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Background Negotiation of a Venture Investment

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP


It is customary to begin the negotiation of a venture investment with the circulation of a document known as a term sheet, a summary of the terms the proposer (the issuer, the investor, or an intermediary) is prepared to accept. The term sheet is analogous to a letter of intent, a nonbinding outline of the principal points which the Stock Purchase Agreement and related agreements will cover in detail. The advantage of the abbreviated term sheet format is, first, that it expedites the process. Experienced counsel immediately know generally what is meant when the term sheet specifies "one demand registration at the issuer's expense, unlimited piggybacks at the issuer's expense, weighted average antidilution"; it saves time not to have to spell out the long-form edition of those references. [1] Second, since the term sheet does not purpose to be an agreement of any sort, it is less likely that a court will find unexpected promissory content; a "letter of intent" can be a dangerous document unless it specifies very clearly, as it should, which portions are meant to be binding and which merely guide the discussion and drafting. Some portions of a term sheet can have binding effect, of course, if and to the extent an interlocutory memorialization is needed of some binding promises, that is, confidentiality of the disclosures made in the negotiation. The summary format of a term sheet, however, makes it less likely that any party will be misled into thinking that some form of enforceable agreement has been memorialized when it has not. [2]

A number of cases have considered the question whether an agreement in principle or term sheet amounts to a contract of some sort. For example, assume an investing entity backs out of financing a start-up company. The start-up company claims that the investing entity had made binding legal promises in the term sheet, including particularly the promise to invest money, and should be liable in the event of breach. Generally, the relevant cases have arisen in the context of a lender-creditor relationship; indeed, the cases concerning promises at the preliminary stage are grouped under the general heading of "lender liability," upon which there has been a good deal of commentary. [3] An illustrative case that raises the alarm systems of investor's counsel if Judge Duffy's opinion in Penthouse International Ltd. v. Dominion Federal Savings & Loan Ass'n. [4] In that case, since reversed by the Court of Appeals, [5] Dominion Federal was held liable to the applicant debtor for $112 million in lost profits for failure to fund its promise to advance a $35 million participation in a loan made by another lender to construct an Atlantic City casino. [6] If one construes the term sheet as equivalent to a lender's commitment letter, then the problems are apparent, including particularly the zany measures of damages that juries award in cases such as Penthouse International and Texaco v. Pennzoil. [7] On the other hand, there may be a recent defendant-oriented trend building in reaction to stretches such as Judge Duffy's. Thus, the Seventh Circuit in 1989 held against the notion that a letter of intent is a binding contract, [8] the letter of intent being expressly conditional on acceptance by the boards of both corporations, which in the defendant's case did not occur. The district court made findings that the parties did not intend the letter of intent to be a binding obligation. The court also rejected, again on the specific facts, the allegation that the defendant had failed to negotiate in "good faith."

The author's firm has, conjured with language such as the following that investing entities should consider including in term sheets whenever the issue is in doubt :

The parties expressly agree that no binding obligations will be created until a document entitled "final agreement of purchase and sale" is executed with the requisite formality and delivered by both parties. Without limiting the generality of foregoing, it is the parties' intent that, until that event, no agreement shall exist between them and that there be no obligations whatsoever based on such as parol evidence, extended negotiations, "handshakes," oral understanding, or courses of conduct (including reliance and changes of position). No legally binding obligations whatsoever are to be created, implied, or inferred, until a document explicitly entitled "final" has been executed and delivered.

In addition, neither party is under any obligation to negotiate in good faith or to use any quantum of effort, including but not limited to "best efforts," to reach an agreement. Either party is free to negotiate with a third party at the same time it is negotiating with the other party to this document and, except as explicitly herein provided, to solicit interest from any available source. Either party may reveal information, whether labeled "confidential" or otherwise, obtained in the course of the transaction unless there is a specific agreement, signed by both parties with the requisite formality, to keep a particular item of information confidential.

It is notable in Penthouse that the default by the defendant, Dominion Savings & Loan, was in its posture as a member of the syndicate and not the lead investor, leading one to conclude that perhaps even a secondary investor involved in presenting a term sheet could be as liable. [9] Parenthetically, it is an article of faith in venture capital that start-up companies can be ruined by the propensity of venture capitalists to pursue a "now you see it, now you don't" commitment to fund the company.

A final note: the recent precedents on the issue of "term sheets vs. contracts" are much more numerous when the defendants, like Dominion Federal, are lenders (versus investors). One wonders why, other than the populist notion that bankers are skinflints, debt commitments (or so alleged) are more easily distilled out of conduct and incomplete papers versus alleged promises of equity.


[1] One should be aware that some of the typical provisions found in a term sheet, i.e., "customary representations and warranties," can constitute less than precise instructions to the draftsmen of the Stock Purchase Agreement.

[2] The fact that a writing is styled as a term sheet does not exclude the possibility the parties have contemporaneously reached an oral agreement, oral agreements being equally as binding as written contracts, given the necessary quantum of proof (and absent legal requirements of a writing for the sale of, e.g., shares of stock or real estate). Williston, Contracts 12 (1957 & Supp. 1986).

[3] See the authorities collected in the bibliography accompanying Kriz & Kavanah, Up-Date On Lender Liability, 3 Rev. Fin. Servs. Reg. 189, 195 (Nov. 4, 1987); see also Goodman, Note, Con- finning Bank Liability in Letter of Credit Transactions: Whose Bank Is It Anyway? 51 Fordham L. Rev. 1219 (May 1983)

[4] 665 F. Supp. 301 (S.D.N.Y. 1987).

[5] Id., rev'd, 855 F.2d 963 (2d Cir. 1988), cert. denied 490 U.S. 1005, 109 S. Ct. 1639 (1989).

[6] 665 F. Supp. at 311-12.

[7] 729 S.W.2d 768, 787 (Tex. App.Houston 1987, writ ref'd n.r.e.), cert. denied, 485 U.S. 994, 108 S. Ct. 1305. See Shannon, Texaco and the $10 Billion Jury (1988).

[8] A/S Apothekernes Laboratorium v. I.M.C. Chem. Group, 873 F.2d 155 (7th Cir. 1989). See also Empro Mfg. Co., Inc. v. Ball-Co. Mfg., 870 F.2d 423 (7th Cir. 1989); Arcadian Phosphates, Inc. v. Arcadian Corp., 884 F.2d 69 (2d Cir., 1989), discussed in 4 Corporate Couns. Wkly. (BNA) 1 (Sept. 13, 1989). For cases to the contrary, see Temkin, When Does the "Fat Lady" Sing? An Analysis of "Agreements in Prindiple" in Corporate Acquisitions, 55 Fordham Law. Rev. 125 (Nov. 1986).

[9] 665 F. Supp. 301, 311-12 (S.D.N.Y. 1987). The reversal of Judge Duffy's opinion does not mean that the issue is behind us. The problem in that case was, in part, that the judgment would have compelled yet another S&L to liquidate.

Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

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