M&A CLUB WEBINAR
Simanpreet: As Greg mentioned my name is Simanpreet Panaych and I'm associate with the corporate finance group with Gowling WLG. I'm here to today to present on letters of intent, or LOI's, for short. We recognize that there's going to be different levels of expertise on this call. So for some of you, you will have dealt with very many LOI's, and for some of you, you might not have seen very many LOI's. Our goal with today's presentation is to provide more of a higher level overview of LOI's and we hope that after today's presentation you will all have a better understanding of the importance of an LOI in a transaction. The benefits an LOI can bring and how an LOI can be used as a tool in your business. This is the road map for today's presentation. I'd like us to being by discussing why transactions should have an LOI and I'd like to move into how an LOI can be used in a variety of different scenarios that may come up in your business. Then I'd like to spend some time discussing key terms that parties may want to consider including in their LOI, and why parties should consider having these discussions and agreeing to these terms, prior to drafting a definitive agreement and then I'd like to give some additional considerations for parties to think about, during COVID-19, in relation to LOI's.
To help illustrate why parties should have a letter of intent in their transaction, I'd like to give an example of what happens when parties don't. Last year I assisted on a transaction where our client was purchasing the assets of a company that he'd been employed with for several years. Our client and the seller had a very long and personal relationship. When they entered the transaction the parties didn't think it was necessary to prepare and LOI. They felt it was relatively simple and they didn't think there was going to be very terms that required heavy negotiations, however, when we began drafting a definitive agreement and began having discussions with our client on the business that he was purchasing, what resulted was that there was actually a variety of terms and conditions that our client wanted included in the definitive agreement that he had not yet discussed with the seller. This led to complications during drafting of the definitive agreement because now time had to be spent negotiating these terms. Parties should consider, early on in a deal, agreeing to the terms of a definitive agreement and putting that in writing in the form of an LOI. Now it's easier for parties to agree to these terms earlier on in a transaction because generally, from the outset parties are more friendly and willing to cooperate, both parties are very eager to close the deal. Because there is this eagerness it is easier to spell out some of the terms. While sometimes parties may think that an LOI is not a crucial step of a transaction, or may even worry that it might lead to unnecessary delay in the beginning of a deal, it's actually the reverse that's true. If parties spend time preparing an LOI they prevent delay later on, because time does not have to be spent negotiating these terms when you're drafting the definitive agreement, and also prevents conflict developing between the parties. Because all the parties will be on the same page as to what the transaction will look like and there won't be any sort of surprises that might come up. It is important for parties to recognize that it's not just enough to have an LOI. Parties should consider spending time, earlier on in a deal, thinking through the transaction and the business, to determine what terms and conditions should eventually form the definitive agreement. So really, an LOI can be tailored for the business and the transaction. It's at this stage that it's a good point to get legal counsel involved. Most times parties may think that a lawyer should really only be involved during a definitive agreement stage. But that's a misconception. Lawyers can work with you at the LOI stage to make sure that all relevant terms and conditions that need to be included in a definitive agreement have been considered and to ensure that you and your business are protected.
If parties have a good LOI this will ensure that there is clarity between the parties on the terms of the transaction, will lead to simplicity when closing the deal and it will maintain agreement between the parties and avoid conflict. So really, an LOI should be considered the building blocks of the transaction. The more building blocks that parties have, ie: the more terms that have been agreed upon, the easier it will be to close the deal. I'm sure that most of you have seen LOI's used in M&A transactions, such as a share and asset deal. This is one area that LOI's are most commonly used but there's actually a variety of different scenarios where LOI's may be beneficial for parties to consider using. For example, parties can consider using an LOI in a capital raising transaction. In a capital raising transaction that's where LOI's would be used in the form of a term sheet. This term sheet would contain the specific terms of the offering, such as the security being offered, the subscription price of the security, the size of the offering and the closing date. By having a term sheet in place, what this ensures is that all parties, such as investors, the corporation and any brokers, all have details on the transaction. You can also use an LOI if you are negotiating a services agreement, a co-development agreement, a distribution agreement and, really, it can be used in any agreement where you'll be negotiating the terms entering into business with another party. So while an LOI can be used in a variety of different scenarios, the focus of today's presentation will be more on M&A transactions, because this is a scenario where LOI's are most commonly used.
