Question

I’m the founder and CEO of a successful startup and we’ve been trying to sell certain non-core assets (including some IP) to a competitor.  Their CEO sent me a letter of intent, which I signed and emailed back to him last week.  Now I just received a much better offer from another company and was wondering if I can back out of the first deal.  I read some articles on the web that letters of intent are non-binding – so I just wanted to make sure.

Answer

Whether a particular letter of intent (LOI) — sometimes referred to as a “term sheet” or “memorandum of understanding” — is binding or not depends upon the precise language used in the LOI and the actions of the parties.  Indeed, parties typically do not want an LOI to be binding because many of the material terms of the deal have not been negotiated (and they do not want a Court to start filling-in the terms in the event of litigation).

There may, however, be certain provisions that the parties do want to be binding.  For example, in the acquisition context, the acquiror would generally want to prevent the seller from shopping the deal subsequent to the execution of the LOI.  Accordingly, a so-called “no shop” provision is generally included in the LOI and deemed binding.  Here are three tips regarding LOI’s:

Use Clear, Consistent Language.  LOI’s are sometimes drafted and signed by business people without vetting by the lawyers.  As a result, one party often finds itself in the awkward position of having a binding agreement on its hands when that was never the intent.

As noted above, the language in the LOI is critical in determining whether an LOI is binding.  If you don’t want an LOI to be binding you must include very specific language to the effect that:

This letter is merely an expression of intent and is intended to serve as a basis for negotiating a definitive agreement and the related documents; it does not constitute, and will not give rise to, any legally binding obligation on the part of the parties hereto and is expressly subject to the execution of such agreement and documents.

The letter should also include words such as (i) “would” (e.g., “the purchase price would be $_____) as opposed to “shall” or “will”; and (ii) “this proposal” or “the possible transaction” as opposed to “this agreement” or “the deal”.

If any provisions will be binding, you should add clear language to the effect that: “Notwithstanding anything in this letter to the contrary, the following obligations will be binding on the parties hereto:”

Act in a Manner Consistent with the LOI.  Not only is the language in the LOI critical in determining whether a binding agreement has been reached, but also the actions of the parties post-signing.  Indeed, many startups have gotten themselves into trouble when, despite the language in the LOI that it is non-binding, they have acted as though an agreement has been reached.  For example, if the LOI is “non-binding,” you should not be having drinks to “celebrate the deal” or you should not be sending “congratulatory” emails.  Nor should there be any partial performance by any party.

Include Language That There is No Duty to Negotiate in Good Faith.  It is generally advisable to include language in the LOI to the effect that: “Neither party hereto has an obligation to negotiate a definitive agreement in good faith.”  This is because many courts have imposed a duty to negotiate in good faith in connection with LOI’s and the related negotiations (even if the LOI is silent with respect to this issue).

Accordingly, you don’t want to run the risk that you walk away from a “non-binding” LOI and terminate negotiations thinking that there’s no problem – only to be handed a summons and complaint suing you for failure to negotiate in good faith.  This is a gray area and big companies (with deep pockets) can exploit this issue if you’re not careful.

Conclusion

I hope the foregoing is helpful.  My advice to my clients is to have all LOI’s vetted by counsel prior to execution.  Indeed, the common practice in New York among sophisticated M&A practitioners is simply to create a bullet-point list of agreed-upon terms — and not to execute an LOI.  As I discuss in my post “Ask the Attorney – Acquiring a Company (Part 1),” exclusivity can be handled via a separate exclusivity letter.

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