Zen and the Art of the Letter of Intent
 
July 2, 2007
 
Ying "Geneve" DuBois- Ft Lauderdale
James M. "Jim" Norman- Ft Lauderdale

In 1974, Robert M. Pirsig published Zen and the Art of Motorcycle Maintenance, a book about neither motorcycles nor Buddhist practices. It was, however, about communication and values. The storyline explored two different types of personalities – one interested mostly in the romantic version or Zen of an undertaking and another, the classicist, interested in the details and the mechanical elements. This dichotomy often describes the two sides negotiating a hotel transaction and establishes why the title to this article was inspired by Pirsig’s book.

The documentation of the negotiations in a hotel transaction often begins with a letter of intent, which not only outlines the scope of the deal, but often sets the tone of the parties’ relationship. Preparing a letter of intent is truly an art. If you don’t appreciate the Zen behind this art, you will easily fall into one or both of two traps: you bind yourself in a contract when you did not intend to do so, or you did not put enough important detail, including critical business points, in the letter of intent. Either trap can be fatal to your deal.

Time Is Money

Why are letters of intent or memoranda of understanding, as they are sometimes called, used? In its most basic form, if done properly, a letter of intent will tell the parties whether or not they have a deal. It may not tell them in an absolutely final sense whether the deal can be concluded, but at least in terms of the major business points and legal issues, they will have major areas of agreement. The best part of it is that you can determine if there is a deal without spending too much in legal fees or investing too much time and effort into the usually long process of negotiating and drafting every detail of the definitive contract. If time is money, then the savings on legal fees alone may more than justify use of a letter of intent, even if ultimately the transaction cannot be completed because of other reasons.

Include Both Parties’ “Hot Buttons” and “Just Enough”

The difference between a good letter of intent and one that is a failure, is not the science, but rather the art, of preparing the letter of intent. Part of the art is determining the essential business terms and each party’s “hot buttons” to be included. The rule of thumb is to not include too much nor too little, but just enough to know if you have a deal. Of course, this is easier said than done. However, there are a number of items that will help you to formulate the “just enough” ingredient in a letter of intent. Perhaps most important is the mindset of each of the parties and what they hope to accomplish. Second, the drafter of the letter of intent must understand the needs of the parties in the context of the hospitality industry and the type of the definitive agreements the parties intend to execute, whether a management agreement, a technical services agreement, or a license agreement and potentially additional related agreements, such as a rental management agreement. Finally, the essential points that are specific for that particular transaction, which may differ from party to party, must be addressed.

With these three general rules in mind, there are a few categories of terms the parties should deal with in a letter of intent. In purchase and sale transactions, the letter of intent should include: property description, purchase price, deposit schedule, inspection period, title and survey matters, targeted closing date, and any contingencies such as financing and conditions precedent to closing. A letter of intent for management agreements should contain, at a minimum: the scope of the resort/hotel being managed, fees and expenses (including accounting definitions), operator’s responsibilities, the term of the agreement, the branding mechanism, approval rights and termination provisions.

Once you determine what to include, you must then decide how much detail is to be incorporated under each category in a letter of intent. Certain terms, such as accounting definitions in a hotel management agreement, for example, are so critical to the calculation of fees, that there is a very logical basis for actually including a number of the most important definitions: gross operating profit, gross revenue, operating expenses and others used in calculating incentive fees. It would be a wasted effort, however, to include all of the defined terms because (a) this is unnecessary to determine whether there really is a deal between the parties, and (b) the letter of intent would be morphing into a definitive agreement, which would defeat the very purpose of a letter of intent, i.e., knowing if there is a deal and saving time and effort if there is not. Your objective, again, is to include “just enough.”

The Intricacies of Binding Obligations

Doing letters of intent is not without some legal risk. If one is not careful, in some jurisdictions you may wind up with an enforceable contract. Some parties develop a reputation for trying to call something a letter of intent, but have it effectively become a contract. This will allow them to bring a lawsuit and effectively tie up the property or the project. You can imagine what a nightmare this would be. In some jurisdictions, it is critical to make sure that the letter of intent is not a contract and that is generally accomplished by clearly stating the intent of the parties is that a contract not be created. However, most letters of intent do have several areas where it is appropriate to create binding obligations on the parties. These include a period of exclusivity where the parties will negotiate the definitive agreements in good faith and an agreement to maintain the confidentiality of the existence of the negotiations. These can be particularly important in dealing with public companies. With confidentiality, it is vital to make sure that there are necessary carve-outs, such as disclosure to lenders or potential equity investors. Most parties do also include the timeframe, which establishes a limitation on the time during which the definitive documents will be negotiated. This is good practice. How long that period is depends on the parties and the nature of the transaction. In most cases, the parties will agree on too short a time. However, a short timeframe does encourage the parties to proceed and the timeframe can always be extended.

Deal Distraction

When is it time to throw in the towel? If the letter of intent is seemingly endless, either in terms of the number of its pages or the duration of the negotiations, or the parties have such a difficult time agreeing on the fundamentally important business terms, it’s time to close your briefcase and go home. Protracted negotiations or extreme detail in a letter of intent are clues that a deal between the parties does not exist, or is not likely to be made. Even if the basic terms are finally agreed upon, the journey to the completion of the deal will probably be one that is full of obstacles and headaches. The correlation between pages and negotiation duration and transaction failure is very strong.

Remember that focusing on one potential transaction that may or may not happen tends to foreclose opportunities for other deals. This is called “deal distraction.” There are hospitality industry executives who believe that if a management deal does not result in a letter of intent within 30 days, it’s time to move on. Is that a good rule? It depends. In each case, the parties must evaluate the benefits and costs and come to their own conclusion.

Don’t Start With a Definitive Agreement

Some have suggested an alternative to a letter of intent – use an existing standard management agreement or purchase agreement as the basis for the negotiation. Whether or not that is a good strategy depends on whether the party that produced that form intends to limit discussion to only a few key terms, such as the purchase price and date of closing, or the amount of the base fee and incentive fee. Most parties cannot withhold their urge to negotiate most provisions of a contract. Therefore, while it sounds like a good and expeditious way to finalize a transaction, in most cases, trying to start with a definitive agreement is expensive, time consuming and no more likely to result in an executed agreement than beginning the process with a letter of intent.

Before drafting a letter of intent, stop and consider the following:

• why it is needed

• what categories to include

• how much detail to include in each category

• what should be binding on the parties and what should not

Don’t forget to get input from those in your organization who will have to live with the deal (operations, risk management and counsel, for example) and work on the definitive agreement. It’s far better to get it right the first time, to avoid retrading parts of the deal later. If you do it right and do it for the right reasons, it will contain “just enough” business terms and set a solid foundation for the relationship of the parties and early completion of the definitive agreements. However, doing it right requires extensive knowledge of the hospitality industry, the deal and both parties to the transaction. This is the art of the letter of intent.

For more information, e-mail Jim Norman or Geneve Dubois at jim.norman@hklaw.com or geneve.dubois@hklaw.com, respectively, or call toll free, 1-888-688-8500.

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