So, one term that parties may want to consider including in their LOI is the purchase price. Parties would want to consider including the amounts. So how much will the purchaser being paying to the seller for either the shares or the assets that they're purchasing. Parties also want to consider thinking about the mechanics. So how will the purchase price be satisfied. It's on this piece that we see that the seller and the purchaser are diametrically opposed in terms of interest. For the seller, the seller will generally want to have the purchase price paid in the full amount, in one payment, and they'll usually want it paid in cash. On the other hand, for the purchaser, they may want to structure the payment of the purchase price based on the needs of their business. They may not be beneficial for their business to pay the purchase price out at once. If this is the case there are other forms of payment such as a promissory note, a vendor take back note and the issuance of shares that the purchaser may want to consider using to satisfy the purchase price. The purchaser can even ask to have an adjustment provision built into the definitive agreement to adjust for the profitability of the business. There's really a variety of different approaches that can be taken with respect to how the purchase price will be paid out. We can work with you to ensure that the mechanics meet your business needs. There are also a variety of different tax considerations that parties need to think about in relation to the purchase price. There's different tax considerations if you are selling shares versus assets. When structuring the transaction, so determining if it's going to be a share purchase or an asset purchase, it's important for the structure of the transaction to be reviewed by the seller and their tax advisors, to determine if the vendor can use any exemptions, tax exemptions that are available, such as a capital gains exemption. It's important for parties to determine the selling strategy before the LOI is signed so that the purchase price can be allotted to the class of assets, the goodwill and the actual capital property, prior to that LOI being signed.
On the tax piece, we're also going to find that the seller and the purchaser usually want different things. For the seller, it's usually more advantageous to structure the transaction as a share transaction, a share purchase, because what this allows, it allows for the seller to maximize their use of the capital gains exemption. In some cases multiply their use if there is, for example, family trusts involved. For the purchaser it's more advantageous to have it as an asset transaction because this allows them to limit the liabilities that they're exposed to, because the liabilities are limited just to the assets that they're purchasing and it also allows them to increase the basis of the asset and class of assets on the balance sheet. They're likely going to want to depreciate and amortize the class of assets to a maximum amount available. There's really many considerations to think about in relation to the purchase price and because there is a opposition, in terms of interest of the seller and the purchaser, it'd be advantageous for the parties to get this settled earlier on in a transaction, when it's easier to negotiate and settle on these terms.
Parties may also want to consider the reps and warranties that will be included in their transaction. The reps and warranties that parties will want to include in a transaction should be business and transaction specific. Really, there's not just one set of reps and warranties that can be used from one transaction to the other, it really can be tailored for the specific transaction of the business. One such example of a rep and warranty that could be used, that would be a little bit more transaction specific, is a transitional services period provision. A transitional services period provision is advantageous where you have a seller selling their business to a purchaser who may not have knowledge of the business that they're buying. What allows, it allows for the purchaser to retain the services of the seller for a certain period of time after closing, to allow for a smoother transition of the business. Where I've seen this used is, I assisted on a transaction recently where our client was selling his business that he had for about 30 plus years, and really he was the only individual that had the know how on the business, and he was selling it to a private equity firm that had never been engaged in this type of industry. To ensure that the transition of the business was smooth, and to increase the chances of the profitability of the business after closing, we built into the definitive agreement that the purchaser was going to retain the services of our client as an employee for about a year after the deal closed.
Parties also want to consider how employees will be dealt with in definitive agreements. So what reps and warranties will be included in relation to the employees of a company? There's different considerations to think about depending on the type of transaction in relation to employees. If the transaction is a share transaction, because there's no employment contracts terminated, the parties should be thinking about, especially the purchaser, is if there are written contracts in place. If the seller only has verbal contracts in place, the purchaser may want to consider including provisions in the definitive agreement that would require the employees to sign written employment contracts at closing. In an asset transaction, where you have employment contracts being terminated, the considerations are different. In this case the parties need to be thinking about which employees will be re-hired, what the terms of new employment agreements will look like, and for any employment agreement that will be terminated, how will severance obligations be satisfied. For the most part, usually it is the seller's responsibility in transactions to payout severance, but there are cases where sometimes the purchaser can agree to assist with either some or all of the severance obligations. If the transaction, if the business that's being bought has any sort of intellectual property, then it would be advantageous for the purchaser to include specific reps and warranties around IP. For example, the purchaser may want to consider including a rep whereby the seller would be repping that all IP rights have been assigned from parties such as employers, developers, and contractors, to the seller prior to closing. If the business that's being sold has anything to do with the environment, so for example, if it's and oil and gas company, the purchaser may want to consider having the seller rep and warrant that, for example, all environmental regulations have been complied with. So really, the reps and warranties that parties can include in a definitive agreement can be tailored to the specific transaction, and it's advantageous for parties to think the business through, earlier on in a transaction even before the definitive agreement drafting is started.
