When I’m first introduced to a transaction, often I’m told that the parties have reached agreement, only to discover later that the only things set in stone are the client book and the price multiple to be paid for it. Of course, this is not a deal; it has the makings of a deal which won’t be settled until the critical components (such as timing of payment, trade restraints, transmission of staff and limitation of liability) are considered and agreed to in principle.
Alan Kenyon posted a really useful blog on 9 November which summarised the role and key benefits of using a Term Sheet or Heads of Agreement in a transaction (link here). I see many terms sheets (good and bad) in my advisory role and agree with Alan that a well considered pre-contractual summary of the key deal terms is a terrific way to ensure that “everyone is on the same page” before a binding commitment is made. This said, care must be exercised to understand which terms are actually binding and to ensure that the key terms agreed ‘in principle’ make their way into the substantive sale contract precisely in the form you expect.
A term sheet (or ‘heads of agreement’ or ‘memorandum of understanding’) is technically an agreement to contract and may or may not be binding upon the parties. However, even when non-binding, it can be a useful tool to sharpen the focus of negotiating parties, to obtain early consensus on critical issues and to establish ground rules for due diligence and the negotiations to follow.
This blog builds on the issues raised by Alan and examines the benefits and practical applications of term sheets as well as some pitfalls to avoid.
Use and application
Once the emotional commitment to the transaction is made, it can still take weeks or months for the necessary paperwork to be drafted and finalised. For this reason, a case a no-fuss document setting out the core terms of the transaction can flush out any significant issues early in the process, before a party has committed significant time and money on due diligence or negotiating full blown agreements with a party that has irreconcilable commercial expectations.
Importantly, a term sheet is not a substitute for the contract proper. Rather, it should be viewed as a foot in the door – an agreement to contract – which is used to outline the core commercial terms and will confirm the conditions on which parties will access and use information and deal with each other during the investigation and negotiation process.
These core terms will serve as the basis upon which the lawyers draft the definitive sale agreement. If the parties can’t agree on these core terms at the pre-contract stage, it is likely that parties will end negotiations there, before wasting further time and resources.
Exclusivity
A term sheet may also include a term preventing the seller from negotiating with another potential buyer during the negotiation period. This restriction gives the buyer time to complete due diligence and negotiate the agreement without having to worry that a competing purchaser will steal the deal away from it. From a seller’s point of view, while an exclusivity clause can be a necessary evil, the exclusivity period should be as short as possible, so that it can start discussions with another purchaser quickly if negotiations with the proposed purchaser stall.
Confidentiality
If a confidentiality agreement has not already been entered into, a term sheet usually will include provisions dealing with the disclosure, use and return of confidential information. Access to this information (especially client details) should also be covered.
Binding or non binding?
In a term sheet, it is common for the parties to stipulate that some, but not all terms are intended to be binding. For example, if the parties have agreed to an exclusive negotiating period, that term will be confirmed as binding on the parties, even though other terms (such as the proposed commercial terms) are “subject to contract” and are not binding. Accordingly, an “agreement status” clause is usually included at the start of the agreement. This clause will identify exactly which clauses are intended to be binding and will make it clear that all other clauses will not be binding.
Top tips
- Where possible, include all “deal-breaker” issues to establish consensus on key commercial terms.
- An agreement to contract or term sheet can include binding terms which provide the parties with a secure framework within which they can commence negotiations and complete due diligence.
- Be clear which clauses are intended to be binding and state that fact.
- Merely identifying a clause as being enforceable, however, does not necessarily make it so – if the clause leaves something that is important or central to the contract to be agreed between the parties later, then it is likely not to be enforceable.
- Keep it brief – consider costs and time – don’t try to squeeze too much in, or you might as well skip this stage and proceed directly to preparing and negotiating the definitive agreement.
- Set a time limit by which time the parties are required to execute formal documentation.
- Good brokers or experienced lawyers will have templates to guide you on what to consider including (see Alan’s blog) and, importantly, which terms should be binding on the parties.
