A letter of intent is frequently used by entrepreneurs and investors to buy or lease commercial real estate. Despite its popularity, however, parties continue to make avoidable, crucial mistakes. The following Q&A will help you understand the key elements of a letter of intent and provide tips for avoiding common mistakes.
Q: What is a letter of intent?
A: A letter of intent is a written summary of the key deal terms of a contemplated transaction. Although a letter of intent, commonly known as a LOI , may be used in a variety of contexts, the discussion here focuses on two types of commercial real estate transactions: (1) purchase and sale transactions and (2) lease transactions.
Q: Who prepares the LOI?
A: Either side may participate in the preparation of the LOI. A prospective buyer or tenant (as applicable) may initiate the process by preparing the initial draft of the LOI or by authorizing its broker to prepare the initial draft. Although it is a matter of personal choice, each principal to the transaction should carefully consider involving its real estate attorney as early as possible in the process (more on this below).
Q: What does it mean when a party submits the LOI?
A: Submission of the LOI signals a genuine interest in buying or leasing the referenced property. Taking the time to prepare and deliver the LOI represents a significant preliminary milestone in a transaction. The LOI serves as a starting point for preparing the more formal, definitive agreement, which is why it is imperative that each party involve their respective attorneys as soon as possible — ideally before finalizing the LOI.
Q: What does the LOI contain?
A: The LOI contains the key business terms. The level of detail in each LOI varies greatly depending on the context. As a practical matter, the parties must balance the desire to keep things simple to increase the likelihood of reaching an agreement against the need to flesh out potential disagreements as to essential deal terms.
Factors that affect the number of items and the level of detail in the LOI include: (1) the level of motivation of the parties, (2) the negotiation style of the parties, (3) the sophistication and experience of the parties, (4) the potential value of the transaction, and (5) the complexity of the transaction. The LOI may be structured as an in-depth, lengthy (15 to 20 pages, or more) narrative discussion of the contemplated terms, or a short (1 to 2 pages) list of the key terms of the transaction.
Below is a brief overview of the typical structure of a LOI:
1. Introductory Paragraph(s). This is where the purpose of the LOI is stated, for example, an expression of interest in purchasing or leasing the referenced property.
2. Parties. The parties should endeavor to set forth as much information as possible to identify the principals, such as the full legal name, the type of entity (if applicable), and the home state of each entity (for example, Main Street, LLC, a California limited liability company). Accurately identifying the parties in the LOI reduces the risk of a misunderstanding and the risk of including inaccurate information in the definitive agreement.
3. Key Deal Terms. The parties are free to decide which terms to include in the LOI regarding the proposed transaction. Below are items for consideration .
|Purchase and Sale Terms||Lease Terms|
|Description of the Property||Description of Premises/Property|
|Earnest Money Deposit(s)||Security Deposit|
|Purchase Price||Permitted Use|
|Opening of Escrow||Lease Term/Extension Option(s)|
|Due Diligence Period||Lease Effective Date/Commencement Date|
|Title Report||Delivery Date/Move-In Date/Conditions to Effectiveness of Lease|
|Due Diligence Items; Seller Disclosures||Condition of Premises Upon Delivery (Tenant’s Work and Landlord’s Work, if applicable); CASp; Furniture, Fixtures, and Equipment (FFE)|
|Inspection Rights and Obligations; Right to Enter||Permit Contingencies and Other Contingencies (if applicable)|
|Disapproval of Due Diligence Items;Objection Notice(s); Rights to Cure||Rent Commencement Date; Conditions|
|Condition of Property||Rent, Additional Rent, Rent Adjustments, and Rent Concessions (if any); Common Area Maintenance Costs (if applicable)|
|Indemnifications/Releases||Tenant Improvement Allowances (if any)|
|Inspection Contingencies||Real Estate Taxes|
|Representations and Warranties||Guarantor(s)|
|Financing Contingency (if applicable) and Other Contingencies||Use Restrictions|
|Buyer’s Closing Conditions||Maintenance, Repair, and Replacement Obligations|
|Seller’s Closing Conditions||Environmental Matters, Obligations and Indemnities|
|Prorations and Adjustments of Expenses||Alterations|
|Form of Conveyance Deed||Signage Rights; Access Rights|
|Title Insurance||Operating Covenants/Rights (e.g. co-tenancy requirements; Radius Restrictions; Competition; Operating Requirement; Relocation)|
|Assignment of Leases, Service Agreements, and Other Agreements||Options to Purchase (Right of First Refusal, Right of First Offer, etc.), if applicable|
|Waivers, Releases, Disclaimers, and Limitations on Liability||Waivers, Releases, Disclaimers, and Limitations on Liability|
|Allocation of Closing Costs||Casualty/Condemnation|
|1031 Exchange||Disclosure of Tenant’s Financials (if applicable)|
|Post-Closing Matters||Subordination, Non-Disturbance and Attornment|
|Events of Default; Remedies; Liquidated Damages||Events of Default/Remedies|
|Broker Commissions||Broker Commissions|
|Form of Purchase and Sale Agreement||Form of Lease Agreement|
Additional items may apply depending on the property type and the context of the contemplated transaction. An experienced commercial real estate attorney should be consulted to help you identify and evaluate legal issues specific to your transaction.