Another term that...
Greg: Can I just interrupt there.
Simanpreet: Of course.
Greg: And let the attendees know that yesterday, Gowling's M&A team out of Toronto did a webinar where they talked about representations and warranties and the MAC clause, material adverse change, due to COVID-19 and how the MAC clause, depending on how it's drafted, can either hinder or help your deal, especially in the light of going forward now, COVID-19 issues, dealing with force majeure and the strict definition of force majeure, in the definitive agreements. It's beyond the scope of this discussion, but I just want to bring it forward that those webinars are on our Gowling main website under a certain tab called COVID-19 Webinars. People can download those for free afterwards. Okay? Thank you.
Simanpreet: Thanks, Greg. So another term that parties may want to consider including in their LOI, to be included in the definitive agreement, is covenants. Covenants really are advantageous for the purchaser because they provide a form of protection for the purchaser by restricting the seller's ability to do certain things after the deal closes. Some examples of these covenants are non-competition covenants, which would ensure that the seller would not be able to engage in any way in a business that competes with the business that the purchaser is buying, non-disclosure covenants whereby the seller would covenant not to disclose any confidential information for a certain period of time after the deal closes, and non-solicitation covenants which would prevent the seller from soliciting any pleas or customers of the purchaser after the deal closes. Now I'm sure that most of you have seen these covenants used in M&A transactions because they are quite common. But even though they're common they can be quite contentious because what they do is they limit the seller's ability to do business for a certain period of time and within a certain area. Because they can be sometimes contentious it's advantageous for parties to, if they want to include covenants in their definitive agreement, to discuss and negotiate them earlier on in a transaction when parties are more willing to cooperate.
Greg: Siman, just to add some tax aspects to covenants not to compete, Income Tax Act, section 56.4(7) has a number of ins and outs and safe harbours for covenants not to compete, and they have to be executed properly, their terms and conditions have to be well thought out because there could be adverse tax consequences to the seller, vendor, covenantor, in those instances. So that's again beyond the scope of this presentation but just wanted to highlight that.
Zafar: And I'll just add to that, Greg, that it's important in these situations to also include legal counsel, because a lot of the terms that may be desired between the parties may not be enforceable in court. The changing landscape, with respect to covenants such as non-competition provisions, happens all the time with employment law, so its important to get a legal counsel involved in the right time there to provide some guidance with how that covenant ultimately is drafted and takes shape in the LOI, so that there's common understanding between the parties right from the get go.
Simanpreet: Alright. So, as you can see an LOI really can be used as a road map for your transaction. But you can also use an LOI to include certain provisions that would be binding upon the parties, to dictate the relationship of the parties in that time period from when the LOI is signed, to the signing of a definitive agreement. One such term that parties may consider including in their LOI, that would be binding, is an exclusivity clause. An exclusivity clause would ensure that it would provide the purchaser with peace of mind in knowing that when they are sending with their resources on negotiating, and doing their due diligence, when they get to that point where there was a signed definitive agreement, that the seller hasn't found a better offer and is then going to walk away from the deal. You can build in an exclusivity clause to state that for a certain period of time the seller will be prevented from finding any other offers. This allows a purchaser to have a peace of mind while they are going through these negotiations and doing their due diligence.
Siman, I'm just going to cut you off here very quickly. We have a question here from Eugene. So Lorraine, if you don't mind opening the mic here to Eugene.
Lorraine: Hi, Eugene. I think your mic is on. Eugene?
Eugene: Sorry.
Lorraine: We can hear you.
Eugene: Yeah. I have no question. Sorry.
Lorraine: Okay.
Greg: Okay.
Eugene: I'll try and mute.
Greg: Thank you. Sorry, Siman.
Simanpreet: That's okay. Perfect. There's also certain outs that can be included in the LOI that basically provide an out for the purchaser to walk away from the transaction. The purchaser may want to consider including a due diligence provision, and what the provision would essentially state, is that if there's anything that comes up during the due diligence, the purchaser would be able to walk away from the transaction. But the due diligence provision could also state that the seller has to provide access to the purchaser to its records to perform due diligence. You can also include a financing condition, and what this condition would allow, is it would allow for the purchaser to walk away from the transaction if they're not able to find financing. The closing of the deal would then become conditional upon the purchaser obtaining financing.
