Equity investors and other financiers typically seek agreement on a term sheet early on in the investment process, prior to undertaking detailed due diligence.
A company seeking funding or a founder seeking investment partners for a project or other venture might also issue a term sheet to potential investors or funders. Indeed, a term sheet (or a similar preliminary document setting out key terms) serves a useful purpose for almost any proposed transaction.
In most cases a term sheet (or any similar ‘key terms’ document) will be non-binding, at least in respect of the key deal terms it sets out. This begs the question- ‘why bother’?
PURPOSE OF THE TERM SHEET
A term sheet sets out the key terms for a proposed investment or other transaction. Its key purpose is to identify whether the parties are likely to reach agreement on the terms of the proposed transaction before significant financial and other resources are committed to one or more of due diligence, legal drafting and negotiation of detailed documents.
The idea is to flush out any ‘deal- breakers’ earlier rather than later and reduce ‘deal risk’ before substantial costs are incurred. The term sheet also plays an important role in setting the framework for the subsequent documents (should the transaction proceed) and reducing the costs of subsequent drafting and negotiations.
COMPARISON TO HOA, MOU AND LOI
A heads of agreement (HOA), memorandum of understanding (MOU) or letter of intent (LOI) are variations on the same theme. The forms may be slightly different and a term sheet or heads of agreement tend to have greater pretensions of being binding in parts (compared to a MOU or LOI), but the purpose, substance and legal effects are more or less the same.
The advantage of the term sheet format is that it tends to be more focussed on the key deal terms without the constraints of trying to fit within a typical legal agreement structure. A term sheet is usually in a table format (headings on one side and corresponding key terms opposite each heading), which aids ease of reference and encourages simple language.
HOW BINDING SHOULD IT BE?
As noted above, a term sheet does not usually bind the parties legally to the key deal terms (which are the principal substance of the term sheet). A term sheet will often contain some binding terms, but they usually stop short of obliging the parties to enter into the proposed transaction on the key terms set out.
The binding terms will typically include obligations to negotiate exclusively with the other party and in good faith and to observe confidentiality. A break fee may be specified and payable for a breach of the exclusivity or good faith negotiation covenants. Sometimes the obligation to pay a break fee extends to the circumstance when an investment is offered on terms consistent with the term sheet, but the investee company does not agree to accept the investment, but such an obligation is difficult to enforce in practice unless it is clear that the company failed to negotiate in good faith and observe the exclusivity covenant.
Some term sheets go further and purport to bind the parties to do the deal according to the key terms stated. This is more common and makes more sense for debt finance, where the other deal terms not set out in the term sheet (or offer letter) tend to be very standardised. That is not the case where equity is being invested and the term sheet tends to become an ‘agreement to agree’ in respect of other terms not set out in the term sheet.
Making the term sheet binding in respect of the deal terms introduces a tension to set those terms out in much greater detail and to include less material terms. The approval processes to sign the term sheet are also likely to be more laborious. These factors may defeat the very purpose of the term sheet.
HOW MUCH DETAIL SHOULD BE INCLUDED?
The term sheet should incorporate the important commercial terms and variables of the proposed deal in sufficient detail (and no more) so that the parties are confident that they will be able to agree on the remaining and more detailed terms of the definitive documents. Accordingly the term sheet should cover off terms which might otherwise be ‘deal-breakers’, so what remains should be relatively standardised or non-contentious.
It can be a delicate balance to satisfy the above objective, while not getting too bogged down in the detail or costly and time consuming negotiations.
HOW MUCH TIME SHOULD BE SPENT NEGOTIATING THE TERM SHEET AND IS IT NECESSARY TO SIGN IT?
Parties can often get bogged down on the terms in the term sheet even though they are in broad agreement on most of the key deal terms. Sometimes a party will want to set out additional detail for certain terms before agreeing to them or seek legal advice regarding the full implications of certain provisions and, before the parties know it, they are more or less negotiating the detail of the definitive documents. In other cases, one or both parties may need to go through time consuming approval processes to sign the term sheet, but the parties wish to progress the transaction in the meantime.
Such circumstances may call for a measure of pragmatism, particularly if the parties have reached agreement on most of the material terms and are confident that the remaining terms will be agreed ultimately. One option (usually the preferred option) is to modify the term sheet so that it records everything that has been agreed, along with any agreed processes to resolve the remaining contentious items. In other cases the term sheet may have served its purpose (i.e. it has identified the key commercial terms which are agreed and those which will require further negotiation) and the parties may be sufficiently comfortable and confident of the ultimate outcome to move on to the next stage without actually signing the term sheet. Whether this is tenable will depend on the importance placed by either party on the binding provisions.
The term sheet plays an important role early in the negotiation process of a transaction, by identifying (cost effectively and before the lawyers get too involved) whether the parties are in agreement on the key terms of the proposed transaction, such that they can be confident of agreeing the more detailed definitive terms. This is a useful step to undertake before the parties incur significant additional transaction costs.
The trick and balancing act with a term sheet is where to draw the line in satisfying the above objective, as far as is practical, without getting into detailed and time consuming negotiations and legal processes regarding the detail.
For some sample term sheets, please follow the link below
Andrew Lewis Law