Term Sheets: Five Legal Tricks To Make Them Work For You

One of my first questions when asked to draft the agreement for a client’s new business deal is whether a term sheet (also known as a letter of intent or summary of terms) has been prepared.

A term sheet is a short and sweet document that sets out the parties’ mutual understanding of the main terms they will agree on in a later definitive agreement. The key word is mutual: while you and your counterpart may have agreed a deal over a nice wine dinner, your individual perceptions of the main terms may actually be different than you believe. To the rescue comes the term sheet to crystallize the basic terms on which both parties agree and serve as a road map for drafting the definitive agreement. The act of preparing the term sheet also allows you the contemplative time to assess opportunities or risks you may not have previously considered.

In this way, the term sheet helps prevents misunderstandings at an early stage and saves valuable time and attorney’s fees when drafting the definitive agreement. Once complete, the term sheet symbolically bolsters the parties’ commitment to the deal and focuses negotiations.

Term sheets are commonly used for M&A and financing transactions, as well as commercial deals, such as joint ventures, IP licenses, sales of goods and services, and executive employment agreements. Of course, if your deal is simple, you can skip the term sheet and draft the definitive agreement. If not or if there is any doubt, then use a term sheet.

Here are five tricks of the trade to help you draft term sheets to your advantage:

  1. Prepare the First Draft. There is no convention as to which party prepares the first draft of a term sheet, but I advise my clients to prepare the first offer because it can become the anchor for negotiation (as demonstrated in compelling psychological studies). Also, if your adversary later seeks to change your terms, you can argue, “Well…I gave up X from my first draft, so I will need Y” in the next draft. Often “X” will be a slight reach, so “Y” may not be the fallback it appears. To use the first draft to your advantage, however, your term sheet should be a reasonable first shot at crafting the basic deal terms (i.e., no excessive overreaching, which may erode your credibility and associated negotiating leverage).
  2. Make it Non-Binding (Usually). The general rule is that the term sheet should not be legally binding. There are exceptions to this rule, such as binding obligations of exclusivity or confidentiality included in acquisition transactions or other special cases in which a party will intentionally seek to bind the other party in furtherance of its goals. The key is to avoid unintentionally binding obligations. Courts review several factors to determine whether a term sheet is binding, such as the language used, the definitiveness of the terms (e.g., are there remaining terms to be negotiated?), and the context of negotiations. If there are binding provisions, both binding and non-binding provisions should be clearly identified. Non-binding term sheets should not be signed and should also include non-binding boilerplate, such as: “This term sheet is for discussion purposes only and is not intended to be construed as a binding agreement. The parties do not intend to be bound until they enter into definitive agreements regarding the subject matter of this term sheet.”
  3. Focus on the Big Issues. The term sheet should cover only the main deal points. It should not include every potential contract detail. Remember that this is a short and simple document, preferably one- or two pages maximum. The idea is to agree on the big picture items and defer the details to the definitive agreement. For example, in a minority investment in an LLC, the big issues might be the purchase price, pre-money valuation and number/percentage of outstanding shares to be acquired, director/manager appointment rights, other minority investor rights, pre-closing conditions, and the projected closing date.
  4. Use Catch-Alls and Conditions to Cover Future Needs. You should use catch-all phrases in the term sheet to preserve your right to include additional terms in the definitive agreement to cover anticipated and unanticipated issues. For example, in a term sheet for a licensing deal, you could say: “The definitive agreement will include additional terms and conditions customarily included in comprehensive [insert type] license agreements.” This sentence gives you the flexibility to include a variety of additional terms in the definitive agreement while staying within the symbolic boundaries of the term sheet. Similarly, if you need to conduct more diligence or obtain financing, then you could say: “The possible transaction is subject to additional due diligence by [buyer] to [buyer’s] satisfaction, as well as [buyer] being able to obtain financing necessary to complete the transaction.” Without these catch-all and conditions provisions, your counterpart may argue that terms you later request should not be included in the definitive agreement because they were not mentioned in the term sheet.
  5. Use Assumptions to Protect Against Unknowns. At the term sheet stage, the parties have typically not conducted substantial due diligence and open questions remain regarding known unknowns and possibly unknown unknowns.  You should use assumptions in the term sheet to hedge against this uncertainty. For example, if your willingness to pay a price for a target company is based on certain assets being transferred to the company at closing, then state the assumption in the term sheet so you have the ability to change the price without disrupting the deal if the assumption proves false.

By using these five tricks of the trade (and the advice of a good lawyer), you should be able to prepare a simple term sheet that serves as a foundation for the successful negotiation and drafting of the definitive agreement for even the most complex of your business deals.

Top 9 Warning Signs in a Business Deal

One of the benefits of being a corporate lawyer is the opportunity to participate in a variety of interesting deals.  In these, you encounter a motley crew of characters.  You witness a range of negotiating styles and tactics, and learn which are effective and which are not. You see some ventures succeed and many others fail.