There is also a series of terms that the parties may consider including that would be advantageous for both the purchaser and the seller. For example, parties may consider including indemnities, and these indemnities would essentially be provided for any sort of reps and warranties that might be in the LOI. It could include confidentiality provision, which would ensure that any confidential information that might be exchanged during negotiations is kept confidential, and cannot be disclosed without the consent of the other party, and a no public disclosure provision. Which would prevent any party from making any public announcement of the deal without the consent of the other party.
Greg: Siman, may I interrupt there. Just add a comment that on this slide and the previous slide, we could also introduce the concept of refundable deposits and/or non-refundable deposits in the LOI, with respect to due diligence and financing and drop dead dates so that the seller has some comfort on disclosing and opening up it's books and records to the potential acquisitor, buyer. That there is some good faith deposit placed into trust, with either buyer's counsel or seller's counsel, and some distinct timeframes when they have to kick the tires and then make a decision or walk. And whether or not that deposit is fully refundable, or partially refundable, that's a negotiation amongst the parties at the LOI stage and it can be discussed at that point, and naturally, counsel on both sides should be involved in that discussion because an escrow in one of the two solicitor's accounts may be appropriate. So, I'll hand it back to you.
Simanpreet: Right. In connection with the additional terms that we've discussed it can be binding on parties in an LOI. So such as the exclusivity, due diligence, the financing conditions. Here's an additional consideration that parties may want to think about in connection with some of these terms during COVID-19, for any LOI's that they may currently have, or any LOI's that they may be considering entering into. So, for exclusivity, what parties may find is that their initial exclusivity period for due diligence and negotiation of a definitive acquisition agreement, may be too short. What's likely to happen during COVID-19 is that purchaser's are likely going to be requesting very long exclusivity periods, given the uncertainty as to when social distancing measures will end, and non-essential businesses will be allowed to re-open. But seller's are likely going to be resistant to being tied up for a period of many months rather than a few weeks, which is more common, in normal circumstances. With respect to due diligence, the restrictions that are now in place for non-essential business activities, travel and group gatherings are going to have a significant impact on transactions that require physical inspections or inventory accounts of facilities and assets. Even conducting these inventory accounts, or even environmental assessments, may be impossible to carry out given the restrictions that are now in place, and this is likely going to have significant impacts and delay on the timing and execution of definitive agreements. For where you have a transaction that hinges on the purchaser obtaining financing, there's a lot of funding uncertainties that are currently happening during COVID-19 that may put a deal at risk. At this stage in the crisis, many lenders and equity investors are more focused on their existing portfolio investments as priority. Until they have a better understanding of the impact of the pandemic on current investments, it's likely that new investments will be delayed. Also, the funding capacity of these investors will also need to be considered in light of the pandemic. As well, with the pandemic there's also, of course, increased risk due to supply chain disruptions and decreases in work flow, due to remote work policies. To allocate this risk this can take many forms. Such as having additional reps and warranties in place in the agreement, covenants, further escrow holdback of proceeds or even having a reduction in the purchase price. So because of the uncertainty around COVID-19 we recommend, if you're going to be entering into any transactions or even transactions you might currently have LOI's signed for, that you talk to your legal, tax and business advisors on what you can do to mitigate the risk during COVID-19.
So, an LOI really is a simple but powerful tool. You can tailor an LOI for your transaction, and you can use an LOI to dictate the relationship of the parties, between the time period from when the LOI is signed to when the definitive agreement is signed. It's also important to remember that an LOI is an agreement to agree. So while most provisions of the LOI are not enforceable, an LOI brings parties together to negotiate and can form the road map to close a transaction. Now you don't need to necessarily have every single term of the definitive agreement agreed to prior to drafting. But by having the main terms figured out it will make that much easier to close the transaction. Because there are so many considerations that parties need to think about when they do enter into a transaction it's a good idea to involve legal counsel. Legal counsel is here to help. We can help out in a variety of different ways. We can assist with drafting an LOI, reviewing an LOI that has already been drafted to make sure that nothings been missed, and we can even negotiate on your behalf in the earlier part of the transaction. Really, we can work with you to ensure that you and your business are protected during and after a transaction. As mentioned before we've left some time for questions and we really appreciate your time today and we hope that this has been helpful and informative. Lorraine, I think we can open it up to questions.