Are Term Sheets Really Nonbinding?

• 3.30.2023

AJ Febles was the author of this post.

You’re in the thick of week two of negotiations on a term sheet with a potential investor and you can’t help but wonder why you’re spending so much time on a document that has “nonbinding” written all over it. While it is true that term sheets summarize essential terms to be reflected later in binding legal documents, most term sheets do in fact adhere legal obligations to your company. 

Investor Favored Terms

So, it is important to know that while term sheets are typically labeled as “nonbinding,” certain specific terms will create legally binding obligations. There are two legally binding commitments an investor will expect for any transaction: Confidentiality and Exclusivity. 

Confidentiality refers to the request by venture capitalists (VCs) or potential investors to keep the term sheet and its specific terms confidential, in part to protect the VC’s ability to evaluate companies and propose winning terms. But given that both parties will disclose detailed information to each other in order to consider the transaction, confidentiality in a term sheet also protects the company’s sensitive information from disclosure to any third parties. 

Exclusivity, or “no shop”, refers to the set period of time during which a company and its founders agree not to shop for other potential offers. This period should more or less align with the deal timeline, typically around 30 days. Having an exclusivity provision in a term sheet makes it more likely that the deal will be consummated. Potential investors feel more comfortable devoting the time, effort, and resources required to complete the diligence and drafting process of a financing when the company can demonstrate that they have skin the game. 

One example of a confidentiality and exclusivity provision can be found in the National Venture Capital Association model term sheet, which combines both concepts. It’s drafted as follows:

The Company and the Investors agree to work in good faith expeditiously towards the Closing. The Company and the founders agree that they will not, for a period of [______] days from the date these terms are accepted, take any action to solicit, initiate, encourage or assist the submission of any proposal, negotiation or offer from any person or entity other than the Investors relating to the sale or issuance, of any of the capital stock of the Company [or the acquisition, sale, lease, license or other disposition of the Company or any material part of the stock or assets of the Company] and shall notify the Investors promptly of any inquiries by any third parties in regards to the foregoing. The Company will not disclose the terms of this Term Sheet to any person other than employees, stockholders, members of the Board of Directors and the Company’s accountants and attorneys and other potential Investors acceptable to [_________], as lead Investor, without the written consent of the Investors (which shall not be unreasonably withheld, conditioned or delayed).  

Duty to Negotiate In Good Faith

Have you also noticed that your term sheet includes a provision requiring the parties to negotiate in good faith? Whether or not this is a binding duty is up for debate and may depend on your jurisdiction.

In some jurisdictions, like Texas and Virginia, even explicit agreements to negotiate in good faith included in a term sheet are not enforceable as a matter of law.  But such is not the case everywhere. In Delaware, for instance, a signed term sheet may be considered a preliminary agreement, that while not binding in regard to consummating the proposed transaction, still requires the parties to negotiate in good faith toward that goal.

And the Delaware Supreme Court does not take a breach of good faith lightly. In 2013 it held that if the parties would have reached a definitive agreement but for the bad faith of the breaching party, the non-breaching party could recover contract expectation damages in an amount equal to the value that it could have reasonably expected to receive under a definitive agreement having those terms set forth in the term sheet. (Siga Techs., Inc. v. PharmAthene, Inc., 67 A.3d 330 (Del. 2013)).

That’s why we always emphasize that deliberation and care are paramount when negotiating a term sheet. If the parties want to be able to walk away without any liability while drafting the definitive agreement, the term sheet should clearly state so and should not include an obligation for either party to negotiate in good faith. If the parties decide to be bound by a duty to negotiate in good faith, they should consider specifying what constitutes bad faith (for example, violating the exclusivity clause, lack of cooperation with due diligence, or failure to use reasonable efforts to obtain financing).

Conclusion

It’s always best to say what you mean and mean what you say in a term sheet. We always advise our clients to be as clear as possible with regard to which provisions in a term sheet are expected to be binding. When it is unclear whether a provision is meant to be binding, a court infers the parties’ intent by evaluating:

• whether the language of the term sheet reveals an intent by the parties to be bound by its terms;
• the context of the negotiations;
• the existence of open terms;
• whether the parties have partially performed with regard to the obligations at issue; and
• the necessity of putting the agreement in final form, in a manner customary for such transactions

We also counsel our clients to include language explicitly stating that the parties are not bound to consummate the contemplated transaction unless and until a definitive agreement is signed. 

Bottom Line

Calling term sheets “nonbinding” is a misnomer. VC investors will want to feel assured in their potential investment by seeing exclusivity and confidentiality provisions in any term sheet. Whenever expenses are included in a term sheet, founders should have clarity on whether such provisions are meant to be binding, and if so, they should ensure that the company will not be required to fund expenses if the financing doesn’t close.