In the increasingly crowded new media marketplace, deal-makers must move quickly and decisively. High-flying companies find themselves negotiating simultaneously with multiple parties, including investors, customers and strategic partners. A useful contracting tool that imposes some order to this chaotic process is the term sheet, which enables a company to memorialize commitments without going through the rigors of immediately negotiating a formal contract. More and more, "netrepreneurs" then leverage these commitments by playing them off one another, with the goal of obtaining higher valuations and striking better deals.
The initial failure of "netrepreneurs" to use term sheets of term sheets is perhaps a reflection of the relative inexperience of a young industry or the rashness of overzealous (and overworked) entrepreneurs trying to lock in relationships without first nailing down the terms. On the flip side a company which overdoses on term sheets, using these non-binding instruments to pump up its business, may create the illusion of strength but harm the long-term health of the business.
The term sheet (otherwise known as a letter of intent, memorandum of understanding, agreement in principle or, according to one judge, a "hug before marriage") typically outlines the salient points of a deal and identifies issues requiring further discussion. Term sheets are also intended (absent specific provisions to the contrary) to allow either party to walk away unscathed from the bargaining table if the negotiations break down. Thus, it is poor business practice for an entrepreneur to build a business by unduly relying on term sheets because he may not have a legal leg on which to stand.
Ironically, the inability of a party to simply walk away from the deal unscathed is, without question, the single greatest hazard of term sheets. On more than one occasion, provisions that may have appeared to be non-binding have been held enforceable by courts as a binding contract. The classic example is the $11.1 billion jury verdict against Texaco in 1985 for interfering with a binding letter of intent between Getty Oil and Pennzoil. Even in the absence of an adverse ruling, however, a company threatened with litigation over the enforceability of a term sheet may exhaust its resources as nervous investors and lenders back down.
Predicting the enforceability of term sheets and letters of intent has baffled sophisticated business people and their lawyers for years. Nevertheless, the basic rule is easy to state: the parties’ intent is the key factor in determining whether a term sheet or letter of intent will be binding. Because a court will look first at the document itself, the parties’ intent should be expressed clearly and unequivocally. Where a term sheet states specifically and unambiguously that the parties intend it to be non-binding (or that they intend only certain provisions of the term sheet to be binding), the courts will generally uphold that intent. If, on the other hand, the document is silent or ambiguous as to the parties’ intent, then the court will look at other factors to determine their intent, including the context of the negotiations and the parties’ conduct.
Determining intent is a question of "fact," one that a jury will often decide. Unfortunately, statistics suggest that jurors’ inexperience with term sheets makes them more likely to find that a binding contract was formed. To jurors, a written document, describing rights and obligations, and signed by both parties may look very much like a contract. To this end, practitioners have questioned the utility of signing a term sheet when doing so only makes the document look more like a contract to a jury. Another pitfall that signed term sheets may trigger is unwanted disclosure requirements. For instance, the Securities and Exchange Commission would almost certainly impose additional disclosure requirements (and unwanted delay) on a company that signed a term sheet while preparing for an IPO.
Of course, the disingenuous entrepreneur who intends for a term sheet, signed after a short meeting and a loose handshake, to be enforceable is quite a different matter. Not only could he be violating the obligation that all contracting parties have to engage in fair dealing, but it is also by no means certain that a costly litigation would result in a court finding a binding contract. Nor is it certain that the terms of the contract would be interpreted to favor the entrepreneur.
No consensus exists regarding the desirability of term sheets. As a matter of industry practice, however, term sheets appear more often in complex transactions. Parties that are able to formalize a contract and leapfrog the term sheet process should earnestly attempt to do so in order to avoid the litany of problems accompanying the ambiguities of term sheets (and potential SEC disclosure issues, as discussed above). Sometimes, all that is really intended by a term sheet is to engage the other party in talks, in which case a non-disclosure agreement or simple no-shop undertaking might suffice. All too often, term sheet negotiations create issues early in the relationship that may damage the deal’s momentum or derail it entirely.
That being said, there are a number of advantages to beginning negotiations with a well-crafted term sheet. The parties can memorialize the essential deal points, both to identify areas of disagreement and to avoid misunderstandings down the road. In addition, the parties may feel morally, if not legally, obligated to abide by terms that have been set out clearly in writing.
Strategically, a particularly important advantage of term sheets for many Internet companies is that they provide evidence to financing sources or strategic partners that a deal is viable, thereby justifying a step-up in valuation. Another advantage is that a company may use a term sheet to get its "foot in the door," especially where the company (often venture capitalists or companies with a leading market share) believes that it will ultimately be able to resolve the inevitable ambiguities in its favor. For the very same reason, companies without the upper hand should avoid term sheets, or at least specify the essential terms up front, including price, percentages and other quantifiable measures. Additionally, term sheets which are contingent upon the performance of satisfactory due diligence on one of the parties rarely result in placing that party in a more favorable position because the very nature of due diligence does not lend itself to the revelation of beneficial information. Attorneys who work with new media companies are all too familiar with the situation where, as the contract is formalized, the company is forced to accept a host of lop-sided last minute terms that were not specifically addressed in the term sheet. The company is handcuffed into accepting these terms because it has psychologically spent the money (in the case of financings), marketed the deal to the public or made other contingent commitments, and is left with no other viable alternatives.
While a number of courts around the country have considered the question of whether a term sheet amounts to a binding contract, a large number of the reported cases have arisen in New York and involve New York law. Because having a relatively developed body of case law on this issue increases the predictability of the outcome of litigation, it is recommended that parties specify that a term sheet or letter of intent is to be governed by New York law, to the extent there the requisite New York contacts exist for such a choice of law provision.
There are two theories under which New York courts have imposed liability when ruling on the enforceability of term sheets. In the first, courts have found that the parties intended to enter into a binding agreement and the term sheet merely memorialized that intent. In such instances, although the provisions of the term sheet may not necessarily give rise to any liability, the parties’ conduct and the surrounding negotiations may create a binding agreement. For example, courts have generally found term sheets used in venture financings to be non-committal instruments. Perhaps courts fear that holding otherwise may do more damage by discouraging investment activity than it may do good by protecting companies from mercurial investors. In such situations, however, the conduct of the parties and the negotiations occurring outside the four corners of the document may render the investor liable for damages sustained by the company as a result of the unconsummated transaction.
The second theory of liability presents a greater hazard for the unwary. Although the failure of a party to close a deal may not give rise to liability per se (after all, not all term sheets are supposed to result in formal contracts), the party’s failure to negotiate in good faith, especially where such an undertaking was expressly agreed to, may be fatal. What constitutes "good faith negotiation" varies on a case by case basis. Examples are whether a party made counteroffers, consulted with its board of directors and kept open channels of communications with the other party. Thus, an entrepreneur may not find it that easy to kill a deal or walk away from the bargaining table. In addition, some courts have held that a letter of intent to create a joint venture or partnership may create a fiduciary duty that is independent of the obligation to consummate the deal. A fiduciary duty imposes special obligations to treat the other party as a partner. Among other obligations, partners must disclose all material information to one another and share in all business opportunities.
Consequently, whatever the situation, companies should enter into term sheets and letters of intent with a great deal of care, including review by competent legal counsel.
This article was written for and appears in the November, 1999 issue of AlleyCat News.