What to Know About Exclusivity Clauses in Letters of Intent
A common misconception is that Letters of Intent (LOIs) are nonbinding. But that’s a half truth. While much of an LOI is non-binding, some provisions are (or, at least, should be) 100% binding. And that includes exclusivity.
Any LOI worth its salt should contain a binding exclusivity provision. Exclusivity prevents the seller from entertaining other offers while you conduct diligence. It also gives you space to negotiate a purchase agreement without having to worry about competing buyers.
From the moment you sign the letter of intent, to the moment you sign the purchase agreement, exclusivity is all you have holding your deal together. It’s therefore worth understanding.
What Is an LOI Exclusivity Provision?
Your exclusivity provision should cover two bases.
First, it should stop the seller from continuing to market the business for sale.
Seller shall not initiate, solicit, entertain, negotiate, accept, or discuss any proposal or offer from any person (other than buyer) to acquire all or any portion of the business, whether by merger, purchase of stock, purchase of assets, or otherwise.
Second, it should require the seller to halt existing negotiations with other buyers.
Seller shall terminate any and all existing discussions or negotiations with any person (other than buyer) regarding an acquisition proposal. Seller is not a party to or bound by any agreement with respect to an acquisition proposal other than under this letter.
You need exclusivity to last long enough to give you time to conduct diligence and negotiate the purchase agreement (typically between 60-90 days). Make sure to also sweep in the seller’s affiliates and representatives (including the seller’s broker).
Once you have a signed purchase agreement, you are under contract and exclusivity is less of a concern (although your purchase agreement should still address it if using a sign-then-close structure).
Why Exclusivity Matters
Like many things SMB M&A, it’s about information asymmetry.
Prior to diligence, you have no way of knowing whether the actual financials differ from those presented by the seller’s broker. And you have yet to probe the seller’s assertion that there are no undisclosed liabilities.
But diligence costs real money. And to justify that outlay, you need to know that a larger offer cannot swoop in and steal your deal.
By preventing the seller from entertaining other offers, exclusivity protects your investment in diligence. And if you decide to move forward with the deal, it creates a safe space to negotiate the purchase agreement (based on what you’ve learned during diligence).
That’s why some form of binding exclusivity provision has to be included in your LOI. The seller has to take the business off the market and commit to dealing only with you.
And that’s non-negotiable.
Until it isn’t…
What Can and Can’t Happen During Exclusivity
Deals sometimes fall apart, despite the best efforts of the parties. And in that case, the seller will have to find another buyer.
This takes time. Potentially, the seller has already lost months to the buyer’s exclusivity period. Another solid offer may take weeks to cultivate. The new buyer will also want exclusivity.
Months can quickly turn into a year, which, if you’re trying to sell a business and retire, can be difficult to swallow.
To mitigate this issue, sellers sometimes push for an exception: They want their brokers to continue to market the business during the exclusivity period.
This is actually quite common. Indeed, if the parties are relying on a form purchase agreement, this exception may be included as standard.
Yet from your perspective, this exception creates the very risk that exclusivity is designed to mitigate: If the broker continues to market the business and receives additional offers, one of those offers may exceed yours.
If the seller were to find out about this new offer, she may intentionally frustrate negotiations in an attempt to get out from under your LOI.
Feet dragging as a tactic can work in the right circumstances.
Key Negotiation Tips for Buyers
Despite the risk, it can be hard to push back against the seller’s demand.
It depends on the competitive nature of the sale. If the seller receives lots of interest, the seller may feel emboldened to insist on favorable terms. If you really like the look of this business, you may not want to lose it over a fight about exclusivity, regardless of the risks.
While it can be hard to push back in this situation, you have options.
You always have options.
You can accept the seller’s exception to exclusivity but:
Require that the seller is kept in the dark about any contact the broker has with other would-be suitors. This is as common as the exception itself. So if a seller pushes back here, this should raise a red flag.
Demand that the broker keep you abreast of any competing offers. If the seller’s behavior changes for the worse during negotiations and you know that a competing offer has come in, you have grounds to suspect bad faith (and can act accordingly).
Push for a longer exclusivity period. If the seller employs the waiting game as a means to frustrate the deal, she will need to wait months just to start the process all over again with a new buyer.
If the seller is less than 100% committed to your offer, the seller will not want to wait out a longer exclusivity period. After all, neither the seller nor the seller’s broker get paid until the deal is done.
The competing offer would have to be significantly larger to take on that risk.