Agreeing on a term sheet is the first step in the exciting process of raising money for startup founders. It sets out the parameters of the deal that will be executed in one or more legal documents to follow due diligence. But you may be wondering to yourself: "Are term sheets binding?" Unfortunately, the answer is that it depends.
Everything in a term sheet can be broken down into two parts in terms of what's binding: a "No-Shop"/confidentiality provision, and everything else.
Most term sheets have a No-Shop/confidentiality provision. Typically, a No-Shop provision may:
This provision is binding, and violating it by the startup can result in an obligation to pay damages to the investors. These may include liquidated (i.e. pre-determined) damages.
Almost every term sheet will include conspicuous language stating that the term sheet is not binding. No court would force the parties to the term sheet to follow through with the terms. But the courts in many states view an agreement like a term sheet as a promise to negotiate in good faith based on the terms agreed upon in the term sheet.
This does not mean that the parties have to reach an agreement if, for example, something comes up during due diligence. But the parties cannot refuse to negotiate or fail to negotiate in good faith (for example, by negotiating in form without having any intention of actually closing the deal). While a court may not force the parties to negotiate, it may grant damages incurred in reliance on the promise to negotiate (such as any costs of negotiation and provable opportunity costs). However, the party alleging a violation of the duty to negotiate will not receive the "benefit of the bargain" (i.e. lost profits). As one California court has mentioned:
For obvious reasons, damages for breach of a contract to negotiate an agreement are measured by the injury the plaintiff suffered in relying on the defendant to negotiate in good faith. This measure encompasses the plaintiff's out-of-pocket costs in conducting the negotiations and may or may not include lost opportunity costs. The plaintiff cannot recover for lost expectations (profits) because there is no way of knowing what the ultimate terms of the agreement would have been or even if there would have been an ultimate agreement.
Copeland v. Baskin Robbins U.S.A., 96 Cal. App. 4th 1251 (2002).
The states that follow this approach include Delaware, California, New York, and Illinois, among others.
Delaware courts have actually gone one step further by allowing the aggrieved party to receive the "benefit of the bargain" (i.e. the profits it would have received had the breaching party not violated its duty to negotiate in good faith) in situations involving breach of a duty to negotiate in good faith.
One criticism of this approach is that, unlike damages suffered in reliance on the promise, lost profit damages are very speculative and difficult to prove with certainty.
Because a choice of law provision in a term sheet dictates what law applies, parties should select the choice of law carefully. Some advocate strongly against using Delaware law in term sheets. However, in certain situations, the parties may prefer the additional certainty that comes with using Delaware law in this context.
Another key takeaway is that if you negotiate a term sheet that is governed by Delaware law, even if the term sheet says that it is not binding, once you sign a term sheet you have to continue to negotiate in good faith. Otherwise, you may owe the other party profits that it lost as a result of your breach.
Get in touch with us if you have any questions about your term sheet.
DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal advice. This article may constitute attorney advertising under applicable state laws.