Before concluding a final agreement on the sale and purchase of equity interests or shares, participants in an M&A transaction (mergers and acquisitions) usually need to agree on the basic structure of the deal, conduct a legal, financial and tax analysis of the target company, secure financing and obtain the necessary regulatory approvals. Negotiations may therefore last for months and require significant engagement by both parties.

A letter of intent (LOI) is used to record the results of negotiations reached up to that point at this early stage and to establish the rules for their continuation. Although an LOI is often described as a non-binding document, such a designation does not necessarily mean that none of its provisions produce legal effect. In practice, an LOI most often combines non-binding commercial proposals and provisions that the parties wish to apply immediately upon signing.

Therefore, one of the most important questions when preparing it is whether the LOI merely expresses an intention to continue negotiations or already creates certain obligations for the participants.

What Is an LOI and What Purpose Does It Serve in an M&A Transaction?

Serbian regulations do not define a letter of intent as a specific type of contract. Its content and form therefore differ from one transaction to another. An LOI may be a short letter containing the basic commercial terms, but it may also be a detailed document governing the structure of the deal, the course of negotiations and the conduct of the parties until the final agreement is signed.

Its primary purpose is to determine whether there is a sufficient level of agreement between the buyer and the seller for it to make sense to continue the transaction. In this way, the parties can identify key outstanding issues before investing additional time and resources in the due diligence process and the preparation of the final transaction documents.

An LOI most often contains:

• the identity of the buyer, the seller and the target company,
• the subject matter and indicative structure of the transaction,
• the indicative price or the method for determining it,
• the way the due diligence process will be conducted,
• the expected timeframe of the transaction,
• the required regulatory and other approvals,
• the period of exclusive negotiations,
• confidentiality,
• allocation of costs,
• governing law and the method of dispute resolution.

However, an LOI is not a substitute for the final purchase agreement. It usually does not regulate in detail the seller’s warranties, limitations of its liability, damages, the purchase price adjustment mechanism, conditions for completing the transaction and other matters that are addressed only after the due diligence process has been conducted.

Is LOI Legally Binding?

The answer depends on the content of the document and the intention of the parties. Under the Law on Obligations, a contract is formed when the parties agree on its essential elements. When interpreting disputed provisions, not only is their literal wording considered, but also the common intention of the contracting parties.

Therefore, the title of the document is not decisive. An LOI may contain legally binding provisions, while even a highly detailed document may remain non-binding if it is clear that the parties have made the final decision conditional upon the signing of a definitive agreement.

In practice, LOI most often has a mixed nature. The basic commercial elements of the planned transaction are non-binding, while certain protective provisions produce legal effect immediately upon signing.

Therefore, even a general statement that the document is non-binding is not always sufficient if its other provisions are formulated as final and unconditional obligations. The language of the entire document must be consistent with the legal effect intended by the parties.

Which Provisions of an LOI Are Most Often Binding?

 Even when an LOI does not oblige the parties to complete the transaction itself, certain provisions generally begin to apply immediately. Among them, confidentiality and exclusivity are particularly important. Their purpose is not to create an obligation to complete the planned transaction, but to protect the interests of the parties during negotiations and the conduct of the due diligence process.

Confidentiality

During the preparation of the transaction, the buyer may gain access to financial statements, agreements with customers and suppliers, business plans, prices, employee data, intellectual property and other sensitive information concerning the target company. The mere fact that the owners are considering the sale of the company may also be confidential, as its premature disclosure could affect employees, business partners or the company’s position in the market.

The confidentiality provision should clearly determine which information is protected and for what purpose the buyer may use it. It is customary to limit its use exclusively to the assessment and preparation of the specific transaction. It should also be determined to whom the information may be disclosed, for example, to the buyer’s employees, affiliates, financing providers and external advisers who need the information in order to work on the transaction. The buyer most often undertakes to ensure that those people also comply with the same confidentiality regime.

Information that is already publicly available, that was lawfully held by the recipient before its disclosure, that was independently developed or lawfully received from a third party is usually excluded from the confidentiality obligation. The procedure to be followed when the disclosure of information is required by a court, regulatory authority or other competent authority is also specifically regulated.

