There is usually a long run into an acquisition during which the two sides make some ‘preliminary agreements’. Most will be agreements on how the parties will behave during the negotiations but some will make it into the final sale and purchase agreement. Most will not be binding, but some will be. You do not want to find yourself unwittingly bound by a preliminary agreement which you had assumed was not binding; this is why you should involve your lawyers although they can often make what might seem like an unnecessary fuss.
The most common pre-contractual documents are the confidentiality agreement and the letter of intent and it is these that we will examine in this chapter.
The pre-acquisition period is a lot like the dance of the seven veils. The prospective target will slowly reveal more and more so that the buyer can decide whether or not to go ahead. The prospective target is very vulnerable because it will be revealing more and more confidential information with no guarantee that the deal will complete. Therefore, despite a general obligation to negotiate in good faith, the seller will want an informal confidentiality agreement in which both sides agree their rights and obligations.
The things you will need to think about and agree are set out below.
This should be the easy bit. Usually, but not always, there are only two parties – you and the seller. The point is that if you and the seller are companies, the entire company is bound. The confidentiality agreement sometimes mentions who within each company is authorised to receive and to give the information. Naming individuals like this is designed to organise the exchange of information from company to company. In addition agreements nearly always have a clause binding advisers, which is what you want because it means you can pass on information received without separate negotiations. All they have to do is agree to be bound by the same agreement as you.
You may need to think carefully about what information is covered. The other side will want to draft this part as broadly as possible but if, for example, you are in the same industry as the target, a lot of what lawyers think is confidential information you may already have. Because no-one can be expected to keep information confidential if it is not confidential in the first place, confidentiality agreements usually contain a list of things which are not covered:
Information which is, or comes into, the public domain through no act of the receiving party which is in breach of the agreement
Information which was already in the possession of the receiving party
Information which is independently developed by the receiving party
Information which is received from another source without any restriction on use or disclosure
If you are given confidential information which the authorities order you to disclose you would not be in breach of a confidentiality agreement. To cater for this somewhat unlikely event confidentiality agreements stipulate that if a party receives such a disclosure order, it should immediately tell the other side so that it can take appropriate action.
There has to be a time limit on a secrecy obligation. You cannot be expected to keep silent forever – it would be like having the sword of Damocles hanging over you. Besides information loses its value pretty quickly. The norm is usually between three and five years.
If the non-disclosure obligation is for an undetermined period or just not mentioned in the agreement, which is not unusual, its actual duration will be decided by the relevant law. In some jurisdictions, for example under French law, any party may terminate an agreement with no time limit by sending the other party a termination notice. This is quite dangerous because that party could then communicate the privileged information to third parties. For this reason it is advisable to have a time limit in the confidentiality agreement.
Confidentiality agreements, unlike some letters of intent, contain contractually binding obligations. Violation of these obligations is a breach of contract giving the other side the right to sue for full compensation for the damage suffered. Damage would be determined by the courts or may have been set out in a penalty clause in the agreement.
In practice, it is also very difficult to prove even that a secrecy obligation has been violated and proving that you have suffered loss is also very difficult. Both factors may explain why there are so few court cases for breaches of confidentiality agreements. But this does not stop lawyers from taking them extremely seriously. Confidentiality agreements can go back and forth between legal advisers several times, racking up their fees. Principals need to be aware of this and decide how much value is actually being added.
The letter of intent is another preliminary agreement. It is referred to under a variety of names, including ‘memorandum of understanding’, ‘commitment letter’, ‘binder’, ‘agreement in principle’, ‘Heads of Agreement’, ‘Heads of Terms’ or ‘Heads’.
Heads of Terms is a written document generally exchanged between the parties when negotiations have reached an advanced stage, usually at the point where there is agreement to agree. At this point both sides usually want to formalise their intentions and expectations before proceeding. Its function is to summarise the broad terms of what has been agreed and put in writing how the negotiations are expected to continue before both sides embark on the detail of finishing off the transaction. The parties do not normally want Heads to be binding because they do not want to be on the hook until negotiations have reached a satisfactory conclusion. Nonetheless, they do want reasonable assurance that they are not about to waste a great deal of time and money trying to get the deal done. That is the function of the letter of intent. While it may not be binding it does at least force both parties to take stock of where they are and what they want to happen from here.