In the great theatre of the deal, there are rare moments in which something may not feel right to the lawyer or the client about a proposed business transaction or partner.  The thing amiss may only be verifiable by circumstantial evidence.  To paraphrase the Delaware Chancery Court, it may be that the circumstances surrounding the person or transaction stink bad enough that they simply do not pass the “smell test“.

Questions may arise following diligence on the target (which should minimally include Google and litigation searches), from a person’s conduct in negotiation or from other third party sources.  There will not typically be any proverbial smoking gun, so your judgment and careful diligence will be your guiding light.

In my years as a deal lawyer, the appearance of any of these nine elements (not in any order of priority) has been a fairly reliable harbinger of difficulty, dishonesty or even fraud in proposed business deals.  If any of these elements arise in your dealings, you should consider diving deeper into diligence to determine if there is genuine cause for concern or possibly re-negotiate or abandon the deal altogether.

  1. The demanding long-winded negotiator of trivial things.  Excessive demands for non-substantive or patently unreasonable changes to the initial non-binding deal document, such as the term sheet or letter of intent, may foreshadow protracted and possibly agonizing negotiation of the definitive agreements and a challenging ongoing business relationship.  If the demands are coupled with the party’s long-winded or repetitive arguments why he is right and you are wrong (or other ridiculous anectdotes), they may suggest personality issues.  In my experience, character defects are not easily remedied and often worsen with time. The unreasonable negotiator should distinguished from the tough savvy negotiator, who requests substantive deal points but is often reasonable and a good business partner after the deal is papered.
  2. The deal requires urgent participation and won’t be available after “X” occurs.  This is the classic illusion of scarcity tactic.  If your prospective business partner claims that if you fail to act now, (i) a large investment from Mrs. “Y” will soon be received and the price of the investment will increase or (ii) the deal will not be available for “Z” reason, the claim may be a red herring and should be carefully scrutinized.  Fictional future money is sometimes characterized as coming from abroad or from some well-known person with whom the partner purports to have a close relationship.
  3. The secrets that cannot be revealed.  If the target’s founder or your prospective partner is unwilling to reveal certain fundamental aspects of the business or how it expects to make money, the company may not have a business plan.  You have a right to know the company’s business model and growth strategy, with the understanding that the model will likely evolve over time. In one startup deal I reviewed for a client, the founder made repeated excuses why he could not provide information about critical company inventions and provisional patent applications.  Later diligence revealed that the company had no inventions and its business plan was impracticable. After spending the other investors’ money, the founder abandoned the company and the U.S.  This is akin to Bernie Madoff’s “black box” investment strategy that was “so good” that it could not be understood or replicated by any reputable investor.
  4. The anonymous “big money” partner.  Any person who must remain anonymous is often a red flag, particularly if this mystery man is a primary financing source.  A client once instructed me to prepare the draft documents for a “big investment by a Chinese investor who needs to remain anonymous.”  A third party had informed the client that the Chinese wanted this, that, and the other, and I prepared several draft iterations at the client’s request.  The Chinese investment never materialized and the client wasted money on legal fees. Some celebrities and others have genuine reasons to protect their privacy, but if you are doing a deal with someone (including a celebrity), you have a right to know their identity and to size them up.  Always insist upon lifting the veil of anyone who says they must remain anonymous.
  5. The shell company spider web.  Domestic and offshore entities are often formed to execute lawful business strategies, including liability and tax mitigation, particularly for companies with substantial non-U.S. source income.  But as the Panama Papers confirmed, offshore shells with limited assets may also be created for tax evasion and other corrupt purposes.  Before doing any deal with a company that owns or operates affiliates, especially offshore shell entities, you should fully understand the organization chart and confirm that each entity exists for lawful and legitimate purposes.
  6. The paperless office.  It is fine if your partner keeps a clean desk and operates in the cloud, but a lack of paperwork memorializing a business’s structure, assets and operations is almost invariably a red flag.  You should have access to reasonable diligence paperwork and you should be able to freely ask questions and to have them answered.
  7. No skin in the game.  If the deal does not require your business partner to put money or something else of value into the deal, your interests may be de-aligned from the beginning.  In the startup context, this could be the situation where a founder’s shares are fully vested from day one and he has no invested capital or other hook to prevent him from walking away when the going gets tough or he receives a better offer.  In a joint venture, it could be the ability of a party to enrich himself at the expense of the venture.  De-alignment can usually be remedied by careful drafting of the legal incentives in the deal documents.
  8. The promise of abnormally high or guaranteed returns. This trick is as old as prostitution: returns above market rates or guaranteed returns on invested capital are often signs of a Ponzi scheme, where the prompter lures you to invest to pay his prior investors rather than to make bona fide investments with you money. You should always determine the source of returns and whether that source is capable of generating the projected payout.  Most financial projections are exactly that, and vary dramatically from actual results.  There is no such thing as a guaranteed return.
  9. It sounds too good to be true.  This is a corollary of abnormally high returns.  As the adage goes, if what you are to receive in exchange for your participation sounds too good to be true, then it probably is.  In most of these cases, you should run away from these deal absent a reasonable and verifiable justification for its sweetness.