When Two Become One: Legal Considerations in the Mergers & Acquisitions Process – Part IV: The Term Sheet or Letter of Intent

In June, I began a series of blogs regarding the most important legal considerations in the mergers and acquisition process.   The first blog discussed the mergers and acquisition process at a global level generally laying out the six most important legal considerations in the process.  In the second blog of the series, I dove deeper into the first step of the process, engaging a financial advisor and drafting the engagement letter.  The third blog discussed the drafting of the nondisclosure agreement.

This fourth installment focuses on the term sheet or letter of intent.  By now, at this point in a deal, after engaging the financial advisor and drafting the nondisclosure agreement, the parties probably have started talking about the actual terms of the potential deal.  It is at this time the parties should get some of those terms on paper, even if that paper is less than legally binding and the terms remain subject to change based on the due diligence that will be conducted by the buyer.  This paper will take the form of either a term sheet or letter of intent, and these provide preliminary framework for a potential sale, purchase, or merging of the business.

Purpose of a Term Sheet or Letter of Intent

Both term sheets and letters of intent provide an overview of the significant terms that will be included in the final deal between the buyer and the seller for the purchase, sale, or merger of the company.  Neither a term sheet nor a letter of intent is binding.

So what is the purpose of a term sheet or letter of intent?  By having either, the parties can at least get on the same page regarding what they are both working towards so that everyone involved has one frame of reference for the proposed deal.  The M&A process can be a costly and time-intensive ordeal for both the buyer and seller, and it is not good for anyone to get to the end of a length due diligence process in which the seller has exposed its inner workings to an outside entity only to find that there were fundamental misunderstandings from the start regarding what a final deal would look like.  With a term sheet or letter of intent, you do no have to rely on decentralized, oral assertions between the parties and can instead have a single document that can be referenced throughout the process.

Is a Term Sheet or a Letter of Intent Preferred?

Both a term sheet and a letter of intent will include preliminary terms for the proposed transaction with the understanding that the buyer will conduct due diligence of the seller and that later documents signed at closing will include the final, binding terms of the actual agreement.

The main difference between the two is that a term sheet is simply a document that lays out the terms that both parties wish to include, and usually neither party will sign the document.  The letter of intent, on the other hand, includes those terms but is singed by both parties involved.  Because the letter of intent is a signed, legal document, the buyer may need to disclose its existence it if it is a publicly traded company.  Further, although the terms of both the term sheet and the letter of intent as the relate to a final transaction are generally understood to be non-binding, numerous lawsuits have been brought on the basis of letters of intent to enforce their terms based on the argument that assertions were made which created a binding contract.  Because of this, some buyers may wish to avoid this risk through use of a term sheet.

What should be included?

Whether using a term sheet or a letter of intent, the buyer working together with the seller may include as many terms or as few as they would like.  Here are some items that should be included in a term sheet or letter of intent:

  1. The document must be clearly identified as a term sheet or letter of intent. The document she clearly stated that it is not a binding contract to buy or sell the business.  The parties may want to include a duty to negotiate in good faith.  A good faith provision can be useful to prevent one party from using the negotiation and due diligence process solely to collect information about the other party and their business.
  2. The term sheet or letter of intent should state from the outset whether the deal will involve the sale of stock of the sale of assets. It would be devastating if both sides of the deal spent copious amounts of money but one party thought from the outset that they were talking about a stock sale and the other party thought they were talking about an asset sale.  If this is not discussed from the very beginning, the deal could fall apart as the deal structure that is preferred by one party may not be reasonable to the other party.
  3. The term sheet or letter of intent should include both a purchase price and an explanation of the assumptions on which the purchase price is based. During the due diligence process, it may turn out that many of the early assumptions used in calculating the purchase price will turn out not to be true.  If the method for calculating the purchase price is included in the letter, the parties have a road map on how the purchase price should be adjusted.
  4. If the deal is a purchase of assets, the parties should allocate the purchase price to the different assets on the acquisition target’s balance sheet. This allocation can have great effect on the tax implications of the deal for the parties.  Since tax considerations are often critical to whether a deal is reasonable, there needs to be a common understanding of purchase price allocations at a very early stage of the deal.
  5. The method of payment should be set out. As in point 2, if one party has in mind an all-cash deal, and the other party has in mind a deal where the seller will hold onto a note or some other retained interest in the acquisition target, then it is a good idea for the parties to get on the same page from the outset, before either party has spent significant amounts of time and money on the deal.
  6. All other major deal points that are important to either party should be included. If either party has any other deal points that are crucial to them, they should let the other party know relatively early.  Examples include:  whether key employees must be retained for the deal to close, any expected noncompete agreements that the seller will sign, and if the buyer will be assuming any liabilities of the seller.  Springing these on the other party late in the process may result in a failed deal after everybody has spent a lot of time and money.

Some attempt to move forward in the deal with vague term sheets or letters of intent with the assumption that the details will be ironed out later.  But the details are often what kills a deal.  Parties may also assume that it is best not to put too much in writing because they will be boxed in when negotiating the final purchase and sale agreement.  However, if a term sheet or a letter of intent is drafted correctly, the parties will not be boxed in.  Rather, the parties will have find it easier to agree to changes in the deal as circumstances change because the assumptions they used will be in term sheet or letter of intent.  The non-binding nature of a term sheet or a letter of intent always provides the parties with an option to walk away if things do not turn out the way the parties expected.  The effort spent on drafting a term sheet or letter of intent will be helpful later by smoothing future negotiations and by eliminating unfeasible deals from the outset.

What if the Buyer Wants an Exclusivity Agreement?

A buyer may also want to include an exclusivity agreement in a letter of intent or add a standalone exclusivity agreement to a term sheet which the buyer and seller both sign.  An exclusivity agreement says that the seller will agree not to engage other buyers within a given period so as to give the buyer time to proceed without competitors standing by.  The purpose of this agreement is to alleviate the buyer’s concerns that the buyer is investing numerous resources into conducting due diligence and negotiating the deal that might be poached by someone else.  However, this agreement may hurt the seller should a much more promising buyer come along.  The seller should work with its financial advisor and outside counsel to determine whether an exclusivity agreement is necessary in order to place the buyer.

Conclusion

Although a term sheet or letter of intent is not necessarily the legally binding agreement that concludes the transaction, it is a very crucial step in the M&A process.  A term sheet or letter of intent services many purposes, including: (1) to clarify the key points of a complex transaction for the convenience of the parties; (2) to declare officially that the parties are currently negotiating; and (3) to provide safeguards in case a deal collapses during negotiation.  The term sheet or letter of intent is the first step in the process leading to a definitive agreement that will reflect the terms of the transaction.  To ensure your deal stays amicable, occurs smoothly, and results in the best deal possible for all parties involved, make sure to follow the rest of this series of blogs on the M&A process.  The next blog in this series will delve deeper into the letter of intent, which provides the preliminary framework for the potential transaction.

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