Negotiating Heads is therefore very important to the final outcome of the deal and it is worth thinking about the agenda in some detail. From an acquirer’s perspective the following list covers the main issues, but the order of events must be down to judgement on the day. Topics will include some or all of the following:
Update since last meeting. It is vital to clarify even at this late stage any change of information which affects the deal.
Confirmation of what is included. It is possible that misunderstandings still exist – what are the key assets to be included in the deal?
Price of certain assets to be purchased by directors. This is a sensitive but necessary part of the negotiation process, and must form part of the acquisition price.
Timetable. This is a good opportunity to agree the timetable and as a by-product secure all access and cooperation you need for due diligence. Both sides will want to move as quickly as possible but of the two, sellers will be the keenest. Make sure you get enough time to do everything you want. Allow six weeks for due diligence to give enough time for briefing advisers and, more importantly, digesting their findings. You may need two weeks or more on top of that to negotiate the agreement, carry out any pre-completion stock-takes and so on.
Obligations of the parties during negotiations. For example the buyer will want access to management and customers to carry out due diligence.
Earn-out formula and period. All too often earn-out deals are not clarified in sufficient detail. It is important to illustrate the earn-out formula with examples to ensure all parties understand the deal.
Transfer of pension funds. The complexity of pensions is frequently underestimated. Sufficient time is required to resolve the issues. It is quite acceptable for the detailed administration of pension funds to be transferred and finalised over a 6–12 month period post completion.
Intellectual property rights. When intellectual property is a major reason for the deal, buyers must ensure that the relevant rights are owned by the target company and that they do not rest with individual directors, contractors or other companies outside the target.
Removal of personal guarantees. In private companies especially, directors may be standing behind loans or other liabilities. Buyers will have to offer the release of guarantees.
Key warranties and indemnities. These are discussed in detail in Chapter 8 (The sale and purchase agreement). At this stage it is important to flag the main warranties and indemnities expected.
Purchase price and consideration. The final price negotiations must be agreed at this meeting and its position on the agenda should be driven by the acquirer.
Standstill agreement or ‘exclusivity’. Another very important concern for buyers is that the seller might hold parallel negotiations with third parties. A standstill agreement is an agreement in which the seller agrees not to conduct negotiations with third parties for a limited time to give the buyer a clear run at getting the deal done. Heads of Terms signal that there is an agreement to agree. From the point they are signed, the buyer will start spending time and money to complete the transaction. There is no point in a buyer going to all the time, trouble and expense involved in completing an acquisition if it is not reasonably confident of a positive outcome. While this can never be guaranteed there is clearly a much lower chance of success if another party is still in the running. The existence of parallel negotiations can also adversely affect the buyer’s bargaining position. Its negotiating strategy would be very different if it knew that in effect it was in an auction. From a strictly legal point of view, there is no need for the seller to disclose parallel negotiations hence the frequent use of standstill agreements and as a buyer you should always demand a period of exclusivity.
Secret research and development. Where the acquirer and the target company are competitors in an industry which requires continuing secret research and development, an abortive transaction may lead to allegations from the seller that the acquirer has used the potential transaction as a ruse to gain access to the target company’s ideas. The acquirer may be required to enter a specific agreement to cover this possibility and to establish an agreed dispute resolution procedure.
Binding provisions. Various binding provisions can be negotiated into Heads of Terms. These are covered later in this chapter.
A letter of intent gives comfort to both parties that the other side is serious. However, practitioners in the mergers and acquisitions arena disagree widely about the desirability and enforceability of letters of intent, which is what we will now look at.
There are three definite advantages of a letter of intent.
The fact that the parties agree on the basic terms and structure of a proposed transaction gives them comfort that they will be able to agree in the future on the detailed points which will inevitably crop up later. The letter of intent generally serves as a good roadmap for the final agreement. It may also be used to guide the negotiation process itself.
