Reading a letter of intent before you sign it
It says non-binding at the top, and most of it is. The parts that bind are the parts that decide how the rest of the sale goes.
A letter of intent is a buyer’s offer in outline, setting out the price and its terms. Most of it is non-binding. The exclusivity and confidentiality clauses do bind, and exclusivity typically ties you to one buyer for 45 to 90 days. Settle working capital and the earnout terms before signing, because the letter anchors the purchase agreement.
What it is
A letter of intent is a buyer’s offer in outline, usually three to six pages, written after they have seen the statements and before they spend money on lawyers. It states the price and how it will be paid, then what the price covers and the conditions attached to it.
It is called non-binding and most of it is: the price and the timetable are stated as intentions. A few clauses bind, and those are the ones to read as a contract. The rest binds in a different way, because whatever the letter says becomes the starting point for the purchase agreement, and moving off it later costs something.
Price, and what it is a price for
The headline number is the first thing you read and the last thing you should settle. What it buys matters as much, starting with whether the buyer takes the shares or the assets and what stays with you.
- Shares or assets. The two are taxed differently and the same price is worth different amounts to you under each. Share sale or asset sale explains why; the letter should say which.
- Cash free, debt free. Most offers assume you keep the cash and pay off the debt before closing. The letter should say so, and should say what counts as debt, including any CEBA loan still on the books.
- What is excluded. Owners often keep a vehicle or a property the corporation owns. Anything you are keeping belongs in the letter by name.
How the price is paid
A price of $3 million paid on the day is worth more than $3 million paid over four years with conditions. The letter sets out the parts.
- Cash at closing. This is the part that is certain.
- Vendor financing. This is a portion you lend the buyer, repaid with interest over a term. It is normal in deals under about $2 million, and the piece on vendor financing covers the security to ask for in case the buyer defaults.
- Earnout. This portion is paid later, and only if the business hits targets after the sale. Settle the targets and the period in the letter, along with how the figure is calculated and who runs the business in the meantime, while you still have other buyers.
- Holdback. The buyer keeps back an amount for a period to cover claims under your representations. Ask how much it is and how long it lasts, and what triggers a claim.
- Rollover. Some buyers ask you to keep a stake. Ask what it is worth and when you can sell it.
Take, as an illustration, a letter that offers $3 million and divides it as below.
| Part of the price | Amount | When you have it |
|---|---|---|
| Cash at closing | $2,250,000 | On the day |
| Vendor note | $300,000 | Over four years, with interest |
| Holdback | $150,000 | When the holdback period ends, less any claims |
| Earnout | $300,000 | Over the earnout period, if the targets are met |
Three quarters of the headline is in your account on the day. The other $750,000 arrives later, and how much of it you collect depends on what happens after the buyer takes over. The AI Offer reader separates a real letter into these parts, and earnouts explains how the conditional share is measured.
Working capital
Working capital is the clause first drafts most often leave out, and the one that most often costs money at closing. The buyer expects the business to come with enough receivables, inventory and cash to run, and the letter should state how much, as a target figure or a method for setting one.
Left out of the letter, the number is negotiated during diligence, when you are tied to one buyer, and it tends to move in the buyer’s favour. The piece on working capital in a business sale shows how the target is set.
The clauses that bind
- Exclusivity. You agree to deal with this buyer alone for a period. Forty five to sixty days is customary for an owner operated business, and ninety is the top of the usual range. It should end automatically on a set date and be tied to the buyer meeting its own deadlines, so that a buyer who stalls loses exclusivity.
- Confidentiality. Usually already covered by the non-disclosure agreement; the letter confirms it and extends it to the terms of the offer.
- Costs. Each side usually pays its own costs. Check the letter for any clause that shifts them to you.
- Governing law. This clause names the province whose courts decide disputes, and it should be yours.
Conditions
Conditions are the buyer’s way out. Satisfactory due diligence appears in almost every letter and is open ended. Financing is the one to watch, because a letter conditional on the buyer arranging financing comes from someone who may still lack it. Ask for evidence during diligence, well before closing, since a lender that lends less than planned is among the commonest reasons deals come apart before closing.
Expect consents as well, from the landlord on the lease and from key customers or suppliers on their contracts. The buyer will also ask you to agree to a transition period and a non-compete.
What is asked of you
- Transition. This is a period in which you stay on to hand over, sometimes paid and sometimes unpaid. Three to six months is common, and the letter should state whether you are paid and at what rate.
- Non-compete. You agree to stay out of any competing business for a period and within a distance. Reasonable ones are enforceable, and the letter should state both the period and the distance. How courts read the period and the distance in a sale is set out in what makes a non-compete hold up.
- Representations. These are statements you make about the business in the purchase agreement, backed by the holdback. The letter usually calls them customary, and the lawyers settle what customary means later.
Before you sign
Do three things, in order:
- 01Compare the offer after tax and after time, using the cash you keep in place of the headline. Your accountant can do this in an afternoon, and the answer is often surprising.
- 02Settle everything you can now. The letter is the last moment you have another buyer to point to, and exclusivity ends it.
- 03Have a lawyer read the binding clauses, since those are the parts of the outline that work as a contract.
A good letter of intent leaves the purchase agreement only the wording to decide. A poor one offers a headline price and defers the decisions to a stage where you have less leverage than you have today.
This piece describes what a letter of intent customarily contains and is general information. Have your own lawyer read the letter before you sign it.
Questions owners ask
- Is a letter of intent legally binding in Canada?
- Most of it is a statement of intentions, including the price, the structure and the timetable. Exclusivity and confidentiality usually bind, along with the clauses on costs and governing law. Read those as a contract, because they are one.
- How long should exclusivity in a letter of intent be?
- Exclusivity should last as long as due diligence needs. Forty five to sixty days is common for an owner operated business, and ninety is the top of the usual range. It should end automatically and be tied to the buyer meeting its deadlines, so a buyer who stalls loses it.
- What is an earnout?
- An earnout is part of the price paid later, and only if the business hits targets after the sale. It bridges a gap between what the buyer believes and what the seller claims. The targets and the period belong in the letter of intent, together with who controls the business during it and how the figure is calculated.