MOUs, LOIs and Term Sheets: Understanding Preliminary Agreements

Authored by Phil Vandekerkhove, UCalgary Law | JD Candidate 2023

You’re a new business looking to outsource the manufacturing of your product to another business. You have just finished negotiating the basic elements of the agreement. The supplier pulls out a memorandum of understanding (MOU), letter of intent (LOI), or term sheet for you to sign. As with any agreement, you should know what legal obligations are being created before signing.
 
What are MOUs, LOIs, and Term Sheets?
These agreements come in different forms but share the same substance. In this post, they will be referred to as term sheets. Term sheets are a useful and flexible stepping stone in coming to business agreements. They are often executed once key terms of a transaction are agreed upon. Using the above example, a term sheet may set out the price, quantity and timing expectations for a manufacturing agreement. Such a term sheet will usually be signed before drafting the final manufacturing agreement.
 
Are term sheets legally binding?
You may want to know the specifics of an agreement before committing to a price. Many believe that signing a term sheet specifying prices could create a legal obligation to ensure the final agreement integrates those prices. But this is not usually the case.
 
            Non-binding Provision
Standard term sheets contain a non-binding or “subject to definitive agreement” provision.[1] This provision makes clear that the agreement is not intended to create legal obligations.[2] It is unlikely for a court to find a legally binding intention in an agreement with a non-binding provision. Including a non-binding provision carries the lowest risk that the agreement could become legally binding.
 
            Agreements to Agree
Without a non-binding provision, a term sheet is more likely to be enforced by the court. In such a case, the court will turn to the legal principle of agreements to agree. An agreement to agree, or agreements subject to contract is an agreement that leaves out essential terms, expecting the parties to agree on those terms in the future. Using our example, the supplier and buyer may agree on a price and quantity of product and agree to negotiate delivery timelines in the future. If the parties cannot conclude on a delivery timeline, and a dispute arises, the court is unlikely to find this “agreement to agree” enforceable due to uncertainty.[3] Where a contract lacks an essential term, it becomes too uncertain to enforce. Term sheets are often too short to set out all essential elements of an agreement. This legal doctrine adds protection to term sheets, usually making them unenforceable. [4]
 
Why execute a term sheet if they are unenforceable?
There are four main reasons why term sheets are useful business tools:[5]

1. Moral commitment
   Although not legally binding, term sheets can create moral commitments. In our manufacturing example, a manufacturer is less likely to raise the price of their product at the end of negotiations if they have previously signed a term sheet recognizing their original price.
   
   
2. Guidance for Lawyers
   Once key terms have been agreed to, lawyers can use a term sheet as a skeleton around which they can start drafting the final agreement. Early drafting can reduce delays and identify important terms as negotiations continue.
   
   
3. Creating Timetables for Continued Negotiations
   Depending on the transaction, companies may wish to create timelines for due diligence or other inspections. Such inspections often occur before executing the final agreement. With our manufacturing example, the buyer may want to schedule an inspection of product quality during negotiations.
   
   
4. Preliminary binding Legal Clauses
   Although term sheets are generally unenforceable, certain obligations may still be created to benefit ongoing negotiations. If legally binding terms are included, parties should ensure a non-binding provision reflects this intention.[6] Legally binding obligations may include:[7]

• Confidentiality and Non-Disclosure: Parties disclosing confidential information during negotiations will want to bind the other party through a confidentiality provision. In our example, the buyer may be disclosing confidential product ingredients. 

 

• Exclusivity: Exclusivity provisions ensure the parties do not negotiate with a third-party while current negotiations are ongoing. Exclusivity provisions reduce the risk of losing a deal to a third-party offer.

 

• Expenses: Parties often divide expenses incurred during negotiations such as legal, financial and accounting service fees. Parties may each pay their own incurred fees, or devise a fee-splitting arrangement.

 
Conclusion
Be not afraid when a term sheet is put before you. Read the terms to ensure they represent the key provisions agreed on in principle. Ask yourself if it may become binding. A non-binding provision should always be included. Finally, consider the binding terms under the circumstances. For example, if you are receiving other offers, consider whether an exclusivity commitment is the right choice for you.
 
If you would like more information about an MOU, LOI or term sheet, please feel free to reach out to the BLG Business Venture Clinic.


[1] Standard Document: Memorandum of Understanding, Practical Law

[2] Practice Notes: Term Sheets, Practical Law

[3] Bawitko Investments Ltd. v. Kernels Popcorn Ltd., 1991 CarsewellOnt 836, [1991] O.J. No. 495 at para 21.

[4] Practice Notes: Term Sheets, Practical Law

[5] Practice Notes: Term Sheets, Practical Law

[6] Standard Document: Memorandum of Understanding, Practical Law

[7] Practice Notes: Term Sheets, Practical Law