Your Contract Lawyer fields inquiries on a regular basis about drafting or reviewing a term sheet or letter of intent, and there is inevitably a discussion of whether or not such agreements are legally binding. The short answer is that they are not – at least not generally in the ways that are expected by the client.
Term sheets and letters of intent are often seen as a quick way to get the terms of a transaction down on paper and agreed upon, without having to labor over and negotiate a more substantive agreement. In a way, they are often viewed as a shortcut to “locking in” the deal terms. This shortcut is seen as useful to clients who are concerned the other party might pull out of the deal if there are protracted negotiations over the final contract or there is a time pressure to lock in the deal due to circumstances specific to the transaction. This is often the case with a purchase transaction, where parties are hasty to get the agreement down in principle, so that either or both parties are barred from negotiating with others, or that a timeline to close the purchase transaction is laid out clearly.
While the goals laid out above are indeed good reasons to pursue a term sheet or letter of intent prior to negotiating and signing a more substantive agreement, there is often a misunderstanding of exactly what is binding about these agreements. Put simply, term sheets and letters of intent are by nature “agreements to agree” in that while basic terms of the transaction may be laid out, such as purchase price and what is being purchased, they are not the ultimate agreement in that they don’t bind the parties to actually consummate the transaction. So even though it appears that the material terms of the deal have been agreed to, the parties are really only kicking the can down the road and must execute a more substantive agreement, such as a purchase and sale agreement, later on for the transaction to actually be completed. The purpose of term sheets and letters of intent is to lock the parties into exclusive negotiations to complete the transaction in a certain time period, not an agreement to complete the transaction itself. They can also be useful in establishing a time period for such negotiation, which can include a due diligence period so that an acquiring party may review or inspect the assets or business they are acquiring, so that the parties are properly motivated to execute a substantive agreement in a timely manner.
When a Term Sheet or Letter of Intent Can Be Disadvantageous
In many cases, however, it may make the most sense simply to move forward with a substantive agreement rather than agreeing to agree later via a term sheet or letter of intent. If the parties know they want to complete the transaction now, simply prepare the proper agreement and negotiate it right away. Adding a term sheet or letter of intent to the process will actually just delay matters and may not provide any benefit. We can draft a substantive agreement inside a week, and while negotiations can always draw matters out, when both parties are motivated (and they always are most motivated before anything has been signed), a substantive agreement can often be negotiated and signed in short order. Not to mention the fact that term sheets and letters of intent can often be heavily negotiated themselves.
On the flip side, signing a term sheet or letter of intent can sometimes leave the parties with a half-baked transaction. Since by their nature term sheets and letters of intent are scant on protections and legal language and are usually just an outline of the overall transaction concept, they do not serve to protect the parties’ interests in relation to the transaction or even clarify the full scope of the transaction. Term sheets and letters of intent certainly do not contemplate all the mechanisms and angles of the transaction, so they have a very diminished capacity to serve either party well in enforcing the terms of the transaction, if it were to be held as a binding agreement to complete a transaction. And that’s the converse danger – while term sheets and letters of intent are generally considered agreements to agree rather than substantive agreements, in some situations, where there is no language about its non-binding nature or that there will be a substantive agreement entered into later on, a term sheet or letter of intent may be enforced on its face. And, for all the reasons mentioned above, enforcing a document not meant to cover all the bases or fully protect anyone’s interests may ultimately cause more problems than not executing such a document in the first place.