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Advantages and Disadvantages of Using a Letter of Intent in a Transaction

By July 21, 2020No Comments

A Letter of Intent or “LOI” functions to outline the basic terms of a transaction before parties begin conducting due diligence and negotiating and drafting a formal agreement.  LOIs can be used in all types of transactions whether it be a business acquisition and sale, real estate purchase and sale, lease, or a loan.  Another important aspect of a LOI is whether the parties intend it to be binding or non-binding.  In most cases, some parts of the LOI will be binding, while other aspects are non-binding.

Advantages of the LOI

LOIs can have several advantages and, in most cases, these advantages weigh in favor of using a LOI.

  1. Setting Out the Essential Terms of the Transaction.  The LOI stage allows the parties to focus on the essential terms (such as purchase price, rent amount, loan amount, and closing date) of a transaction without having to negotiate and determine the specific legal terms prematurely.  “Cutting to the chase” early on helps save time and money for all parties involved.
  • Addressing the Big Issues.  Sometimes transactions have an important issue where, if it cannot be resolved early on, the deal will not be consummated regardless of any other terms.  In such instances, the parties may want to agree on these issues before moving forward with other aspects of the transaction.
  • Establishment of Good Faith.  While the essential terms of a transaction are generally not legally binding at the LOI stage, the identification of, for example, the purchase price, may make a party feel committed to that term.  In addition, the execution of a LOI indicates the other party’s commitment to completing the deal.
  • Guide to the Deal.  Lastly, a LOI can be presented to the buyer or seller’s board of directors and shareholders as a guide to the deal, so that those individuals will not need to comb through the final documents in order to assess a transaction.  In addition, a LOI helps provide each party’s attorneys and other professional advisors with a guide to the deal for the preparation and negotiation of the formal legal documents.

Disadvantages of the LOI

Despite a LOI’s advantages, there are oftentimes circumstances in which a party should resist using a LOI. 

  1. Potential for a Legally Binding LOI.  Because the majority of due diligence is yet to be completed at the LOI stage, the parties should want the essential terms of a transaction as set forth in a LOI to be non-binding.  However, if the language of the LOI is not carefully drafted – even if it states it is non-binding – the LOI may indeed create a legally binding contract.  The issue of whether a LOI creates a legally binding contract has been the subject of many court cases and can result in a great deal of expense for litigants. 
  • Showing Your Hand.  For sellers, the execution of a LOI may indicate to competitors, customers, vendors, employees, and other constituents that a party is “selling out”, which can have negative business consequences even if a transaction is never actually consummated.
  • Deal Shopping.  In general, LOIs indicate the seriousness of a party to enter into the deal, but not always.  A third potential disadvantage is that the other party to the transaction is merely executing the LOI in order to use it to shop around to see if other parties can beat the terms of the deal. 

While parties should generally use a LOI, unfortunately, there is no bright line rule to follow in order to determine whether to use one for any given transaction.  Parties ultimately need to weigh these advantages and disadvantages against the circumstances of the transaction at hand.  An attorney or other professional advisor will be able to provide guidance in making this decision.  Lastly, it is important to view LOIs like any other legal document before signing.  They should be carefully and fully understood.  The key is to be sure of the purpose of the LOI and any potential consequences of using one.