If you have been following our series on the major legal steps involved in selling an emerging growth company, you know that we have already come a long way in negotiating an agreement with a financial adviser as well as entering into a non-disclosure agreement with your potential buyer. You probably would not have gotten this far in an actual deal without at least talking about the actual terms of the potential deal with the would-be buyer, but at this point it is finally time to get some of those terms on paper, even if that paper is less than legally binding and the terms remain subject to change based on the due diligence that will be conducted by the buyer. It is at this point that you and the buyer will work toward either a term sheet or letter of intent providing the preliminary framework for a potential sale of your business.
What is the Purpose of a Term Sheet and Letter of Intent?
Both term sheets and letters of intent provide an overview of the significant terms that will be included in the final deal between the buyer and the seller for the sale of the company. Neither a term sheet or a letter of intent is binding, at least in theory, which raises the question of what purpose they might serve.
By having a term sheet or letter of intent, the parties can at least get on the same page regarding what they are both working towards so that everyone involved has one frame of reference for the proposed deal. The M&A process can be a costly and time-intensive ordeal for both the buyer and seller, and it is not good for anyone to get to the end of a lengthy due diligence process in which the seller has exposed its inner workings to an outside entity only to find that there were fundamental misunderstandings from the start regarding what a final deal would look like. With a term sheet or letter of intent, you do not have to rely on decentralized, oral assertions between various parties and can instead have a single document that can be referenced throughout the process.
Which is Preferred: A Term Sheet or a Letter of Intent?
A term sheet and a letter of intent will both include preliminary terms for the proposed transaction with the understanding that the buyer will conduct due diligence of the seller and that later documents signed at closing will include the final, binding terms of the actual agreement.
The main distinction between the two documents is that a term sheet is simply a document that lays out the terms that both parties wish to include, and usually neither party will sign the document, whereas a letter of intent includes those terms but is signed by both parties involved. Because a letter of intent is a signed, legal document, the buyer company may need to disclose its existence if it is a public company. Furthermore, although the terms of both a term sheet or a letter of intent as they relate to a final transaction are generally understood to be non-binding, numerous lawsuits have been brought on the basis of letters of intent to enforce their terms based on the argument that assertions were made which created a binding contract. Because of this, some buyers may wish to avoid this risk through use of a term sheet.
What Should Be Included?
Whether using a term sheet or letter of intent, the buyer working together with the seller may include as many terms or as few as they would like, but at the very least the documents should include a few basic terms:
- The assets to be acquired, e.g. what specific property (including intellectual property) that the buyer will be acquiring from the seller
- The consideration to be provided in return for those assets, and the form that such consideration should take (e.g. cash, note, stock, etc.), with the understanding the numbers might change through the process of due diligence
- The type of stock in the buyer that might be issued to the seller (e.g. private placement stock) if stock is potentially part of the deal
In addition, a term sheet or letter of intent might include terms related to board of directors representation following a sale, confidentiality matters, expenses, and conditions of closing.
What if the Buyer Wants an Exclusivity Agreement?
A buyer may also want to include an exclusivity agreement in a letter of intent or add a standalone exclusivity agreement to a term sheet which the buyer and seller will both sign. An exclusivity agreement says that the seller will agree not to engage other buyers within a given period so as to give the buyer time to proceed without competitors standing by. The justification for an exclusivity agreement is that the buyer is investing numerous resources into conducting due diligence and negotiating the deal, but such an agreement can obviously hurt the seller should a much more promising buyer come along. The seller should work with its financial adviser and outside counsel to determine whether an exclusivity agreement is necessary in order to placate the buyer.
Once a term sheet or letter of intent is finalized, the next step for both buyer and seller will be to enter into the due diligence process, which we will take up next month.
© 2016 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.