When commencing a business transaction – whether an investment, acquisition, joint venture, or major commercial agreement – one of the first questions to consider is whether to prepare a term sheet. Some parties prefer to move straight to drafting formal contracts, while others may believe a handshake deal is sufficient. However, in the right circumstances, a well-prepared term sheet can save time, reduce costs, and prevent disputes during negotiations.
A term sheet (sometimes referred to as a ‘heads of agreement’, ‘memorandum of understanding’, or ‘letter of intent’) is a document that outlines the key terms of a proposed deal before full legal agreements are drafted. While often non-binding, term sheets serve as a critical roadmap for negotiations.
In this article, we outline the key factors you should consider when deciding whether to use a term sheet for your transaction.
1. Complexity of the Deal
If the deal is high-value or involves a complex transaction structure, it may make sense for the parties to agree on key terms upfront, including pricing, conditions, deal structure, and the key rights and obligations of each party. This ensures all parties are aligned from the outset, preventing later misunderstandings and disputes.
Conversely, if the deal is relatively straightforward and the parties are already clear on the key terms and structure, a term sheet may add unnecessary time and expense.
2. Saving Time and Costs in Legal Drafting
Without a clear consensus on the key terms of the transaction, one party’s lawyers may begin drafting lengthy contracts without sufficient guidance or understanding of the parties’ commercial intentions. This may lead to unnecessary revisions, protracted negotiations, and higher legal costs. A well-drafted term sheet streamlines the negotiation process, ensuring the final transaction documents reflect the agreed terms.
3. Identifying Deal-Breakers Early
Preparing and negotiating a term sheet can help the parties identify any red flags or deal-breakers early in the process. Each party may have different requirements regarding risk appetite, regulatory and reporting obligations, and legal protections. Understanding the other party’s unique requirements may enable you to better gauge whether you can accommodate their needs and interests before incurring considerable time, cost, and effort.
During term sheet negotiations, you may discover that the parties’ interests are too far apart to reach a mutually acceptable deal.
4. Strengthening Negotiation Power
A term sheet provides a structured framework for negotiations, preventing one party from later backtracking or changing terms at the last minute. It ensures that important items are agreed upon in principle before finer legal and commercial points are addressed.
The party preparing the first draft of the term sheet has the first opportunity to set the proposed deal terms. As a starting point, that party may suggest positions that favour its own interests. If those terms are accepted, great. If not, the parties can negotiate and hopefully reach a middle ground.
5. Providing a Deal Timeline and Roadmap
For transactions involving investments or acquisitions, a term sheet often outlines key project milestones. For example, if one party is conducting due diligence on another, the term sheet may specify the timeframe for due diligence investigations and provide a target completion date. This enables the parties to plan and allocate resources accordingly, helping to prevent protracted negotiations and delays to completion.
6. Identifying and Managing Conditions and Third-Party Approvals
Some transactions are subject to certain conditions. A robust term sheet should provide an overview of any conditions that must be satisfied before the transaction proceeds, giving the parties greater clarity on the likelihood of the deal eventuating and facilitating informed decision-making.
For example, a transaction involving the acquisition of land by a company may be conditional upon the purchaser obtaining development approvals from the relevant regulatory authority or securing approval from its board of directors.
7. Reducing the Risk of Disputes
Clearly documenting agreed terms in a term sheet reduces the risk of misinterpretation and disputes during negotiations. If disagreements arise, the term sheet serves as a reference point for resolving them. Without this reference, the deal may collapse.
In some cases, term sheets also include dispute resolution procedures, providing a framework for handling disputes if and when they arise.
8. Bidding and Procurement Processes
If the party hosting the transaction receives significant interest in the deal but is unsure which party to proceed with, a term sheet may help identify the most favourable offer. For example, in capital-raising and investment transactions, where companies receive interest from multiple investors, they may wish to negotiate term sheets with several parties simultaneously to determine the best fit and the most advantageous deal.
However, negotiating with multiple parties at once can be perceived as acting in bad faith. If you take this approach, you should be open and transparent in your dealings with all parties and mindful of any existing obligations requiring exclusive negotiations. Investors may be willing to offer more favourable terms if they know they are competing with others who could potentially make a better offer.
9. Demonstrating Serious Intent
A term sheet signals to all parties – including companies, investors, lenders, buyers, sellers, and other stakeholders – that the deal is serious and progressing. This can be particularly valuable in competitive transactions involving multiple interested parties. A term sheet may serve as a useful tool in converting preliminary discussions into a concrete agreement.
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While some deals can proceed without a term sheet, having one can be highly beneficial. Term sheets generally minimise risk, time, and cost while ensuring commercial and legal alignment between the parties.
If you’re unsure whether your transaction requires a term sheet or need assistance preparing and negotiating one, contact our experienced transactions lawyers at 03 9481 2000 or info@tauruslawyers.com.au