“O lente, lente currite, noctis equi…,” – or as translated, “Slowly, slowly run, O horses of the night…,” - Doctor Faustus quoted Ovid with palpable dread in the eponymous play by Christopher Marlowe. When the good doctor’s deal with the devil had reached the end of its term, it was time to pay up.
We all understand the dangers inherent in signing a contract, as courts generally enforce the terms of an agreement reached by two willing parties, even if those terms may be quite unfavorable to one side.
In the context of complex agreements – asset purchases, mergers, loan agreements, and real estate transactions, to name a few – myriad detailed points are negotiated before each party is willing to sign on the dotted line. Reaching a definitive agreement takes considerable time.
How can the parties ensure they are adequately protected – and headed in the right direction – as they take on the expense of diligence review, negotiation, and drafting of deal documents? The problem is as relevant for nonprofit corporations as it is for their profit-seeking peers, often more-so due to potentially limited manpower and financial resources. Negotiating parties may address these problems through so-called “nonbinding agreements” that lay out basic deal terms in advance of contract execution.
Nonbinding Agreement Overview
For those well-versed in U.S. law, the term “nonbinding agreement” is a bit of an oxymoron, since an “agreement” is by definition “binding.” All contracts impose legally enforceable obligations on the parties, and a document that does not impose such obligations is not a contract – in other words, not an agreement. However, the law has carved out room for these helpful written tools, which depending on their own stated terms may be binding in part or not binding at all. These agreements perform several vital functions.
First, they help clarify communications between two negotiating parties. By centering discussion around a defined list of essential terms, such agreements foster clarity: each party knows what the other is asking for. As the parties take turns modifying the proposed document’s language regarding price, timing, etc., they are spared the risk of talking past each other by side-stepping or insufficiently articulating their position on important issues.
Second, and closely related to the first point, such agreements expose deals that have no future before the parties waste potentially significant time and money negotiating and reviewing them. Lawyers are admittedly expensive, as are accountants, title agents, environmental engineers, appraisers, and all the other professionals that may be required to bring a potential deal to fruition. As an example, if the parties to a real estate transaction stand far apart on purchase price, then they probably have no need of identifying particulars for title issues, escrow account mechanics, applicable provisions for due diligence and document exchange, financial prorations, exit strategy, or other contract details.
Third, such agreements protect each party from inadvertently forming a contract and binding themselves to obligations they cannot or do not wish to keep. Business negotiations can be fraught with risk in this regard. For example, one party’s communication of interest may be taken by the receiving party as an absolute offer to deal, creating the power of unilateral acceptance in the recipient. If a reviewing court agrees with the recipient, the offeror may find itself bound to a lengthy or expensive contract, perhaps without ever having signed a piece of paper. As addressed further below, nonbinding agreements articulate such nature clearly from the outset, keeping the parties safe as they hammer out deal specifics.
Such agreements may be characterized as letters of intent (LOI’s), term sheets, or memoranda of understanding (MOU’s), as discussed in turn below. These general categories are not exclusive or definitive, as each has arisen from common use and may be characterized differently depending on the understanding of the parties or the nature of the underlying deal.
Letters of Intent
LOIs are styled as formal letters from one party to another, typically from buyer to seller or from lessee to lessor. They are commonly used for real property purchases or other asset purchases, as well as for merger agreements, business partnerships, or joint ventures. LOIs use plain language to describe the contemplated deal in practical terms, avoiding complicated jargon or legalese. They tend to focus on key business terms and the broad strokes of the proposed agreement.
LOIs are a good first-step option in contract negotiation, especially if extensive further negotiations are expected. Though LOIs are often signed by the delivering party, they are typically revised by the recipient with proposed changes, then passed back and forth between the parties with iterative revisions until there is general agreement on the included terms. Once both parties are satisfied with the LOI, the parties may both sign the LOI to memorialize their willingness to move forward with the deal.
Term Sheets
Term sheets are similar to LOIs, but they are typically prepared in outline form with bullet points for each key term. They tend to be more detailed than LOIs, with a short deal summary at the beginning document followed by a list of business (and often legal) terms. Term sheets are standard for negotiating capital funding or loan financing agreements, but they are also commonly used for mergers and acquisitions. They can be used as well in real estate deals, especially if the material terms are quite complicated (e.g., sale-leaseback, or other transactions involving significant complexities).
