M&A Letters of Intent (LOI): Points to Check on Exclusivity, DD and Legally Binding Effect

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

In the early negotiations of an M&A deal, the parties exchange a letter of intent or LOI. It may also be prepared under the name of an MOU (memorandum of understanding) or a term sheet. It is a document in which the buyer and seller confirm the basic structure of the transaction, the expected consideration, the exclusivity period and the schedule, in order to move on to detailed investigation and negotiation of the definitive agreement. Because it precedes the definitive agreement, it is sometimes taken lightly as "a provisional confirmation with no legal binding effect," but depending on how its clauses are drafted, there can be large differences in who leads the subsequent negotiations, the scope of DD (due diligence) and the setting of terms in the definitive agreement.

In particular, if you sign while leaving the scope of exclusivity and whether the document is legally binding vague, the parties may face unexpected constraints or the matter may develop into a dispute. Before signing, decide concretely the exclusivity period, how the investigation will proceed and which clauses are to be binding.

The Nature of an LOI and Separating Binding from Non-Binding Provisions

A letter of intent is a document that confirms the basic terms of the transaction between the parties and how they will proceed, at a stage before the definitive agreement is signed. It goes by various names, such as LOI (Letter of Intent) or MOU (Memorandum of Understanding), but in practice the legal effect is not determined by the title of the document alone. Its legal nature is judged based on the specific wording of the clauses and the history of the negotiations.

A point requiring particular attention in practice is that a single LOI contains a mix of legally binding and non-binding clauses. There are examples in which the purchase price and any obligation to sign the definitive agreement are non-binding, while confidentiality obligations, exclusivity, cost allocation, and governing law and jurisdiction are made binding. If you write that "none of the clauses is binding," also check that this does not contradict the clauses you want to keep binding.

If the document is drafted with this distinction left vague, gaps in understanding arise: the seller may regard the figure as "merely an estimate with no binding effect," while the buyer understands that "we entered exclusive negotiations on the premise of this price." It is important not to treat the LOI as a formality but to review it as a document that reflects your negotiation strategy and risk management.

Drafting the Exclusivity and Consideration Clauses

The exclusivity clause is a provision in an LOI with a strong impact on both seller and buyer. Because the seller is prohibited for a certain period from contacting or negotiating with other potential buyers, the seller faces the risk of losing the opportunity for competition to raise the price. For the buyer, on the other hand, it is an important protective measure for committing substantial DD costs and internal resources. If the exclusivity period is too long or the scope of transactions covered is too broad, it excessively constrains the seller's business decisions.

How the purchase price is described also requires careful consideration. The room for subsequent negotiation changes greatly depending on whether the price is stated as a fixed figure, such as "the purchase price shall be JPY 1 billion," whether it is to be "determined through consultation based on the results of DD," or whether it is expressly stated to be "premised on adjustments based on cash and deposits, interest-bearing debt and normalized working capital." In growth companies and startups, valuations tend to fluctuate with recent performance trends and the continued involvement of key officers, so bear in mind that if the price is stated too rigidly in the LOI, it becomes harder to seek a price reduction if a serious problem is found in DD.

Fixing the Scope of Investigation and Setting Conditions

In clauses on DD (detailed investigation), the buyer wants to proceed promptly with a broad investigation covering legal, financial, labor, tax and other matters, while the seller wants to appropriately control the scope of disclosed materials, restrictions on access to the data room, and prohibitions on contacting employees and customers. If the scope and procedure of DD are left vague in the LOI, disputes can arise after the investigation starts over the provision of materials and interviews with management.

Organizing the conditions precedent to signing the definitive agreement is also important. Examples include obtaining DD results satisfactory to the buyer, obtaining approval from both parties' boards of directors or shareholders' meetings, obtaining consent from key business partners (addressing change of control clauses), and the continued employment of key officers and employees.

As for cost allocation if negotiations break down, it is necessary to make clear, together with the rules for withdrawal partway through, whether each party bears its own costs as a rule, or whether cost reimbursement is allowed in the event of a breach of the exclusivity obligation.

Points for the Buyer and the Seller

The buyer's risk is that the exclusivity period expires without sufficient DD access having been secured, and negotiations proceed with the conditions inadequately checked. If opportunities for disclosure of materials, interviews with management and information sharing with experts cannot be secured, risks may surface just before the definitive agreement and derail the negotiations. How the price and the basis for its calculation are reflected in the LOI is also important; even if non-binding, a figure left in writing becomes a strong anchor in negotiations.

The seller's risk is losing opportunities with other candidates because of an overly long exclusivity period, and being caught up in delays in the buyer's internal approvals. Furthermore, in case the transaction does not go through, it is essential to set information management rules such as the prohibition on use for other purposes under the non-disclosure agreement, cutting off access rights to the data room, and the return or destruction of disclosed information.

What both sides should be careful about is the excessive belief that "because the LOI has no legal binding effect, signing it creates no legal liability whatsoever." Breaching a clause agreed to be binding can give rise to liability for damages, and disputes can arise over the interpretation of the agreement. The key to the review is striking a balance between the two sides: securing clauses that give the buyer a firm footing for investigation and negotiation, and including provisions that protect the seller from excessive constraints and information leakage.

Legal DD and the Definitive Agreement After Signing the LOI

Specific practical points on the investigation conducted after signing the LOI and the design of the definitive agreement are also covered in What Is Legal Due Diligence? Purpose, Process, Required Documents and Costs, SPA (Share Purchase Agreement) Indemnities, Price Adjustments and Closing and M&A Attorney Fees and Quotation Items. The scope of support and fees from the LOI to the definitive agreement are described under M&A Support.