When navigating the complex world of mergers and acquisitions (M&A), the Letter of Intent (LOI) is often the first significant document exchanged between the buyer and seller. While typically non-binding, an LOI sets the tone for negotiations and reflects the seriousness and intentions of both parties. For sellers, identifying red flags in an LOI can help avoid pitfalls later in the process, while buyers must ensure clarity and fairness to build trust.
In this article, we outline the most common red flags in LOIs, offering essential insights for both buyers and sellers to navigate M&A negotiations effectively.
1. Overly Vague Terms and Ambiguities
Red Flag: Unclear language or undefined key terms.
An LOI should balance detail and flexibility. However, overly vague terms—such as "reasonable," "industry standard," or "subject to further discussion"—can lead to misunderstandings and disputes. Ambiguity allows one party to reinterpret the LOI to their advantage during negotiations.
Example:
If an LOI states, "The purchase price will be
determined based on standard industry metrics," without
specifying the metrics or methods, it leaves room for conflicting
interpretations. The seller may expect a revenue multiple
valuation, while the buyer might lean toward an
EBITDA-based valuation.
What to Do:
Ensure key terms like purchase price,
payment structure, and timelines
are clearly defined. Both parties should agree on valuation
methods, metrics, and any
contingencies upfront.
2. Excessive Exclusivity Periods
Red Flag: Long or open-ended exclusivity clauses without clear deadlines.
Most LOIs include an exclusivity period (also known as a "no-shop" clause), during which the seller agrees not to negotiate with other potential buyers. While some exclusivity is standard, excessively long periods can tie up the seller unnecessarily, reducing leverage and delaying alternatives if the deal falls through.
Example:
An LOI stipulating a 6-month exclusivity
period without progress checkpoints can hinder the seller,
especially if the buyer slows down due
diligence.
What to Do:
Negotiate a reasonable exclusivity period
(typically 30-60 days) with built-in
milestones for progress. For example, exclusivity
can be conditional upon the buyer completing due diligence within a
set timeframe.
3. One-Sided Binding Provisions
Red Flag: Overly restrictive obligations imposed on one party with no reciprocal commitments.
While LOIs are typically non-binding regarding deal completion, certain provisions—like confidentiality, exclusivity, and breakup fees—are often binding. Red flags appear when these terms are heavily one-sided, favoring one party over the other.
Example:
An LOI may state that the seller must cover all
legal fees if the deal falls through, regardless of cause,
while the buyer faces no penalties for walking away.
What to Do:
Ensure that binding provisions are
fair and mutual. If the LOI
includes penalties or breakup
fees, they should apply equally to both parties if either
fails to uphold their commitments.
4. Unclear or Unfavorable Payment Terms
Red Flag: Vague payment structures or heavy reliance on earn-outs or long seller note periods.
The payment structure—whether it's all-cash, stock, or a mix—should be clearly defined in the LOI. Red flags include vague language around deferred payments, earn-outs (where part of the payment depends on future performance), or excessive contingencies that reduce the seller's certainty of getting paid.
Example:
An LOI outlining a $10 million deal but
specifying that $6 million is contingent on future
revenue milestones over three years exposes the
seller to unnecessary risk if the metrics aren't well-defined
or attainable.
What to Do:
Clarify the amount,
timing, and conditions of
payments. If earn-outs are involved, ensure performance
targets are realistic,
specific, and measurable to avoid
disputes post-closing.
5. Lack of Clarity on Due Diligence Scope
Red Flag: Vague or overly broad due diligence requirements.
Due diligence is a critical phase in any M&A deal, where the buyer reviews the seller's financials, operations, and legal matters. However, an LOI with undefined or overly broad due diligence clauses can lead to endless requests, delays, or even fishing expeditions.
Example:
An LOI stating the buyer has the right to conduct
"comprehensive due diligence on all aspects of the
business" without time limits or defined scope can
overwhelm the seller and slow down the process.
What to Do:
Outline a specific due diligence timeline
(e.g., 30-45 days) and define the
scope—such as financial records for
the past three years, legal contracts,
and key operational data—to keep the process
efficient and focused.
6. Absence of a Clear Timeline
Red Flag: No deadlines for key milestones like due diligence, contract negotiation, or closing.
Without a defined timeline, deals can drag on indefinitely, causing frustration, resource drain, and potential loss of alternative opportunities.
Example:
An LOI stating, "The parties will work towards
closing the transaction in due course," provides no
concrete timeline, allowing either party to stall without
repercussions.
What to Do:
Include specific deadlines for major
milestones, such as:
- Due diligence completion: 30 days from LOI signing
- Drafting of the purchase agreement: Within 15 days after due diligence
- Target closing date: No later than 90 days post-LOI
7. Overly Broad Non-Compete or Restrictive Covenants
Red Flag: Non-compete clauses that are too broad in scope, geography, or duration.
While non-compete or non-solicitation clauses are common, they should be reasonable and specific. Overly broad restrictions can unfairly limit the seller's future business opportunities, even if the deal doesn't close.
Example:
An LOI that prohibits the seller from engaging in
any related business worldwide for five
years, even if the deal falls through, is excessive.
What to Do:
Negotiate reasonable limitations on
scope (specific industries),
geography (regions where the buyer operates), and
duration (typically 1-2
years).
8. Missing or Weak Confidentiality Clauses
Red Flag: Lack of strong confidentiality provisions protecting sensitive information.
M&A discussions often involve sensitive financial, operational, and proprietary information. If the LOI lacks strong confidentiality clauses—or worse, omits them entirely—it opens the door for misuse or unauthorized sharing of information.
Example:
An LOI without a confidentiality clause
could allow the buyer to share sensitive financial
data with competitors or use it as leverage in future
negotiations.
What to Do:
Include robust confidentiality provisions
ensuring all shared information remains private,
regardless of whether the deal closes.
9. Inflexible or Unreasonable Conditions Precedent
Red Flag: Excessive or unrealistic conditions that must be met before closing.
Conditions precedent are events or actions that must occur before a deal can be finalized. When these conditions are too numerous or unrealistic, it signals a lack of commitment or an attempt to renegotiate terms later.
Example:
An LOI requiring the seller to secure multiple
third-party approvals or meet unrealistic
financial performance targets before closing gives the
buyer an easy exit if desired.
What to Do:
Ensure that conditions are reasonable,
achievable, and clearly defined.
Both parties should agree on essential closing conditions and avoid
unnecessary hurdles.
10. Ignoring Working Capital Considerations
Red Flag: Failure to address working capital in the LOI.
Working capital is a key component in M&A transactions, representing the operational liquidity available to run the business. If working capital expectations are not clearly outlined in the LOI, it can lead to disputes during the final negotiations or at closing.
Example:
An LOI that specifies the purchase price but omits any
mention of working capital adjustments can create
confusion. The buyer may expect a certain level of working capital
to be included in the purchase price, while the seller might assume
any excess working capital is theirs to retain.
What to Do:
Clearly define working capital targets
and adjustment mechanisms in the LOI. Both parties
should agree on the baseline working capital level
and how any deviations will affect the final purchase price.
Conclusion
A well-crafted LOI serves as a blueprint for successful M&A negotiations, but identifying red flags early can save both buyers and sellers from costly mistakes. By focusing on clear terms, balanced payment structures, fair exclusivity clauses, and defined due diligence scopes, parties can foster transparency and trust for smoother transactions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