A letter of intent may not itself be binding but it usually contains some binding provisions which are important in getting to agreement. While they could be agreed separately, with a letter of intent you have them all under one roof and, more importantly, you only need one set of negotiations. These are generally:
The confidentiality clause. The confidentiality clause binds both buyer and seller not to disclose to a third party any information discovered in the course of the transaction, the terms of the proposed transaction or even the existence of the letter of intent itself. This provision may also have been included in the confidentiality agreement (covered above)
The standstill clause. As already mentioned, the standstill clause is the provision by which the parties agree that the seller will not negotiate or deal with a third party while the buyer and seller are negotiating a definitive agreement
A ‘no-solicitation’ provision. To reinforce the standstill clause, the letter of intent may also contain a ‘no-solicitation’ provision which forbids the seller from soliciting, encouraging, entering into discussions or providing information to any third party bidder
Give-and-take issues. In the letter of intent the parties may clearly set out the conditions that need to be settled before the transaction can be finalised. If one of these conditions is not met both sides are in no doubt as to where they stand
Expenses and fees. A letter of intent may also include a provision saying who will pay which fees and other costs if the transaction is not consummated. Usually, each party bears its own expenses unless one of the parties abruptly or unlawfully terminates negotiations. In this case, a penalty, known as a ‘break fee’, may kick in. This is established in the agreement to compensate the other party
Indemnification against liabilities. It is also advisable to include in a letter of intent a clause establishing that one party will indemnify the other against any potential liabilities which may arise because of the proposed transaction
Defensive clause. The letter of intent may also include some defensive provisions, such as ‘lock-up’ or termination fees, designed to compensate the buyer if the proposed transaction is not consummated due to a third party bidder
The three most discussed disadvantages of the letter of intent are the following.
Once the parties have set out the key transaction points, such as price, the letter of intent may make it difficult for either party subsequently to negotiate on such points.
Any price mentioned in a letter of intent will be an estimate because the parties have not started due diligence. The price mentioned in the letter of intent, therefore, should be stated as subject to due diligence.
Negotiating a letter of intent may create an unnecessary delay in signing the final agreement. Especially when time is short, it is sometimes preferable to proceed directly to the definitive agreement.
Additionally, the attempt to achieve too much in the letter of intent may be fruitless before the parties have conducted their due diligence.
A major concern when drafting a letter of intent should be its enforceability. In general, the seller wants it to be as binding as possible, the buyer, on the other hand, usually wants the opposite.
There is always a debate as to whether a letter of intent is a binding and enforceable contract or whether it is an unenforceable agreement to agree. The answer is: it depends on which jurisdiction you are in. Anglo-Saxon M&A practitioners will tell you that Heads of Terms are non-binding ‘agreements to agree’ unless the parties specifically provide otherwise. In Napoleonic jurisdictions it is possible for the parties to be legally bound by Heads of Terms even if they do not want to be because European courts examine the intent of the parties and how definite the agreement is in order to determine its enforceability. They usually examine:
The context of the negotiations
The language used in the letter of intent
Whether the subject matter of the negotiations concerns complicated matters that customarily require a definitive written agreement
The parties’ respective degrees of performance of the letter of intent’s terms
The size and complexity of outstanding issues which remain unresolved
Therefore, outside the Anglo-Saxon countries, if the parties wish to avoid being bound by their letter of intent, the language of the letter must clearly say so. Bear the following in mind:
The text of the introductory paragraph should clearly state that the purpose of the letter is to create either a wholly non-binding or a combination of binding and non-binding obligations
It may also be helpful to refer to the buyer as the ‘Prospective Buyer’ and the selling shareholders as ‘Prospective Sellers’ to emphasise the contingent nature of the transaction
Where non-binding provisions are desired, use conditional language such as ‘would’ and ‘might’. Conversely, where the parties wish to create a binding agreement, words such as ‘shall’ and ‘will’ must be used
List everything that needs to be done before the definitive agreement can be signed
In a concluding paragraph, state that the letter of intent is generally non-binding, but list the paragraphs by number that are intended to bind the parties. To reinforce this, binding and non-binding provisions should be in separate sections
It is helpful to state that other than with the ‘Binding Paragraphs’, a signature on the letter of intent shall not be considered as evidence of intent of the Prospective Seller or Prospective Buyer to be bound by the terms of the letter
If the parties want an entirely non-binding letter of intent the document should be short and, in order to avoid judicial misinterpretation of the intent, the parties should not sign such a letter
Finally, it is worth noting that every deal is different and therefore that the specifics of the deal will dictate the way in which the letter of intent is drafted
This chapter has demystified the two most important documents exchanged in the lead up to final negotiations: the confidentiality agreement and the letter of intent. Both can be long and virtually impenetrable. Keeping the basics in mind is a great aid to understanding. For confidentiality agreements these are: who and what does it cover, how long does it last and what are the chances of being sued if it all goes wrong? For letters of intent the basic questions are: do I want one, and if so, what should go in it and how much of it do I want to be enforceable?