July 2009
Hadef & Partners' M&A team discuss the various approaches to drafting letters of intent including the ways in which such can in fact impede or endanger the deal process if not handled carefully.

In brief:
An LOI, is an important first step in recording key commercial intentions sufficiently so that each side can proceed with a proposed transaction
The interpretation by a seller of an LOI can constitute an obstacle to successfully closing a transaction
An LOI should include the possibility of re-opening key commercial issues such as price and payment if due diligence or developments in the deal process shows this is necessary
An LOI can bridge the gap of expectations between a seller and buyer with respect to the detail of documentation in the transaction process.

There are different schools of thought regarding the merits of a letter of intent (LOI). The "old school", tends to be of the opinion that the best letter of intent is no letter of intent.

The "new school", however, recognises the commercial value of an LOI, as an important first step in recording key commercial intentions sufficiently so that each side can proceed with a proposed transaction.

This interpretation by a seller of an LOI is particularly prevalent in the UAE and GCC and can constitute an obstacle to successfully closing a transaction, or equally as important, closing the transaction efficiently. The approach to an LOI in the region most likely stems from the strong trading culture. From a trader's perspective, an LOI is the deal and any further terms beyond this or re-opening of such deal points can be viewed as trying to back out of a bad deal fairly made.

In developed markets, the size and sophistication of the goods being traded increased dramatically with the industrialisation, corporatisation and finally globalisation of trade and the need for more detailed legal documentation arose. The matrix of representations, undertakings and obligations to document the detail of the actual deal being made became much more sophisticated. By practice, an LOI became a document that summarised some key deal points, but the general expectation and understanding was that any such deal was pending agreement on the detailed matrix of terms.

In the emerging markets, by definition, the terms of the deal are increasing in sophistication to rival developed market deals but the custom and practice of deal making, may in many cases, develop more slowly. Therefore, a seller in this region may expect relatively non-detailed deal documentation, and if not carefully managed, an LOI can simply reinforce this expectation.

The optimal approach to an LOI, may well be to use the LOI to bridge the gap in expectations. The LOI should clearly set out the expectation of further, detailed and potentially onerous obligations. It should include the possibility of re-opening key commercial issues such as price and payment if due diligence or developments in the deal process shows this is necessary.

This approach is not without its own risks, and one risk which quickly presents itself is that such provisions risk taking the wind out of the sails of what may have been a very pleasant negotiating experience for the deal makers and risk the momentum of the deal at an early and possible delicate stage in negotiations. However, all deals raise issues unknown at the time of signing an LOI, and as optimistic as a deal maker may be, there is no getting around the fact that in almost every case, and even more so in an emerging market, the deal process will raise issues that will be price sensitive or which will effect other key commercial terms of the deal or require onerous obligations from the seller which had not been conceived of at LOI stage. Considering the inevitability of the former, there are strong arguments for bridging the gap in expectations and confronting these potential problematic issues at an early stage in the deal process. This approach should be seen as preferable to the risk of a party walking away later, not least because of the expenses of due diligence and initial documentation incurred.

A buyer's negotiating position at this later point will often be weakened by incurring such costs, having made initial announcements to the market or to stakeholders, losing face and reputation for failing to close the transaction, and the disappointment factor where initial board approval for the transaction was already obtained and there is a general "buy in" and excitement from senior management regarding the potential deal. All of these risks of a deal collapsing at a late stage also raise awareness of a further risk which, is that to avoid these risks, the deal maker proceeds with a "bad deal" or concedes key points or risks in order to avoid the deal collapsing. Including detailed provisions in a LOI related to the deal process and documentary expectations significantly lowers the risk of subsequent deal breakers and therefore also the risk of making bad deals.

Bearing this in mind we set out some of the matters that should, at least, be raised in an LOI and some comments on the nature of the expectations or intentions expressed by these provisions.

Sponsorship relationships
Where a foreign entity is acquiring all or a majority of a company where an existing sponsor relationship exists, the LOI should clearly set out the intention of the parties in dealing with the sponsor. If the buyer intends to bring its own sponsor (highly recommended), then the obligation to have the old sponsor bow out gracefully and if not gracefully at least at the expense of the seller needs to be clear. If the buyer intends to keep the existing sponsor then obligations for having the sponsor enter into new terms with the buyer and agree a fee in a similar amount should also be clearly detailed.