Due to their level of detail and outline form, term sheets are quite useful when developing a draft contract. The included terms may be translated into contract language and carried over directly to the draft agreement, which makes term sheets a good choice for negotiations in which a draft contract is the next anticipated step. They tend to be bilateral in style, looking like a document prepared with the cooperation of both parties rather than a communication from one party to the other. Term sheets may be signed by both parties or not signed at all, depending on the parties’ preference.
Memoranda of Understanding
MOUs are less common than LOIs or term sheets, and they are generally used in the context of joint ventures or strategic partnerships. As their name suggests, they are prepared in prose form as typical for memoranda, and like LOIs they tend to describe the contemplated transaction in high-level, practical terms. In look and feel, MOUs thus can look like an enforceable contract. And indeed, some parties prefer the verbiage “MOU” to communicate something that is legally binding and yet less extensive than one may expect for a contract.
Unlike LOIs or term sheets, MOUs are thus bilateral in presentation. Also unlike LOIs or term sheets, they are sometimes used to make binding agreements between parties. Consequently, one should be careful to identify whether an MOU is to be used for negotiating a contract or whether a contract is to be formed as the MOU. If the latter, an MOU should not be viewed as a shortcut to a good contract. The same diligence and attentiveness should be used for a binding MOU as for any other contract. In other words, details matter! MOUs also can be signed by the parties or unsigned, and an unsigned MOU should connote that it is not a binding contract.
Key Terms
Whatever form is employed – letter of intent, term sheet, or memorandum of understanding – a nonbinding agreement should include key business terms such as purchase price (or other financial terms), any down payment, any diligence timeline, closing conditions, other material terms, who is to develop any anticipated contract, and other key aspects of the parties’ arrangement. If the parties cannot agree on these items through preliminary negotiations, then it is doubtful whether a deal can be struck between them at all. In addition to these basic business terms, nonprofit leaders should consider three essential terms for any such nonbinding agreement.
Nonbinding provision. The first is a so-called nonbinding provision, which clearly states that the parties are not required to go through with the contemplated deal or keep the terms identified in the document. If there are any terms in the document that are intended to be binding, then the nonbinding provision should unequivocally carve out those terms as the only ones that are intended to have legal effect. Typically, this will carveout will include the next two provisions identified below. Nonprofit leaders should never sign an LOI or term sheet that leaves out the nonbinding provision, or they may find themselves in Doctor Faustus’s predicament – without even realizing they made a deal.
Exclusivity provision. The second essential term to consider in a nonbinding agreement is an exclusivity provision. This clause stipulates that one or both parties will refrain from negotiating with other parties until a deal is reached or talks are abandoned. Often this is stated in terms of an exclusivity period, during which one or both parties may invest time and resources into diligence, negotiation, and financing without the risk of losing the deal to a dark horse competitor. In the context of a merger, acquisition, purchase, or lease, this provision typically binds the party that is itself the target entity or holds the underlying asset. For the exclusivity provision to do its job, the instrument should clearly state that it is binding. Such provision is not legally required, but it likely is highly advisable (depending on the specific context).
Confidentiality provision. The third vital term is a confidentiality provision. In negotiating a complex agreement, the parties to the proposed deal often learn confidential information about each other that is not known to the general public. In some cases, this information may be prejudicial if disclosed and may impede future dealing with third parties. Often, the possibility of the proposed deal is itself a closely guarded secret, which could lead to internal discord, bad publicity, lost funding, or lost opportunity if disclosed too soon. A confidentiality provision therefore typically forbids either party from disclosing the negotiations, and any information gained through the negotiations, to third parties. As such, it should be clearly identified as a binding term.
Concluding Recommendations
When considering a complex transaction with another party, nonprofit leaders should make strategic use of nonbinding agreements (by whatever name they are called) to mitigate their risks and advance their strategic goals. They are thus mostly intended as tools, not contract substitutes to clarify negotiations, optimize time and charitable resources, and provide a safe exit from any transaction talks – long before it’s time to pay up.
