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What is a term sheet and when do I use one?

A term sheet is an approachable way to explore and agree on the terms of a prospective deal. But is it legally binding?
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You’ve come across an exciting business opportunity or idea. Maybe you’re wanting to raise capital for your med-tech start-up or you’re considering purchasing a new venue? One of the first things you need to do is establish how you can best take advantage of the opportunity and negotiate the terms of any agreements or transactions. 

Enter the humble term sheet – an approachable way to explore and agree on the terms of the prospective deal, which will generally be finalised in more formal documentation down the track. Term sheets are great for working through the legal considerations of your business opportunity, but while term sheets can be legally binding, many of them are not (and with good reason).

So what exactly is a term sheet? How is it used and when it may be considered legally binding?

What is a term sheet?

A term sheet (also known as a letter of intent, memorandum of understanding or heads of agreement) sets out the key commercial and legal terms of a proposed transaction. It’s usually (but not always) a precursor to formal contractual documentation being prepared and signed by the relevant parties.

For start-ups and SMEs, the 3 main situations requiring a term sheet are:

  1. When selling or purchasing a business
  2. When selling or purchasing shares in a company
  3. When new shares in a company are being issued.

What is the purpose of a term sheet?

The purpose of a term sheet is to provide a framework for the parties to prepare and finalise the details of a final contract. It provides evidence that the parties intend to enter a contract with one another and aren’t wasting each other’s time...the ultimate modern-day sin!

A term sheet essentially gives the parties the confidence to invest their time, money and effort in attempting to finalise the deal. It also acts as a mechanism for dealing with pre-contractual issues such as exclusivity, confidentiality, the due diligence process and the payment of any deposits.

What should be included in a term sheet?

As highlighted above, term sheets seek to set out the key commercial and legal terms of a proposed transaction between parties. 

The following items are all required in order to achieve this:

  • Background information that gives context to the transaction, including who the parties are and the purpose of the transaction
  • Details regarding what the transaction is (ie. the sale of shares in a company or the issuing of new shares in a company)
  • Details regarding any consideration to be paid (how much will be paid and for what?)
  • Details regarding conditions that must be met prior to the transaction taking place
  • Confirmation that each party is to pay for their own expenses and legal advice associated with the proposed transaction (or not)
  • How disputes are to be addressed and where (what is the applicable law and jurisdiction in which it operates?)
  • What information is to be kept confidential regardless of whether the transaction actually take place
  • Any promises, guarantees or warranties to be provided in respect of the transaction
  • The signature of an authorised individual or individuals who have the ability to enter into the agreement on behalf of the parties to the term sheet/proposed transaction.

How specific do you need to be in your term sheet?

This largely depends on whether the parties intend on the term sheet being legally binding or not. If the parties don’t intend on the term sheet being legally binding, then you don’t need to be too specific. For example, consideration may be detailed as “fair market value” or “to be determined”. Important dates might be elastic and agreed upon at a later point in time. Obligations of the parties may be listed as “including but not be limited to”. The purpose of a term sheet that is not legally binding is to provide some high-level direction and a framework to the completion of the deal. It will help to steer the transaction ship!

If, on the other hand, you do intend that the term sheet be legally binding, then we would recommend you are very specific. Exact dates and amounts should be detailed. Obligations of the parties must be carefully considered and detailed in the document. You must also be sure that you’re actually able to complete what is being contemplated in the term sheet...otherwise you might find yourself in trouble further down the road.

How to tell if your term sheet is legally binding or not?

The short answer is that it depends. Term sheets will often explicitly state whether they are legally binding or not (however, even when this is expressly stated, the result may differ from the wording!).

Ultimately, it depends on two things.

Firstly, do the parties intend to be bound by the obligations set out in the term sheet? If so, there must be a meeting of the minds regarding the material terms of the transaction. This is established by looking objectively at all the facts – both contained in the term sheet and the actions of the parties when dealing with each other. It’s our recommendation that you have a view on this point and be clear with the other party about whether you intend that the term sheet be legally binding from the get-go.

Secondly, has the term sheet been drafted in such a way that it gives certainty to the agreed terms? Term sheets that use language such as “subject to contract”, “for fair market value” or “to be agreed” are all hints (but not conclusive proof) that the term sheet is not intended on being binding because the terms are too vague and can’t be enforced. If the term sheet contains exact figures and dates, clear obligations and there is nothing left to ponder (with respect to the items contained in the term sheet) then it’s highly likely that it will be regarded as legally binding.

How do I prepare a term sheet?

It’s our recommendation that you have a solicitor prepare or review a term sheet for you – as this is not something you want to get wrong (and face the possibility of failing to capitalise on the hard work that went towards identifying and negotiating the opportunity).

If you would like to discuss your term sheet needs with someone, feel free to reach out to the BlueRock Law team.

If you'd like to learn more about capital raising (particularly in this challenging climate) register for our FREE webinar on Wednesday 3 June at 12 noon.

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