In any business relationship, lack of written documentation is a very dangerous thing. Take, for example, the almighty letter of intent (LOI) and its far-less-recommended cousin, the memorandum of understanding (MOU). I often hear from clients who believe the LOI versus MOU method of negotiating deal points is akin to six of one, half dozen of the other. This is absolutely not the case. Unless the parties truly intend to be bound (as in a contract) from the very outset of negotiations, I almost never recommend an MOU.
A brief primer on the statute of frauds
In California, and at common law (the law that underlies the American legal system), there is a doctrine known as the statute of frauds. Generally, oral agreements are just as enforceable as written agreements. However, in certain circumstances, writing is required. These circumstances vary from state to state and are based on state-specific statutes, hence the name “statute of frauds.” Ordinarily, the statute of frauds will cover the following: contracts that cannot be performed within one year, suretyships (promises to pay the debt or obligation of another), real estate purchase and sale agreements, real estate leases longer than one year, commercial loans, and extensions of credit greater than a threshold amount ($100,000 in California).
So, under certain circumstances, an oral agreement is insufficient. One would think this means a written contract is required. Not so fast. The statute of frauds allows for myriad communications, documentation, or admissions to satisfy the writing requirement. One of these specific documents is known as the “confirming memorandum.” Sound familiar? Confirming memorandum sounds a lot like a memorandum of understanding. Guess what? An MOU is a confirming memorandum.
In other words, an MOU can take what would have been an unenforceable pre-contract deal point yet to be negotiated to its final term and transform it into an enforceable commitment. The confirming memoranda exception to the statute of frauds can take many forms and can be extrapolated from a number of different documents, pieced together.
Even emails can satisfy the statute of frauds, so cannabis industry participants would be well advised to choose their words carefully. California even has amended its statute of frauds (Civil Code §1624) to include any electronic transmission (text, email, instant message, fax, etc.) that can be authenticated as being from the person who sent the communication (except for contracts to convey real property absent certain circumstances).
LOI essential components
It is important to remember an LOI is an outline. It is not a formal contract that needs to cover every potential deal point and every potential remedy for violation of a term. At the same time, an LOI should convey sufficient information to ensure the parties are on the same page about what they are negotiating and on what terms each of them is willing to move forward. The LOI initially is signed by the party presenting the opportunity, but the other party should countersign the LOI as well.
Key provisions of an LOI typically include:
Overall deal structure: This typically is included in the introductory paragraph of the LOI and relays the overall purpose of the transaction, such as to enter into a lease or to acquire a company or its assets.
Consideration: Payments, purchase price, or lease payment terms are referred to as consideration for the deal; some call it quid pro quo. Earnest money, deposits, and down payments should be discussed here as well. If budgets and compensation are at issue, those items also should be addressed.
Share issuance, transfer, options, and warrants: If the deal involves issuing shares of any type (depending on the structure of the business), essential terms regarding how many, at what price, and when shares will be issued should be addressed in the LOI. If there are milestones that must be met before options or warrants are exercised, those terms should be specifically stated.
Timelines: Timelines for due diligence to start and complete, deadlines for contingencies to be met, time frames for financing, and goals and expectations as to when certain events will take place or when the formal binding agreement will be finalized should be discussed.
Compliance matters: Anything from local approvals to state licensing to passing inspections should be addressed here if these are material to the transaction. In cannabis, this is almost always a concern.
Due diligence: General due diligence items and requirements should be outlined so the parties know what kind of information they will be expected to gather. My column in September 2018’s issue (“Corporate Due Diligence Counts”) goes into detail regarding background checks and inspection of company books and records. It is also important to request existing contracts, obligations, and liabilities of the company and its owners.
Specific disclosures and obligations: In the cannabis industry, criminal histories and unfair business practices or any legal dispute involving moral turpitude can be fatal to a company’s ability to obtain a license. It is important all parties know when they enter a deal what they must disclose and what issues may arise from a tarnished criminal or civil record.
Material disclosures: These are any facts or circumstances within the reasonable knowledge of the parties entering the transaction that would tend to affect the other party’s decision about moving forward to close the deal.
Contingencies: These are items to be satisfied or addressed before the transaction closes. Most people are aware of contingencies in a real estate setting. The same is true for cannabis companies. Inspections, permits, licensing, and financing are typical contingencies that should be addressed in an LOI.
Commitment to negotiate in good faith: The parties should agree to work toward a binding contract within a specified time frame. The parties typically will start to shape the contract that will solidify the transaction right away, but it is important to remain flexible as the due diligence process unfolds.
Exclusivity and confidentiality: These are usually the only binding terms in an LOI. Parties are wise to request that all documents exchanged during due diligence be destroyed or returned if the deal does not close.
To bind or not to bind
As discussed above, the objective of an LOI is to outline major deal points and allow the parties room to engage in due diligence and further negotiations with a common understanding and objective. Parties should not be too eager to be bound. We often hear things like, “we want to lock this up,” or “we need to wrap this up now.” No one should enter into a multimillion-dollar business arrangement without taking time to vet the participants and the company (see September 2018’s column for more details) and without taking time to carefully negotiate the terms of the ultimate transaction.
There are two notable exceptions to the non-binding nature of an LOI: exclusivity (also known as no-shop) clauses and confidentiality. Because everyone wants to be in on the “green rush,” knowing the other side is not using your negotiations to solicit more attractive offers is often the most important aspect of an LOI. The time and resources invested in negotiating deals can be significant. To that end, the parties should agree, where appropriate, to negotiate only with each other within set parameters.
The parties to a transaction are going to be exchanging highly confidential, often personal, information. It is imperative this information is maintained confidentially and destroyed if the deal does not materialize.
Letters of intent are revealing
Amidst the ever-changing legal and regulatory landscape, we cannot encourage industry stakeholders enough to obtain clarity wherever and whenever possible. We have seen deals several months in the making immediately quashed when an LOI finally is circulated. There is something about signing on the dotted line that tends to shed light on secret intentions of those at the bargaining table. Some clients end up distraught over failed transactions and lost time and effort.
Only one thing is worse than having to abandon a deal that has been in the works for months or even years: a failed business venture. Lost time up-front pales in comparison to losing hundreds of thousands, if not millions, of dollars—or even worse, litigation.
Moral of the story
Letters of intent should be used frequently. An LOI really gets the ball rolling for any deal and allows the parties to confirm they are on the same page before investing significant time and resources. Be prepared to negotiate deal points contained in the LOI during these early phases. It is not uncommon for LOI drafts to be exchanged four or five times before both parties are willing to sign off on the terms. Be prepared to walk away if the deal is not a good fit. Most importantly, conduct thorough due diligence.
