A letter of intent (LOI) is the short document in which a buyer sets out the main terms on which it proposes to acquire a company, before the parties spend the time and money to negotiate a full purchase agreement. In a private equity context it may be called a term sheet, an offer letter or a final bid letter, and in a competitive auction the final bid letter often plays the same role. Whatever the name, it is where price, structure, timing and the most important protections are first written down.
Most of an LOI is not legally binding. The parties are not obliged to sign a deal on those terms. But the LOI still matters a great deal: it sets the anchor for every later negotiation, and the few clauses that are binding, above all exclusivity, change who has leverage. Terms left vague in an LOI tend to be decided later in the buyer's favour, because by then the seller has stopped talking to anyone else.
This topic covers the binding and non binding parts of an LOI, how the headline price and its basis are defined, consideration and financing, exclusivity and break fees, conditions, a sample term table, and a worked comparison of two LOIs that shows why the higher headline is not always the better offer.
Key takeaways
- The economic terms of an LOI are usually non binding; exclusivity, confidentiality, costs and governing law usually are.
- A headline price is only meaningful with its basis: cash free, debt free, a defined normal working capital peg, and a clear list of what counts as debt.
- The mix of consideration (cash at closing, rollover, seller notes, earnouts, escrows) and the certainty of financing can move the value of an offer more than the headline price.
- Exclusivity hands leverage to the buyer, so a seller should keep it short and settle the important terms before granting it.
- Compare LOIs by the present value of what the seller actually receives, weighted for the chance of closing.
What an LOI binds, and what it does not
An LOI normally says, in terms, that it is non binding except for a listed set of provisions. The non binding part describes the deal: price, structure, consideration, financing, key conditions and the expected timetable. Neither side can sue the other for failing to sign on those terms. The binding part governs the negotiation itself: exclusivity (the seller will not talk to other buyers for a period), confidentiality (often by reference to the NDA already signed), each side bearing its own costs, and governing law.
The line is not always as clean as the parties think. Courts in some US states, Delaware and New York among them, have in some cases found an enforceable obligation to negotiate in good faith in a document both sides treated as preliminary, particularly where the language suggested a commitment. Careful drafting states clearly which clauses bind. For the same reason, parties avoid describing an LOI as an agreement to agree on specific terms unless they mean it.
Even the non binding terms carry weight. Deviating from them later without a reason found in diligence is called a re-trade, and it costs a buyer credibility with the seller and with the banker running the process. A sponsor's investment committee therefore usually approves the LOI terms, not just the final deal, because walking back from them is expensive.
| Provision | Usually binding? | Why |
|---|---|---|
| Purchase price and basis | No | Subject to diligence and definitive documents |
| Consideration mix and structure | No | Subject to tax, financing and legal work |
| Financing description | No | Commitments come in separate letters |
| Conditions and timetable | No | Expectations, refined in the SPA |
| Exclusivity (no shop) | Yes | The buyer's protection for its diligence spend |
| Confidentiality | Yes | Usually refers back to the NDA |
| Expenses | Yes | Each party bears its own unless stated |
| Governing law and termination | Yes | Needed for the binding clauses to work |
The headline price and its basis
An LOI states a price, but the number means nothing without its basis. The standard US convention is an enterprise value on a cash free, debt free basis, assuming a normal level of net working capital. Cash free, debt free means the seller keeps the cash and repays the debt at closing, so the buyer pays for the operating business alone. In practice this happens in the funds flow: the buyer pays the enterprise value, debt is paid off and cash is credited to the seller out of that amount.
Normal working capital, the peg, is the level of receivables plus inventory less payables and accrued liabilities that the business needs to run at its current scale. It is usually set as an average over the trailing twelve months, adjusted for seasonality and one-off items, so that the seller cannot inflate the price by collecting receivables early or delaying payments just before closing. At closing an estimate is used, and a post closing true up compares the actual figure with the peg; a shortfall reduces the price dollar for dollar and an excess increases it.
The definition of debt is where much of the value sits. Beyond bank loans and bonds, buyers seek to treat as debt like items anything that is a claim on the business accrued before closing: unpaid taxes, unpaid bonuses, deferred purchase price from earlier acquisitions, finance leases, deferred capital expenditure and sometimes customer deposits or deferred revenue. Each item added to the definition reduces the seller's proceeds by its amount, so an LOI that leaves debt undefined is leaving price open.
- Enterprise value
- The headline price on a cash free, debt free basis.
- Debt and debt like items
- As defined in the LOI and later the SPA; the list is negotiated.
- NWC peg
- The normal level of net working capital, usually a trailing twelve month average.
Consideration, financing and certainty
Consideration is how the price is paid. All cash at closing is the cleanest. A rollover lets the seller or management reinvest part of the proceeds into the buyer's new holding company, which aligns incentives and reduces the cash the sponsor must find, but leaves the seller exposed to the deal. A seller note defers part of the price as a loan from the seller to the buyer, usually subordinated to the bank debt. An earnout pays more if the business hits targets after closing, which bridges a valuation gap but is a common source of disputes over how the buyer ran the business. Escrows and holdbacks keep part of the price back to secure indemnity claims or the working capital true up.
Financing certainty matters as much as price. A buyer with committed debt financing, backed by signed commitment letters, and an equity commitment letter from its fund, is far more likely to close than one whose offer is subject to raising financing. Public company style deals add a reverse termination fee, paid by the buyer if it fails to close for financing reasons, which gives the seller a remedy. An LOI should say whether the deal has a financing condition at all; in competitive US sponsor deals the norm is no financing condition.