4. Closing Paragraph(s)/Enforceability. Many LOIs conclude with a statement expressing whether all or part of the LOI will be binding or non-binding, that is, legally enforceable or not. For example, the parties may wish to make the confidentiality clause of the LOI binding, or a prospective tenant may require that a landlord’s promise to reimburse the prospective tenant for certain design costs be binding. If the parties intend that all or part of the LOI be binding, then the LOI should describe remedies for breach of such binding provision(s). In the event litigation ensues, clear remedies will be available to assist the court to determine the appropriate remedy.
In the final paragraph of the LOI, there is frequently a request that the receiving party sign and return a copy if the terms and conditions are acceptable, along with an expiration date (to encourage a prompt response).
Depending on the circumstances, the LOI may be heavily negotiated and revised multiple times, or the LOI may be prepared upon completion of the initial negotiations to memorialize the agreed upon terms and conditions. Although LOIs may serve a useful purpose, there are traps for the unwary.
Here are a few tips to avoid potential pitfalls:
TIP #1: Engage a transactional attorney as soon as possible. Oftentimes, principals operate under the mistaken belief that by delaying the attorney’s involvement in the process, they will save on attorney fees. Once the LOI is viewed as final, however, it may be exponentially more difficult for an attorney to effectively address issues revealed during the attorney’s review if the LOI has been deemed “final” by the parties. Consequently, the delayed engagement of an attorney may lead to protracted negotiations and an increase in attorney fees.
TIP #2: Maintain credibility throughout the process. Once the LOI is deemed final by the parties (irrespective of whether it is binding or non-binding), to the extent feasible, avoid subsequent attempts to re-negotiate terms expressly covered in the LOI. Attempting to re-negotiate agreed upon terms in the LOI will likely add strain to the negotiations and adversely affect your credibility. Such attempted re-negotiations will likely be met with significant resistance by the other party. If you find yourself in a situation where you must re-negotiate certain terms, highlight the compelling reasons, such as a material change in circumstances or the discovery of significant new information.
TIP #3: Be wary of unclear terms. Parties tend to view the negotiation of an LOI as an informal process that does not require a close examination or understanding of all the proposed provisions in the LOI. If the meaning of a provision seems unclear, you should definitely seek to clarify it. LOIs frequently contain mistakes and internal inconsistencies, especially in the preliminary drafts. Your attorney can also guide you as to whether certain issues may be better suited for discussion during the LOI stage or during the preparation of the definitive agreement.
TIP#4: Avoid partial performance under a LOI. Avoid taking steps to perform an agreement (i.e., partial performance) before making and entering into a definitive agreement. Doing so is risky for many reasons and it may muddy the waters in terms of evaluating whether an LOI is binding or non-binding. In the event of a dispute, a court may also consider a party’s course of conduct as evidence of whether they intended the LOI to be binding. Consequently, a court may decide that a LOI is binding despite express provisions to the contrary in the LOI itself. Maintain communication with your attorney throughout the process to avoid inadvertently causing your LOI to become binding.