Getting to “yes” with a future partner may involve a lot of negotiating. This can take time, and it requires commitment. But you may not want to jump straight into a partnership any more than you would jump into a marriage without a period of engagement. A Letter of Intent can function as a kind of business “engagement” before a formal marriage.
Right now I am working with two potential partners on a promising development. But gathering all the facts needed to define our business rolls and relationships, and ascertain the deal’s true potential will require time, effort, and the disclosure of trade secrets. It’s too early to form a partnership, and yet the exploratory period requires firm commitment to the deal.
Enter the “Letter of Intent.” Another tool (like the Memorandum of Understanding that we discussed in my last blog) to help you move from informal toward formal business relationships without jumping the gun.
The Letter of Intent
The business Letter of Intent, or LOI, as it’s known to lawyers, helps to define the plan before the plan is quite ready for action. In my deal, we need to establish that a market exists for our project–we believe it does, but require proof–and we need to know how much investment is needed for what level of profit. To obtain all of this information, two of us have to work very hard, investing a lot of time, while the third has to commit to funding the venture if and when all the assumptions pan out. The “if” is what needs to be resolved before it makes sense to create a formal partnership. But because resolving the “if” takes time, effort, and some money, we need a pre-deal deal–an agreement outlining our intentions and stated commitments.
The LOI serves to outline the early terms on an agreement without necessarily pinning down all the details. For example, depending on how much money my investor will have to dish out, and how much of our time will be required, the future profit split might be 20/20/60, or 10/10/80, or… we don’t know. But we know it must be equitable to all parties. So the LOI we could have language such as, “…profits and losses will be split between the parties in an equitable fashion that accounts for the financial risk and effort put forth by each,” while leaving the exact figures for later, once we know more.
We have indeed established that remuneration will be through a profit split, versus salaries, fixed-price contracts, interest rates, or to the common forms of establishing the financial structure. But for an LOI, it could be anything, such as “…a salary competitive with comparable positions in Cincinnati.”
The LOI would include a confidentiality agreement. This portion could be made legally binding, even if the other commitments are not. The confidentiality agreement simply states that the partners will be privy to information that could benefit competitors, or it is simply private. The partners agree not to divulge this information to anyone outside the circle.
But what about if the deal falls apart? Like a prenuptial agreement, one very important part of the LOI comes with the terms of closure if the deal does not pan out. Perhaps there’s a base pay for the poor partners that do all the work and ownership of any research or deliverables going to the investor. Or any partners may agree to repay the investor a proportionate share of the money advanced, if the investor must pony up for appraisals and other services.
Anatomy of an LOI
Since the LOI is used to outline the steps needed to conclude a complex negotiation, it has to clearly establish a process for negotiating the transaction. It must state at least some of the material facts on which the deal is based, and the conditions that must be met for the deal to close. And of course, the obligations of the participants should the deal fall apart.
The LOI can be made legally binding, or not. Since I try to work with people I trust, and have found legal conflicts fruitless, I tend to favor a nonbinding agreement. It’s agreeing to agree, rather than a means to guaranty specific actions by force of law.
Here’s an example:
[Date]
Name(s)
Addresses
Dear Gentlefolk:
This letter confirms our mutual intentions with respect to the potential transaction described herein between ___________ (“party one”) and _______________ (“party two”). This document, in and of itself, does not represent an enforceable legal contract.
1. Terms. The principal terms of the proposed transaction would be substantially as follows:
(a) Acquisition. Should conditions merit, Joe Smith would acquire land in Cincinnati described as [legal description] (The Land) and fund the site development and construction of five single family homes for sale.
(b) Construction. Should Smith acquire the land, Jim Jones would commit all of his personal and the corporate resources of Jones Construction to the design and construction of five single-family homes for sale on The Land.
(c) Due Diligence Review. Promptly following the execution of this letter of intent, Jones will hire Accurate Appraisal Company to conduct a market feasibility study while Jones meets with municipal authorities to determine development feasibility. Smith will fund market feasibility study.
