Term Sheets – Potential Traps for the Unwary

Authors: StartupPercolator

During its life cycle, a typical company enters into several key transactions. These can include debt and equity financings, an exclusive license of the company’s proprietary technology or an acquisition of the company by a strategic buyer. Before signing the “definitive agreement” for a key transaction, however, the company may be asked to sign a term sheet—a short document that outlines the principal business terms of the proposed transaction. Term sheets are often called other names—including “letter of intent,” “memorandum of understanding” or even “heads of agreement.”

Because term sheets focus primarily on the business points of a transaction, clients do not always consult with their lawyers before signing them. Clients worry that it’s not worth the time and expense to have a lawyer review the term sheet or that getting a lawyer involved will create unnecessary friction between the parties. However, signing a term sheet that is not carefully drafted, or that does not address key issues, can be a costly mistake—for several reasons:

  1. A term sheet may legally bind the parties, particularly if it does not expressly state that the business terms are non-binding. In business transactions, negotiations break down for a variety of reasons and, often, one party walks away from a deal before the definitive agreement is signed. However, depending on how the term sheet is drafted, a court may find that it was an “agreement to agree” on the deal points in the term sheet and the court may require the withdrawing party to pay damages for breach of contract. Even if the term sheet expressly states that the business terms are non-binding, in some jurisdictions, a provision requiring the parties to “negotiate in good faith” or to “use best efforts” to reach an agreement can be enough to create an enforceable agreement between the parties based on the deal points in the term sheet. Your lawyer can help you craft appropriate language to ensure that you do not prematurely commit yourself to the deal.
  2. A term sheet may create “deal inertia” that is difficult to reverse. Even if a term sheet is not technically enforceable, as a practical matter, it can be very difficult to renegotiate a deal point in a signed term sheet. Renegotiating a deal point can be necessary if circumstances change and it becomes clear that including the deal point in the definitive agreement no longer makes sense or that it would create a conflict or inconsistency with other terms. If you try to renegotiate the deal point, the other party may accuse you of not negotiating in good faith—or worse, it may view the request as an invitation to reopen negotiations on other issues you thought were settled. Your lawyer can help you avoid this problem by ensuring that the term sheet is drafted at the appropriate level of detail and by helping you think through and identify potentially conflicting terms before you sign the term sheet.
  3. Finally, a term sheet may omit certain key terms. Regardless of the type of transaction, a good term sheet should address the following issues (among others), and it should expressly state that each of these provisions legally binds the parties:
    1. Confidentiality—are the parties restricted from using or disclosing information they obtain during the course of due diligence and negotiating the definitive agreement, from disclosing the existence or contents of the term sheet, or from making any public statements about the proposed transaction;
    2. Exclusivity—is either party restricted from negotiating a similar transaction with a third party while the definitive agreement is being negotiated;
    3. Costs—is each party responsible for paying its own costs and expenses associated with conducting due diligence and negotiating the definitive agreement, or is one party responsible for all or a portion of the other’s costs; and
    4. Termination—under what circumstances (for example, a party’s breach of a binding term or the parties’ failure to sign a definitive agreement before a specified date) may either party terminate the term sheet; and, if it is terminated, which (if any) of the binding provisions survive termination (and for how long). Your lawyer can help you identify and think through which key terms to include that you might otherwise miss.

Term sheets can be useful tools. They can help the parties identify the key business terms of a potential transaction and determine early in the process whether the parties have sufficient consensus on those terms to take further steps towards a definitive agreement. The key takeaways, however, are—do not underestimate the potential consequences of signing a term sheet and get your lawyer involved early in the process.

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