Conditions are the other side of certainty: regulatory clearances, third party consents to change of control in key contracts, completion of confirmatory diligence, and sometimes the signing of new employment agreements with key managers. Each condition is a way for the deal not to happen, and sellers try to keep the list short.
| Form | What it is | Main risk to the seller |
|---|---|---|
| Cash at closing | Paid in full on the closing date | None beyond the true up |
| Rollover equity | Part of proceeds reinvested in the buyer's holding company | Performance of the deal and its leverage |
| Seller note | Deferred price as a subordinated loan | Credit risk of a leveraged buyer |
| Earnout | Extra payment if targets are met | Targets missed, disputes over how the business was run |
| Escrow or holdback | Part of price held back for claims | Claims reduce what is released |
| Buyer stock | Shares of the acquirer | Acquirer share price and liquidity |
Exclusivity, break fees and the sample term table
Exclusivity, or a no shop, stops the seller from soliciting or negotiating with other buyers for a set period, commonly 30 to 60 days in a sponsor deal and sometimes longer for complex carve outs. The buyer needs it to justify spending heavily on legal, accounting and financing work. The seller should limit it in time, tie its extension to progress, and where possible include a fall away if the buyer seeks to cut the price.
Break fees are less common in private deals than in public ones. In a public merger, a target termination fee, often a few percent of equity value, compensates a buyer that loses to a superior proposal under a fiduciary out. In private sponsor deals, the more relevant protection for the seller is the reverse termination fee, and for the buyer it is the exclusivity itself plus, occasionally, expense reimbursement if the seller walks away.
The table below shows the terms a well drafted sponsor LOI typically covers. Not every LOI covers all of them, but each term left out is a term to be negotiated after exclusivity has been granted.
| Term | Proposed provision |
|---|---|
| Transaction | Acquisition of 100 percent of the equity of Pemberton Labs, Inc. |
| Enterprise value | $300m on a cash free, debt free basis |
| Working capital | Peg $25m, the trailing twelve month average, subject to diligence |
| Debt definition | Funded debt, finance leases, accrued and unpaid pre-closing income taxes, unpaid bonuses for prior periods |
| Consideration | All cash at closing |
| Management rollover | Senior management to reinvest at least 20 percent of after-tax proceeds, on the same terms as the sponsor |
| Financing | Committed debt financing and an equity commitment letter at signing; no financing condition |
| Indemnity and insurance | Buyer to obtain R&W insurance; seller liability limited to fundamental reps, tax and fraud |
| Key conditions | HSR clearance, consent under two named customer contracts, confirmatory diligence |
| Diligence | Financial and tax QoE, legal, commercial, IT and cyber, insurance; 30 days |
| Exclusivity | 45 days, extendable by 15 days if the parties are negotiating in good faith |
| Binding provisions | Exclusivity, confidentiality, expenses, governing law; all else non binding |
Comparing two LOIs
When two LOIs differ on several terms at once, the cleanest comparison converts each into the present value of what the seller expects to receive, then weights for the chance of closing. The discount rates and probabilities are judgments, and the seller's banker should show how sensitive the ranking is to them. The aim is not a precise number but a comparison on common ground.
In the example below a higher headline price comes with a higher peg, deferred consideration, an escrow and softer financing. Each element is modest by itself; together they reverse the ranking.
Pemberton Labs: two LOIs on common ground
- Pemberton Labs, a hypothetical contract testing laboratory. Net debt at closing $60m. Normal working capital, and the amount the seller expects to deliver, $25m. Figures in $m; seller transaction costs ignored for both.
- LOI 1: EV $300m, all cash at closing, peg $25m, committed financing, R&W insurance and no escrow. Probability of closing judged at 95 percent.
- LOI 2: EV $320m, paid as $260m cash at closing, a $30m seller note (6 percent coupon paid annually, five years) and a $30m earnout payable in year 2. Peg $28m. Escrow of 10 percent of EV for 18 months. Financing subject to raising debt; probability of closing judged at 80 percent.
- Seller assumptions for LOI 2: note and escrow discounted at 12 percent; earnout 40 percent likely, discounted at 15 percent; 90 percent of the escrow expected to be released.
- 1. LOI 1 equity proceeds, all at closing300 - 60 + (25 - 25)$240.0m
- 2. LOI 2 headline equity value320 - 60 + (25 - 28)$257.0m
- 3. LOI 2 cash at closing before escrow260 - 60 + (25 - 28)$197.0m
- 4. LOI 2 escrow withheld10% x 320$32.0m
- 5. LOI 2 cash received at closing197.0 - 32.0$165.0m
- 6. PV of seller note1.8 x 3.6048 + 30 / 1.12^5 = 6.5 + 17.0$23.5m3.6048 is the five year annuity factor at 12 percent.
- 7. PV of earnout30 x 40% / 1.15^2$9.1m
- 8. PV of escrow release32.0 x 90% / 1.12^1.5$24.3m
- 9. LOI 2 present value165.0 + 23.5 + 9.1 + 24.3$221.9m
- 10. Risk weighted, LOI 1240.0 x 95%$228.0m
- 11. Risk weighted, LOI 2221.9 x 80%$177.5m
LOI 2 is $20m higher on headline EV but worth $18.1m less in present value before any risk weighting, and $50.5m less once its financing risk is counted. The seller should prefer LOI 1, or use LOI 2 to ask the first bidder for more, not accept the higher number.
Templates for this lesson
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- WordMutual NDAAn illustrative mutual non disclosure agreement for an M&A process, with drafting notes. Not legal advice.Download
- WordLetter of intentAn illustrative non binding LOI for a control acquisition, cash free and debt free with a working capital peg, plus a term summary. Not legal advice.Download