LOIs, Term Sheets & Bears, oh my!
I made a mistake with a client last week. We got so caught up in preparing documents for his start up business that I didn't fully explain the difference between Letters of Intent (LOI), Term Sheets and Contracts. This was in the context of getting investors to sign on the dotted line and deliver a check.
First of all, it's important to realize that different people (and deals) use different terminology for different documents.
LOIs are used in a wide variety of situations, not just funding. They fall into 3 categories: Non-binding, binding and part binding and part not. They would be used in the course of long-winded negotiations to document where you are in the discussions, perhaps to solidify some things that have been agreed to already, or even to have people commit to general terms before a more complex and complete agreement can be drafted.
Term Sheets are also used in a lot of different situations, but if you're anywhere near the vicinity of investors, it means a very specific thing -- it means a short summary of the terms of a preferred stock sale. The reason Term Sheets are used almost all of the time in this sort of deal is that preferred stock deal paperwork is measured by the inch, not the page. And all of the negotiations that go into all of those inches of paperwork take time. And no one wants to spend the time doing that sort of work without being sure that everyone's in the same boat about the big terms, and that people are pretty darned committed to the deal.
Term sheets, or rather the terms in a Term Sheet can either favor the company, or more likely, favor the investors.
Contracts are what you want to have come out of both LOIs and Term Sheets. The contract has all of the details. It tells the whole story about who's doing what, when they are doing it, and what will happen if they don't do it at the appropriate when.
If there is going to be a delay between a handshake and a contract, an LOI or Term Sheet is appropriate. If the contract is simple, or if it's already prepared, isn't dependent on the parties agreeing on a lot of small details, and just needs the other side to review it and perhaps make some minor changes, then there is often no need for a Term Sheet or LOI.
That's legally. Psychologically there may be a good reason for using an LOI just to get someone used to signing their name. Never under estimate the power of even a non-binding LOI to get folks to understand that this isn't just talk anymore, and you're going to be asked to actually do something soon.
