Using Letters of Intent to Keep Deals on Track Amid Uncertainty

Letter of Intent (“LOI”) negotiations during times of uncertainty present many intricacies.  Navigating the complexities and safeguarding your position is vital to a successful outcome.

 

1. In the midst of economic uncertainty, with rising interest rates and shifting valuations, now more than ever, it is important to negotiate LOIs in a way that memorializes concretely the agreement of the parties. 
2. Often Overlooked: LOIs are usually an afterthought.
3. General View: LOIs are just a framework that are not legally enforceable (unless they specifically say: “This is legally enforceable”).
4. Rethinking That Position: An LOI may be enforceable; even where the parties don’t commit to a binding LOI.
5. Not So Fast: Most parties rush to begin formal negotiations and use an LOI as a roadmap; dealmakers often execute an LOI without fully considering its ramifications.

 


The Confusing World of LOIs
 
In an article that I co-authored in June with my colleagues, we explored the intricate world of LOIs in contract law. Commonly used to outline deal structures and express the intentions of the parties, LOIs often lead to legal disputes due to their uncertain status. Dealmakers should therefore proceed with caution and note that disclaimers alone are often insufficient to avoid binding LOIs, especially if exclusivity provisions are present.
 
We also noted in the article that choice of law may significantly impact recoverable damages. Delaware allows extensive expectation damages[1], while New York primarily limits damages to reliance damages[2]. Therefore, proper drafting and legal guidance are crucial to prevent disputes and liabilities unexpectedly arising from an LOI.  


Navigating Quality of Earnings in LOI Negotiations during Economic Uncertainty
 
At any time, but certainly during times of economic uncertainty, evaluating the quality of earnings poses a unique challenge. Buyers, particularly, must exercise caution and consider specific factors, including how interest expenses may impact target valuation.

When negotiating an LOI, a buyer should make sure it gives itself enough time to review financials and conduct a quality of earnings analysis.[3] 
 
Rising interest rates and inflation can strain a company’s ability to service its debt, potentially reducing cash flows and affecting both earnings and financial stability. To make informed decisions during LOI negotiations, evaluating a company’s debt maturity profile and interest rate risk management strategies is essential.

Valuations

Understanding the relationship between the company’s valuation and the impact of the overall economic health of the broader market is critical. For example, as interest rates increase, the present value of future cash flows may decrease, potentially influencing business valuations.
 
The uncertainties stemming from rising interest rates can also affect the transparency and reliability of reported financials, leading to concerns among potential buyers during LOI negotiations, and consequently impacting the target company’s valuation. To mitigate these valuation risks, LOI deal terms should address the effects of rising interest rates on earnings, incorporating potential adjustments, earnout provisions, or financing contingencies. By navigating these considerations in the LOI negotiation process, parties can position themselves effectively for economic uncertainty and make informed decisions to secure successful transactions.
 
 
Challenges for Buyers in Finding Lenders Amid Rising Interest Rates 

Securing financing has become more challenging for buyers for a myriad of reasons. Higher interest rates make borrowing more expensive. Also, as credit concerns come to the fore, the pool of lenders available to buyers inevitably shrinks. As a result, buyers may face delays in securing financing and completing deals. Interviewing lenders becomes crucial during LOI negotiations to gain insight into their lending criteria, risk tolerance, and potential impact on the deal.
 
Deal Terms and Actions to Mitigate Uncertainty in LOI Negotiations 

To navigate the uncertainties during LOI negotiations, several key deal terms can be employed:
 

• Earnout Arrangements: Earnout arrangements are financial mechanisms commonly used to mitigate the impact of economic uncertainty on deal negotiations. In such arrangements, a portion of the purchase price for a company is contingent upon the achievement of certain future performance milestones or objectives. This structure allows buyers and sellers to address valuation discrepancies that may arise due to uncertainty surrounding the target company’s future financial performance or market conditions. Earnout provisions serve as a win-win solution, offering both parties a degree of risk-sharing and alignment of interests.

 

• Financing Contingency: Incorporating financing contingencies into agreements, such as LOIs or acquisition contracts, becomes highly appealing. These contingencies offer a crucial safety net for both buyers and sellers, addressing the heightened financial risks and uncertainties that often accompany uncertain economic conditions.

 

• Seller Quality of Earnings: Conducting a quality of earnings (“QoE”) analysis as a seller can significantly enhance the likelihood of a sale. It may lead to a higher valuation and more productive negotiations by instilling confidence in potential buyers. Sellers who proactively assess their financial health through QoE analysis demonstrate transparency and credibility, as well as a commitment to fair dealing. This approach allows them to identify and rectify any anomalies in their financial statements, removing one-time expenses or non-recurring items that could artificially depress earnings. Moreover, addressing operational or financial issues during the QoE analysis process reduces perceived risks for buyers, streamlines due diligence, and fosters a competitive edge in the market, ultimately facilitating a smoother and more lucrative sale.

 
Not Just An Outline  

For most dealmakers, LOIs are meant to provide a strong framework for a transaction and to serve as an aid in negotiating a final contract. They are not intended to be permanent and binding. It is important to note, however, that LOIs are not merely frameworks for future agreements. These documents have legal consequences and may even be binding (especially when provisions establishing exclusivity are included).
 
Moreover, the duty to negotiate in good faith is recognized by courts in many states. If you sign an LOI, it is further evidence of the duty to act in good faith by trying to negotiate a complete agreement of sale that is reasonable in its scope and content.
 
Therefore, it is crucial for dealmakers to involve legal counsel from the start of a transaction in order to avoid being caught up in terms they might want to avoid later due to changing circumstances.
 
Conclusion
 
As economic uncertainty looms and interest rates rise, the art of negotiating LOIs takes on a new level of significance. The rush to formalize agreements must be tempered with careful consideration of potential pitfalls, such as inadvertently creating binding terms or overlooking crucial provisions.

Amid economic uncertainty, a well-negotiated LOI serves as a foundational stepping stone for successful M&A transactions. The dynamics of the market may be turbulent, but with prudence and foresight, parties can fortify their positions and move towards favorable outcomes.