It is also important to determine what happens to the information if negotiations end. The LOI may require the return or destruction of the received documents, while permitting copies to be retained where this is required by law or internal document retention policies. The confidentiality obligation most often continues to apply after the termination of the LOI, for the agreed period.

Exclusivity

Exclusivity protects a buyer that is investing time and money in due diligence and the preparation of the agreement from the risk that the seller may simultaneously negotiate with other interested people and use the buyer’s offer solely to obtain more favorable terms from a third party.

This clause is often formulated as an obligation of the seller not to actively solicit other offers during a specified period (no shop), initiate or continue negotiations with other potential buyers (no talk), provide them with information or enter into a competing transaction. The seller may also be required to terminate existing discussions with third parties and notify the buyer if it receives an unsolicited offer.

The scope of exclusivity should be precisely defined. It is particularly important to determine whether the restriction applies only to the seller or also to the target company, affiliates and members of management, as well as which transactions are considered competing transactions. Unclear and overly broad wording may hinder the target company’s ordinary course of business or give rise to a dispute as to whether the obligation has been breached.

The duration of exclusivity is particularly important for the seller. The period should be long enough for the buyer to conduct its analyses and prepare the final agreement, but not so long that the seller is unjustifiably bound if the buyer delays or does not demonstrate a genuine willingness to continue the transaction. Exclusivity may therefore be linked to specific deadlines or steps, such as the delivery of a draft agreement or the completion of the due diligence process.

The LOI should also determine when exclusivity ends, whether upon expiry of the period, conclusion of the final agreement, the buyer’s written withdrawal or earlier if the buyer fails to complete the agreed steps. A breach of this provision may result in an obligation to compensate for damage or another consequence expressly agreed by the parties, which is why the wording of the clause and the manner of proving the breach are particularly important.

In addition to confidentiality and exclusivity, provisions on the allocation of costs, governing law and dispute resolution are also often designated as binding.

Can a Party Withdraw from Negotiations After Signing an LOI?

If the LOI does not contain an obligation to complete the transaction, as is most often the case, either party may, in principle, terminate the negotiations. The Law on Obligations provides that negotiations preceding the conclusion of a contract are not binding and that either party may terminate them.

However, the freedom to negotiate is not unlimited. A party may be liable for damage if it conducted negotiations without the intention of concluding a contract or if it abandoned that intention without justified reason and thereby caused damage to the other party.

M&A negotiations may be terminated for various business reasons, such as adverse findings from the due diligence process, the inability to secure financing, the absence of required approval or the inability of the parties to agree on the price and other key terms of the transaction. The existence of an LOI does not in itself mean that the parties are required to continue negotiations or enter into the final agreement.

However, a decision to terminate negotiations does not automatically affect the provisions of the LOI that are designated as binding. Even after withdrawal, the parties must act in accordance with the agreed rules on confidentiality, termination of exclusivity, return or destruction of documents, costs and similar matters. The non-binding nature of the commercial part of the LOI therefore does not justify conducting negotiations in bad faith or breaching obligations expressly accepted by the parties.

Between Intention and Legal Obligation

An LOI represents an important step in the preparation of an M&A transaction because it allows the buyer and the seller to establish the basic commercial framework, organize the due diligence process and define the rules for further negotiations before the final agreement is prepared.

Its practical value is also reflected in the fact that the parties can determine, at an early stage, whether there is agreement on the key elements of the planned transaction. This allows outstanding issues to be identified in a timely manner and reduces the risk that, only after significant time and resources have been invested in the due diligence process, it is established that there are fundamental differences between the parties that may delay or prevent completion of the transaction.

However, a letter of intent is not automatically either fully binding or fully non-binding. Its legal effect depends on its content, the wording used and the intention of the parties. It is therefore particularly important to clearly identify the provisions that apply immediately, most commonly confidentiality and exclusivity, and to precisely define the obligations undertaken by the parties during negotiations.

This article is to be considered as exclusively informative, with no intention to provide legal advice. If you should need additional information, please contact us directly.