(d) Consideration. The aggregate net profit of the sale would be split 50/50 by partners, with the understanding that neither will receive a salary or other consideration until all of the homes are constructed and sold, and all costs, including Smith’s investment is paid, with an appropriate reserve established and held for one year from the date of the last sale for warranty and miscellaneous expenses.
(e) Definitive Partnership Agreement. All of the terms and conditions of the proposed transaction would be stated in the Partnership Agreement, to be negotiated, agreed and executed by the parties once all pre-purchase conditions are met and due diligence completed. Neither party intends to be bound by any oral or written statements nor correspondence during the course of negotiations, notwithstanding that statements may be expressed in terms implying a partial or interim agreement between the parties.
(f) Conduct of Other Business. Both parties understand that signatories will remain employed and engaged in other business during the pre-project stage, but that Jones will devote full time to the deal if consummated.
(g) Expediency. All parties would use all reasonable efforts to complete due diligence, sign a purchase agreement for the land, and close the transaction as promptly as practicable thereafter.
2. Expenses. Each party will pay their respective incidental and administrative expenses incident to this letter of intent, while Smith will provide for capital investments over $5000, including the Market Feasibility study, the earnest and down payment money required for The Land, and the pre-construction design work, permits, and eventually construction costs.
3. Public Announcements. Neither party will make any announcement of the proposed transaction contemplated by this letter of intent prior to the execution of the Purchase Agreement without the prior written approval of the other.
4. Broker’s Fees. All parties have represented to each other that no brokers or finders have been employed who would be entitled to a fee by reason of the transaction contemplated by this letter of intent.
5. Exclusive Negotiating Rights. Your lawyer may add a paragraph restricting each party to negotiate in good faith with the other and avoid conflicts of interest for a specific period of time, or until the deal is done.
6. Termination. Should relationships sour or conditions discovered in the course of due diligence investigations make the deal untenable, then either party can opt out of the deal, with either party able to move forward independently, if so desired. Each party would assume their respective costs as nonrecoverable expenses and neither party can make claims against the other, with exception to the terms of the Confidentiality Agreement.
6. Miscellaneous. Here your lawyer may want to outline specific terms along the lines of, “This letter shall be governed by the substantive laws of the State of [YOUR STATE]. This letter constitutes the entire understanding and agreement between the parties hereto and their affiliates with respect to its subject matter and supersedes all prior or contemporaneous agreements, representations, warranties, and understandings of such parties (whether oral or written). No promise, inducement, representation, or agreement, other than as expressly set forth herein, has been made to or by the parties hereto… Etc.
7. No Binding Obligation. Except for Sections 1(d) and 2 through 6, THIS LETTER OF INTENT DOES NOT CONSTITUTE OR CREATE, AND SHALL NOT BE DEEMED TO CONSTITUTE OR CREATE, ANY LEGALLY BINDING OR ENFORCEABLE OBLIGATION ON THE PART OF EITHER PARTY TO THIS LETTER OF INTENT. NO SUCH OBLIGATION SHALL BE CREATED, EXCEPT BY THE EXECUTION AND DELIVERY OF THE PURCHASE AGREEMENT CONTAINING SUCH TERMS AND CONDITIONS OF THE PROPOSED TRANSACTION AS SHALL BE AGREED UPON BY THE PARTIES, AND THEN ONLY IN ACCORDANCE WITH THE TERMS AND CONDITIONS OF SUCH PURCHASE AGREEMENT. The Confidentiality Agreement is hereby ratified and confirmed as a separate agreement between the parties thereto.
Your lawyer would draw up the confidentiality agreement, which binds both parties legally to discretion. For example, Smith may not want his neighbor’s to know the has just inherited a large sum and intends to become a real-estate developer, and both of you may want to keep a lid on the excellent real estate you found to prevent others from making offers to your potential seller.
I am not a lawyer, so this example is only an outline. I like to write my own agreements in plain language that partners can agree to, and then give my lawyer this draft to turn into a legal document.
All in all, the LOI represents a somewhat formal, but not-so-binding precommitment commitment. Enough of a commitment to base the fair amount of work and risk a small amount of capital, and just enough to come to terms and shake hands (in the contractual sense) on a final agreement when and if the time comes.
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