Letter of Intent (LOI) Explained: What to Negotiate and What to Watch Out For

The Letter of Intent is the most important document in a business sale that most sellers don't take seriously enough. It is non-binding on most terms — but the terms you agree to in the LOI set the anchor for every subsequent negotiation. Once you've agreed to a price and structure in the LOI, it is very difficult to change those terms without damaging the deal.

This guide explains what an LOI covers, what to negotiate, and the common traps that cost sellers money.

What Is a Letter of Intent?

A Letter of Intent (LOI) — also called a Term Sheet or Indication of Interest — is a document that outlines the key terms of a proposed business acquisition. It is typically 3-10 pages and covers:

• Purchase price and structure
• Deal structure (asset sale vs. stock sale)
• Exclusivity (the seller agrees not to talk to other buyers for a specified period)
• Due diligence (what the buyer will review and how long it will take)
• Key conditions to close
• Management arrangements (if the seller is staying)
• Timing (expected close date)

Most LOI terms are non-binding — they represent the parties' current agreement on key terms but do not obligate either party to complete the transaction. The binding provisions are typically:

• Exclusivity: The seller agrees not to talk to other buyers during the exclusivity period
• Confidentiality: Both parties agree to keep the terms of the LOI confidential
• Expense allocation: Each party pays their own expenses (or the buyer pays if they terminate)

Why the LOI Matters More Than Most Sellers Realize

The LOI is non-binding, but it creates powerful psychological and practical anchors:

Psychological anchoring: Once you've agreed to a price in the LOI, any subsequent attempt to change it feels like a concession. Buyers use this to their advantage — agreeing to a favorable price in the LOI, then using due diligence findings to justify price reductions.

Exclusivity: The LOI typically grants the buyer 45-90 days of exclusivity. During this period, you cannot talk to other buyers. If the buyer uses the exclusivity period to chip away at the price, you have no leverage — you can't go back to other buyers without terminating the deal.

Deal momentum: Once the LOI is signed and due diligence begins, there is significant deal momentum. Sellers become emotionally invested in closing. Buyers use this to extract concessions late in the process.

Legal costs: By the time you've spent $50,000-$150,000 on legal fees during due diligence, you are very motivated to close. Buyers know this and use it.

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What to Negotiate in the LOI

1. Purchase Price

The purchase price is the most obvious negotiation point, but the structure of the price matters as much as the number.

All-cash at close: The cleanest structure. You receive the full purchase price at closing. No contingencies, no earnouts, no seller notes.

Earnout: A portion of the purchase price is contingent on the business achieving certain financial targets post-close. Earnouts are common when there is disagreement on valuation — the buyer pays a base price now and additional consideration if the business performs.

Earnouts are risky for sellers:

• You lose control of the business post-close, but your earnout depends on performance
• Buyers can make decisions that reduce earnout performance (cutting expenses, changing strategy)
• Earnout disputes are common and expensive
• The present value of an earnout is always less than its face value

If you must accept an earnout, negotiate:

• Short duration (1-2 years maximum)
• Simple, objective metrics (revenue or EBITDA, not complex formulas)
• Buyer obligations to operate the business in a manner consistent with achieving the earnout
• Acceleration provisions if the buyer sells the business or makes material changes

Seller note: You provide financing for a portion of the purchase price. The buyer pays you over time with interest. Seller notes are common in smaller transactions and when buyers have limited capital.

Seller notes are risky for sellers:

• You are now a creditor of the business you just sold
• If the business underperforms, you may not be repaid
• The present value of a seller note is less than its face value

If you must accept a seller note, negotiate:

• Secured by the assets of the business
• Personal guarantee from the buyer
• Market interest rate
• Short term (3-5 years maximum)
• Acceleration provisions if the buyer defaults

Rollover equity: You retain a portion of the equity in the business post-close. Common in PE transactions where the seller is staying to run the business.

Rollover equity can be valuable if the PE firm creates significant value post-close. But it is illiquid — you can't sell it until the PE firm exits. Negotiate:

• Valuation of the rollover equity
• Liquidation preferences (who gets paid first in a sale)
• Anti-dilution protection
• Tag-along rights (you can sell your equity when the PE firm sells)
• Drag-along rights (the PE firm can require you to sell your equity)

2. Deal Structure: Asset Sale vs. Stock Sale

The deal structure has significant tax implications for both parties.

Asset sale: The buyer purchases the assets of the business (equipment, contracts, customer relationships, IP) rather than the equity. The seller retains the legal entity and any pre-existing liabilities.

• Seller tax treatment: Proceeds are taxed at capital gains rates for most assets, but ordinary income rates for some (inventory, accounts receivable, depreciation recapture)
• Buyer tax treatment: The buyer gets a "step-up" in the tax basis of the assets, which allows them to depreciate the full purchase price
• Liability protection: The buyer is generally not responsible for the seller's pre-existing liabilities

Stock sale: The buyer purchases the equity of the business. The seller receives capital gains treatment on the entire proceeds.

