Remember your high school English teacher telling you to write an outline first before writing the whole paper? But sometimes you didn’t follow their advice, and when you got halfway through, you realized it was a mess and you had to throw away what you’d written and start all over? (Or turn in a piece of junk and get a bad grade.)
The same thing is true of deals. You need a roadmap of the deal before you start documenting it. You need to make sure both parties and their tax advisors are all on the same page before you spend money on legal fees having your attorney draft the documents. It’s better to learn that the parties can’t reach agreement on principal terms while negotiating the term sheet than to find that out after blowing tens of thousands of dollars drafting full-blown legal documents or conducting due diligence.
Usually this roadmap is called a “term sheet”. A term sheet sets forth the principal terms or the major “deal points” of the transaction. Things like purchase price, payment terms, and other major components of the deal. In the M&A (mergers and acquisitions) context it is usually referred to as an LOI (Letter of Intent) and sets forth the parties’ agreement on structure (asset purchase, stock purchase or merger), payment terms, indemnification, etc. In other contexts it is referred to as an MOU (Memoranda of Understanding).
You don’t always need a formal LOI or MOU. In smaller transactions we sometimes just exchange bullet points by email. In either case, the point is for all parties to get on the same page on the principal terms before drafting lengthy and expensive legal documents.
Sometimes clients are worried that the term sheet is just an extra document that will add to the cost of the transaction, but in most cases the term sheet saves them money. Recently I was assisting a client on a significant financing/joint venture transaction. I asked the client if there was an LOI or term sheet and she said no. I asked what the terms were and she kind of summarized her understanding of the terms over the phone and through a series of emails. Before the two sides had reached agreement on principal terms, counsel to the other side sent us a draft of the full agreement with all the bells and whistles. I recommended to my client that we hammer out a term sheet first, or even just agree by email on a bullet point list of the principal terms.
But she didn’t want to do that, so we basically used the other side’s draft of the full-on agreement as the term sheet. Not only did our redline of the agreement push back on the major terms, we had to insert our changes to all the finer points including some tax and accounting concepts. Several drafts and at least $10,000 in legal fees later, the parties realized they couldn’t come to terms on some of the major deal points. The deal cratered and the two sides walked away. If we had used a term sheet, they would’ve realized this much earlier in the process, and each side would’ve saved dozens of hours in time and energy and thousands of dollars in legal fees.
So the next time you’re wondering if a term sheet is worth the time and cost, think about the above scenario and decide to use a term sheet!
Feel free to contact me if you have any comments. Thanks,
This article is not intended and should not be relied upon as legal or tax advice pertaining to any specific matter. You are encouraged to seek competent legal and tax counsel before proceeding with any transaction involving any of the matters discussed above.