LOI

What is an LOI?

LOI (letter of intent) is a document in which the parties to a planned transaction declare their intention to negotiate towards a contract and record the key points reached so far. An LOI as a rule creates no obligation to conclude the main contract.

The term belongs to company acquisitions. There the LOI sits between the first offer and the purchase agreement. After an initial review, the prospective buyer sets price and structure. In return, the seller usually grants exclusivity, that is, the commitment to negotiate only with that buyer for a certain period. The buyer uses this period for the review of the company (due diligence) and contract negotiation. Memorandum of understanding (MoU), heads of terms or key terms paper (Eckpunktepapier) are used synonymously. In funding rounds, the corresponding document is called a term sheet.

Content of an LOI in a company sale

The more precisely the LOI regulates the economically important points, the less room remains for later renegotiation. Customary are:

• Subject and structure: purchase of the shares (share deal) or of individual assets (asset deal), scope of the stake, where applicable a re-investment in which the sellers reinvest part of the proceeds in the acquirer.
• Purchase price and valuation basis: enterprise value on a basis free of liquid funds and financial liabilities (cash-free, debt-free). From the enterprise value, net debt, that is, financial debt less liquid funds, is later deducted. In addition come a reference value for working capital (the capital tied up in the ongoing business) and the definition of debt-like items.
• Purchase price mechanism: fixed price as of a reference date in the past (locked box) or adjustment on the basis of accounts as of the closing date (completion accounts).
• Payment structure: share paid at closing, retention in an escrow account as security for the buyer's claims, performance-related deferred payment (earn-out) or vendor loan, under which part of the purchase price is deferred.
• Liability concept: scope of the warranties, liability cap, limitation period and, where applicable, warranty insurance.
• Management and staff: future role of the founders, employment contracts, retention programmes and non-compete covenants.
• Process: scope and duration of due diligence, timetable, closing conditions such as regulatory clearances (merger control, investment screening) and evidence of financing (proof of funds).

Binding and non-binding parts of an LOI

The economic key points are as a rule expressly non-binding. After due diligence, the buyer may offer a different price or end the negotiations, and so may the seller. Binding, by contrast, are usually the exclusivity for a specific period (exclusivity period) and confidentiality, insofar as it is not already regulated by a non-disclosure agreement (NDA). In addition come the allocation of costs as well as choice of law and place of jurisdiction, in some cases also non-contact and non-solicitation provisions.

The LOI should expressly state which clauses are binding. Unclear wording can lead a court to assume a commitment that neither side wanted.

Formal questions on the purchase of GmbH shares

In the purchase of GmbH shares (shares in a German limited liability company), even the obligation to assign requires notarisation (Section 15(4) of the German Limited Liability Companies Act, GmbHG). A non-binding LOI is therefore free of form. If it contained a genuine obligation to sell or buy, it would be invalid without notarisation. High lump-sum payments in the event of abandonment can also create an indirect compulsion to conclude; whether notarisation is then required must be examined in the individual case.

Liability on breaking off negotiations

In principle, each party may break off negotiations at any time and without giving reasons. This also applies after signing an LOI, insofar as it does not bindingly provide otherwise. With the start of contract negotiations, however, a pre-contractual relationship arises with duties of consideration (Section 311(2), Section 241(2) of the German Civil Code, BGB).

Liability for reimbursement of expenses that have become useless (Section 280(1) BGB) comes into consideration only exceptionally. This is the case, for example, if a party has presented the conclusion of the contract as certain and then broken off without good reason, or never seriously intended to conclude. For contracts that, like the purchase of GmbH shares, must be notarised, case law applies even stricter standards, because otherwise the form requirement would be undermined. Anyone who wants to secure costs in the event of abandonment therefore needs an express cost clause.

The LOI in the sale process

In a structured auction process, interested parties first submit an indicative offer, often with a price range. The shortlist receives access to the data room and then submits a binding offer, which despite its name is usually still subject to reservations. An LOI with exclusivity then often follows only with the selected bidder or is dispensed with because the purchase agreement is negotiated directly. In a negotiation with a single interested party, by contrast, the LOI comes early and forms the basis of the entire further review.

With signing, negotiating power shifts. As long as several interested parties are in discussions, the offers compete. With exclusivity, this competition ends, and what the LOI leaves open is negotiated without this pressure.