• Seller tax treatment: Proceeds are taxed at capital gains rates
• Buyer tax treatment: No step-up in tax basis; the buyer inherits the seller's historical tax basis
• Liability exposure: The buyer inherits all of the seller's pre-existing liabilities

The negotiation: Sellers prefer stock sales (capital gains treatment on all proceeds). Buyers prefer asset sales (step-up in basis). The difference in tax treatment can be significant — often 5-15% of the purchase price.

In practice, most lower middle market transactions are structured as asset sales because buyers insist on it. If you must accept an asset sale, negotiate a higher purchase price to compensate for the tax difference.

3. Working Capital Peg

The working capital peg is one of the most common sources of post-close disputes. It is also one of the most negotiable terms in the LOI.

What it is: The working capital peg is the target amount of working capital that the business will have at close. If actual working capital at close is above the peg, the buyer pays more. If it is below the peg, the seller receives less.

Why it matters: The working capital peg effectively determines how much cash you can take out of the business before close. If the peg is set too high, you will owe the buyer money at close.

What to negotiate:

• The definition of working capital (what is included and excluded)
• The peg amount (should be based on normalized working capital, not a peak or trough)
• The calculation methodology (how disputes are resolved)
• The collar (a range within which no adjustment is made)

Get a sell-side QoE before going to market — the working capital analysis in the QoE will give you a defensible basis for negotiating the peg.

4. Exclusivity Period

The exclusivity period is the time during which you agree not to talk to other buyers. This is one of the most important terms in the LOI.

What to negotiate:

• Duration: 45-60 days is reasonable. 90 days is too long. Buyers will ask for 90 days; push back to 60.
• Extension provisions: What happens if due diligence takes longer than expected? Negotiate a specific extension process (buyer must request in writing, you can approve or deny).
• Termination rights: Under what circumstances can you terminate the exclusivity period? Negotiate the right to terminate if the buyer materially changes the terms of the deal.

5. Representations and Warranties

The LOI will typically include a brief description of the representations and warranties that the seller will make in the purchase agreement. These are important to negotiate at the LOI stage because they set expectations for the purchase agreement negotiation.

Key negotiation points:

• Survival period: How long are you liable for breaches of representations and warranties? Negotiate 12-18 months (not 24-36 months).
• Cap on liability: What is the maximum amount you can be required to pay for breaches? Negotiate a cap of 10-20% of the purchase price (not the full purchase price).
• Basket: What is the minimum amount of losses that must occur before you are liable? Negotiate a basket of 0.5-1% of the purchase price.
• Materiality qualifiers: Many representations should be qualified by materiality — you are only liable for breaches that are material to the business.

6. Management Arrangements

If you are staying with the business post-close, the LOI should outline the key terms of your employment or consulting arrangement:

• Role and title
• Compensation
• Duration
• Non-compete terms
• Equity participation (rollover equity, options)

If you are leaving, the LOI should address:

• Transition assistance (how long you will help the buyer transition)
• Non-compete terms (geography, duration, scope)
• Non-solicitation terms (employees, customers)

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Common LOI Traps

The Lowball LOI

Some buyers submit a LOI at a price they know is below market, with the intention of increasing the price during negotiations. The trap: once you've signed the LOI and granted exclusivity, you have no leverage to negotiate the price up.

How to avoid it: Get multiple LOIs before granting exclusivity. Never sign an LOI with a price below your walk-away number.

The Broad Exclusivity Period

Buyers routinely ask for 90-day exclusivity periods. This is too long. During a 90-day exclusivity period, the buyer can conduct extensive due diligence, find issues, and use them to justify price reductions — while you have no ability to go back to other buyers.

How to avoid it: Negotiate exclusivity to 45-60 days. Include termination rights if the buyer materially changes the terms.

The Vague Working Capital Peg

An LOI that says "working capital will be set at closing based on a normalized working capital analysis" is a recipe for a post-close dispute. Without a specific peg amount agreed in the LOI, the buyer will set the peg during due diligence — often at a level that results in a purchase price reduction.

How to avoid it: Negotiate a specific working capital peg amount in the LOI, based on your sell-side QoE.

The Broad Representations

Some LOIs include broad representations that the seller will make in the purchase agreement — representations that are difficult to make accurately and create significant liability. Common examples:

• "No material adverse change in the business since the financial statements"
• "All material contracts are in full force and effect"
• "The business is in compliance with all applicable laws"

How to avoid it: Negotiate materiality qualifiers and knowledge qualifiers for all representations. Work with your transaction attorney to review the representations before signing the LOI.

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Key Takeaways

• The LOI sets the anchor for all subsequent negotiations — take it seriously even though it is non-binding.
• Negotiate the purchase price structure — all-cash at close is always better than earnouts or seller notes.
• Understand the tax implications of asset sale vs. stock sale — the difference can be millions of dollars.
• Negotiate the working capital peg specifically — vague language leads to post-close disputes.
• Limit the exclusivity period to 45-60 days — 90 days gives the buyer too much leverage.
• Negotiate the representations and warranties framework — survival period, cap, and basket.
• Never sign an LOI without a transaction attorney — the terms you agree to here will govern the entire deal.

If you're in the process of evaluating LOIs or want to understand what terms to expect, Deal Flow's team can provide guidance. Start the conversation here.