This is a sensitive issue in many acquisitions as the relationship involves issues of status, of culture and also potentially a loss of income stream for the sponsor or a conflict of interests. A new market entrant may not be sure of its intentions with respect to the sponsor or maybe unsure if it can find its own sponsor. It may be concerned about upsetting the business model. All of these issues mean that a buyer often leaves this issue not discussed or unresolved until later in the deal process when the buyer or seller can find later that the entire transaction can be held to ransom. If allocation of risk and cost for this issue is dealt with in the LOI then this will go a long way to difusing the issue if it arises later.

Due Diligence
Most LOIs state an intention for due diligence to be carried out. However, an LOI should go somewhat further and state the intention and purpose of the due diligence. There is always a risk in the region that a due diligence process is considered by a seller to purge it of any further liability regarding the business whatsoever. Importantly, therefore, a buyer will want to establish that the due diligence process is not a substitute for appropriate warranties and that any matters unveiled by the due diligence process can serve as either a basis for detailed warranties, indemnities and possibly price re-openers. Alternatively a seller may want to establish its intention that due diligence will at least satisfy its obligations of disclosure and that the buyer will be on notice of any matters included in the due diligence documents provided.

Price and payment
Price is always a sensitive issue to a seller, and where an LOI establishes a price, there is the risk that a seller starts to mentally spend (or at least allocate) the purchase price from the date of signing the LOI. Where during the transaction process, the buyer uncovers liabilities against the business, related party debts or similar justifiable offset amounts; the reaction of a seller can be that he is starting to lose money on the transaction or that the buyer is going back on the deal as agreed. This risk is increased where the seller is an individual or family, as is more common in emerging markets.

Therefore, an LOI should include a statement of the possibility of liability off-sets or deductions uncovered by the due diligence process or re-openers against the price. While this is unlikely to make a seller fervently embrace future deductions of the purchase price, it at least provides a basis for meaningfully discussing the merits of such deductions or adjustments and a basis for difusing the emotional element that will likely rise in the seller. A seller may use the LOI to justify his ideas that he is being cheated or the buyer is going back on his deal. It is the ability to rationalise the emotion in this way that leads to a sense of justification on the part of the seller and can act as a real deal breaker to negotiations and the relationship as a whole. If the LOI is very clear on the point, the buyer has a better chance of preventing the seller from applying this pressure.

Warranties
Warranties although initial, should be addressed when and to the extent strictly necessary. Accordingly, when drafting an LOI, many do not mention warranties.

A statement of intent on warranties can make the transaction process more efficient through clarity and should be considered.

Such an intention can be as simple as referring to "appropriate warranties for the nature of the transaction" to having a brief list of those subject matters for which warranties may be required in a form such as, for example, "warranties to secure that seller owns all assets", "warranties that seller has no undisclosed liabilities". The latter is effective at giving the seller a quick glimpse behind the looking glass into the sheer quantity of warranties that may be required and set expectations at an appropriate level. A brief list of subject matters for warranties will, once read, often appear very intuitive to a seller and seem fair and reasonable requests form the buyer. It may be significantly easier to have a seller read and agree to such an indicative list in an LOI than in an acquisition agreement.

Conclusion
An LOI, is quite simply a "statement of intent" with respect to a deal. As such, the more clear and transparent ones intent is shown at the courting stage, the less chance there is of a breakdown during the negotiation of the pre-nuptial. Most breakdowns in a transaction arise from a disconnect in expectations or a miscommunication of intentions, rather than from any deliberate bad faith negotiating on behalf of the buyer or seller. Closing a deal, for either buyer or seller is a highly sensitive and emotionally charged part of the deal process. 

The closer you get to the closing of a transaction the higher the emotion, the more complex the psychology and the greater the stakes of the deal collapsing or a bad deal being made to avoid deal collapse. In such a cauldron, the perception of a change in intentions or a gap in expectations can take exaggerated significance and lead to the collapse of what covered otherwise be a good deal.

An LOI, if drafted along the lines of the approach indicated above, can be a great tool to mitigate against the moveable feast of intentions and expectations that arise in all deals.

By Jeremy Miocevic

© Hadef & Partners 2009