Worked example: from the enterprise value in the LOI to the purchase price

An LOI names for a software company an enterprise value of EUR 40 million on a basis free of liquid funds and financial liabilities. It also sets a reference value for working capital of EUR 3.0 million and a retention of EUR 2 million for 18 months. At closing, liquid funds of EUR 2.5 million and financial liabilities of EUR 6.0 million result. Deferred remuneration of EUR 0.5 million counts as a debt-like item, and actual working capital is EUR 2.6 million.

• Net debt: 6.0 financial liabilities minus 2.5 liquid funds = EUR 3.5 million
• plus debt-like items: 3.5 + 0.5 = EUR 4.0 million adjusted net debt
• Working capital shortfall: 3.0 minus 2.6 = EUR 0.4 million
• Purchase price for the shares (equity value): 40.0 minus 4.0 minus 0.4 = EUR 35.6 million
• Payment at closing after retention: 35.6 minus 2.0 = EUR 33.6 million

This bridge from enterprise value to the purchase price for the shares is called the equity bridge. Of the EUR 40 million in the LOI, the sellers receive EUR 33.6 million at closing and a further EUR 2 million after the retention expires, provided no claims are asserted. If the LOI lacks the definition of debt-like items and the reference value for working capital, precisely these items are negotiated after due diligence, then without competition among bidders.

Distinctions: LOI, term sheet, preliminary contract and definitive agreement

• Term sheet: key points of a funding round with valuation, investment amount and investor rights such as liquidation preference, anti-dilution protection and consent reservations. The LOI regulates the purchase of a company with purchase price mechanics, liability and closing.
• Indicative offer: a bidder's first price indication, often as a range and without exclusivity. The LOI is more concrete and as a rule linked to exclusivity.
• Preliminary contract: obliges the parties to conclude the main contract and, in the purchase of GmbH shares, requires the same notarial form. The LOI specifically does not create such an obligation.
• Definitive agreement: the final, binding purchase agreement that replaces the LOI.

Common mistakes

• Purchase price without a bridge. An enterprise value without a definition of net debt, debt-like items and reference for working capital leaves open what amount reaches the sellers.
• Unclear binding effect. If there is no express rule on which parts are binding, disputes about an unintended commitment and, for GmbH shares, formal problems threaten.
• Exclusivity without an end date. Open-ended or automatically extending exclusivity deprives the seller of the alternative for an indefinite time.
• Essentials left open. Liability concept, earn-out metrics or the role of the founders, if negotiated only after the LOI, enter the negotiation without competition.
• Buyer's financing not checked. An LOI without reliable evidence that the buyer can finance the price ties the seller to an uncertain partner.

Frequently asked questions

Is an LOI legally binding?

Mostly not. The economic key points are as a rule non-binding; usually only exclusivity, confidentiality, costs and choice of law and place of jurisdiction are binding. In the individual case the wording of the LOI decides.

Does an LOI have to be notarised?

No, provided it does not create an obligation to buy or sell shares. Notarisation concerns only the purchase agreement.

Can the buyer still lower the price after the LOI?

Legally yes, because the key points are non-binding. Economically, the buyer generally needs a finding from due diligence that supports the deviation. Renegotiation without a new set of facts damages the buyer's credibility.

How long is an LOI?

Usually a few pages. It becomes more extensive if purchase price mechanics, liability concept and earn-out are already regulated in detail, which shortens the later contract negotiation.

Who signs the LOI?

On the seller's side the selling shareholders, often also the company, insofar as it commits to exclusivity or confidentiality. For the buyer, persons with power of representation sign, for financial investors often subject to the approval of their investment committee.

The Roemer Capital view

When several offers are on the table, Roemer Capital converts each to the same yardstick: purchase price for the shares, payment at closing, retentions, earn-out and liability framework. Only this comparison shows which offer is ahead economically, because the stated enterprise value alone says little about it.

Before exclusivity is granted, Roemer Capital negotiates with the client's law firm the points that are hardest to change later. These are the definition of net debt, the reference value for working capital, the liability concept and a fixed end to exclusivity. The wording of the binding parts rests with the law firm; the economic assessment and the negotiation of the figures rest with Roemer Capital.