What happens after you receive an acquisition letter of intent from a potential buyer? How do cultural differences affect the way LOIs are interpreted around the world?
In Venture Deals, Brad Feld and Jason Mendelson explain the key elements of an acquisition letter of intent and its implications for business owners. From exclusivity clauses to due diligence requirements, understanding these components helps navigate the complex process of company acquisition.
Keep reading to learn crucial insights that could protect your interests when dealing with potential buyers and investors.
Acquisition Letter of Intent
A acquisition letter of intent (LOI) signifies a potential buyer’s serious interest in acquiring your company, indicating that they’re ready to discuss terms more formally. It outlines the basic terms of an agreement before the actual deal is finalized, laying out key elements like purchase price, structure of the deal, due diligence process, and timeline. While it’s typically nonbinding, the LOI does set the stage for deeper discussions by clarifying initial expectations and priorities between you and the buyer.
| LOIs Across Countries LOIs may be interpreted differently across different business cultures. In Western business practice, an LOI typically represents a serious commitment and a significant step toward a formal agreement. However, one American VC says that in his experience, Chinese business culture views these documents with less binding authority. On the other hand, some legal experts report that countries like Germany and China may have more legal obligations associated with the LOI compared to other places. For instance, a Chinese court might find a company liable for damages if they’re accused of negotiating in bad faith. This divergence in interpretation across countries seems to stem from both differences in contract law and cultural differences, indicating that it’s important to understand all obligations associated with the LOI based on where you’re doing business. |
Exclusivity Clauses
The authors advise you to be aware of exclusivity clauses in LOIs—terms that prevent you from engaging with other potential buyers for a certain period. Exclusivity clauses can limit your options and hinder your ability to negotiate with other potential investors for a specified period of time after presenting your pitch. This might leave you in a vulnerable position if the initial VC decides not to invest or delays the process.
| Legal Challenges to Exclusivity Clauses While courts have generally found exclusivity clauses in contracts to be legal and enforceable, there have been instances where these clauses have been challenged on grounds of being anti-competitive or overly restrictive. One potential challenge to exclusivity clauses falls within antitrust law. If an exclusivity clause is used to restrict competition, it might be deemed illegal. For example, if a VC firm used an exclusivity clause to prevent a startup from seeking other investments in order to maintain that VC’s market dominance, that clause could be challenged under antitrust laws. One notable example of this kind of legal challenge (albeit in a non-VC context) involved Apple, which faced class action lawsuits over its exclusive agreement with AT&T for the iPhone service when the smartphone first launched in 2007. Critics argued this exclusivity agreement was anti-competitive and violated antitrust laws.The plaintiffs, who were iPhone users, argued that the exclusivity deal effectively locked them into a contract with AT&T without their knowledge and prevented them from switching to other carriers—even when better deals or services were available, thereby limiting consumer choice. |
The Due Diligence Process
If you’re OK with the terms of the LOI, you can sign it to keep things moving forward. After signing, expect the buyer to conduct a thorough due diligence process, in which they verify the information you’ve provided and assess the financial and legal health of your business. The LOI should outline what this process looks like, including its scope and expected duration.
The authors explain that due diligence can be an intensive process. To uncover any potential risks or liabilities, buyers will want to scrutinize everything from your financial records and customer contracts to intellectual property rights.
For instance, the buyer may discover that your company is involved in a legal dispute. This could be a lawsuit from a former employee claiming wrongful termination or a patent infringement claim from a competitor. These kinds of legal issues represent potential financial and reputational risks that may discourage the buyer from proceeding with the acquisition. Similarly, if the buyer discovers that major customer contracts are about to expire without any guarantee of renewal, that would impact future revenue projections and, as such, may make them think twice about the deal.
Feld and Mendelson advise you to prepare for the due diligence process well in advance by keeping detailed records of all business activities. They also suggest working closely with your legal team during this phase to ensure all requests are handled properly. Most importantly, they caution against hiding or withholding information during due diligence, since any discrepancies found could lead to renegotiation or even termination of the deal.
| Theranos Illustrates the Importance of Due Diligence Buyers and investors both put companies through a rigorous due diligence process for good reason—failure to do so can have disastrous consequences. Yet corporate history is filled with examples of a supposedly groundbreaking company dazzling investors with promises of astronomical returns—and convincing those investors to forego due diligence. In Bad Blood, journalist John Carreyrou explains how medical startup Theranos (whose blood-testing technology was later revealed to be a fraud perpetrated by founder Elizabeth Holmes) lured investors and partners like Walgreens by taking advantage of their short-sightedness. These investors and partners failed to perform due diligence. Walgreens reasoned that if Theranos’s innovation was real, it couldn’t risk competitor CVS taking it—so it committed to partnering with Theranos. Walgreens started building out new clinics with Theranos’s technology and, in a classic sunk-cost fallacy, refused to pull out as concerns about the startup mounted, since pulling out would have been intensely embarrassing. Another Theranos strategy was to land big-name investors—like former Secretaries of State George Shultz and Henry Kissinger, retired US Marine Corps General (and future Secretary of Defense) James Mattis, and former US Senator Sam Nunn. By reeling in these big fish, the company was able to boost its reputation and attract overly enthusiastic investors who failed to investigate the validity and viability of the company’s technology. |
