Using Term Sheets to Your Advantage: Steps to Sharpen Your Strategy

September 2011

By: Edward R. Gates

 

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What This Means to You

  • Use a term sheet to get your key business drivers clearly stated in writing.
  • Make sure you understand the role your term sheet will play in the negotiation process.
  • Commit to your key business terms before you commit them to a term sheet.
  • The devil is in the details; make sure there are no ambiguous terms in your term sheet and you have carefully assessed all potential terms and their impact on the negotiation.
  • Consider how you might use a term sheet to control the pace of negotiation.  

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It would be reasonable to assume that a short, non-binding document that provides a summary of the key terms related to a licensing negotiation would be beneficial to both parties before beginning the expensive process of drafting a formal agreement. Unfortunately, that is not always the case. Instead, these “term sheets” can contribute to misunderstanding and delay,  and, at worst, they can undermine the entire deal. Are there clear strategies to take to avoid the pitfalls and to use term sheets to your advantage?

Term Sheets as a Strategic Tool

A term sheet has the potential, if used optimally, to be a strategic tool that helps shape the pace and structure of the negotiation. It also can help lay a foundation for obtaining key terms in a formal binding agreement. With careful planning and preparation, term sheets can be a significant and integral part of a successful negotiation strategy.

Identify How Your Term Sheet Should be Used

Before drafting the term sheet, contemplate the role it should play in the negotiation process.

What types of terms should it include? What types of terms should be left out? How will these early decisions potentially affect the final deal?

Understand the Psychology Surrounding Term Sheets

A term sheet may be non-binding, but most people do not like to go back on their word.  When that word is in a clear writing, there is little room to argue that something else was intended.  Therefore, act quickly to clearly get your key business drivers in writing. Much can flow from this. 

If the other party attempts to make a change to your key terms:

1.      Hold the line. You can argue they agreed to the term and should stick to it or something close to it.    

2.      Trade up. You can argue they are changing the economic basis for your doing the deal in the first place and that you need something in return.

3.      Trust. You may be uncovering a problem respecting whether the other side will live up to the terms of the agreement. You certainly have an opportunity to let the other side know that changes to the ‘agreed-on’ terms make you uncomfortable and also that further changes will not be well-received, making the other side more hesitant to suggest additional changes.

Timing

You want to be in a position where you do not need to make changes to your key business terms after you sign a term sheet. If you do not understand your key business terms in the deal, then you probably are not ready to sign a term sheet. Negotiations have an ebb and flow, and a term sheet can be used advantageously to close on significant terms when you are in a moment of relative advantage in your negotiations.

Negotiating Deals is Tough Business

Business deals usually do not work out unless they are good for both parties. Having said that, you want to be in a position of strength in your negotiations. Being better prepared than the other side can help you do that, by knowing what will work for you and then nailing those things in a term sheet.

You can be at an advantage, if the term sheet includes everything that really matters to you, but not everything that really matters to the other side. Being on the opposite end of that equation can be a disadvantage.  

Level of Detail

You want to memorialize your key deal drivers with a significant level of detail such that the meaning cannot be questioned at a later time in the negotiation. An ambiguous term is simply an invitation to have the other side argue they thought it meant something else.  

Typical Terms to Include

Every deal is different and each term sheet should be tailored to embrace the key business terms in each deal. Financial components are almost always critical. But within that category, one should be thinking about the detail. Will the money most likely come from the licensee’s activity or a sublicensee’s activity?  Will the money most likely be in the form of milestones, royalties, or payments arising from sublicensing fees? Under what circumstances will a royalty be paid? Will there be a know-how component and will there be payments even if there are no patents? If there are milestones, are the triggers for payment of the milestones clear? And so on.

The scope of the grant should always be addressed in a term sheet. Is the grant exclusive or non-exclusive? Is the grant restricted to a field? Can the grant be sublicensed? Is any know-how required to practice the grant? Does the grant include any future inventions?

Diligence requirements and termination conditions can be critical. Getting a product to market in a certain time-frame or getting the technology back in the future without being blocked can be critical. Accessing certain know-how, key personnel, data or materials might be critical. Confidentiality and  lock-up may be important.

This is by no means an exhaustive list. The point is to make sure you figure out what terms really matter in the deal, think those terms through thoroughly, and express those terms in as much detail as necessary to make sure only one interpretation is possible.   

There are standard forms of term sheets for licenses and standard provisions for certain kinds of deals, such as an exclusive patent license in a particular field of use or a non-exclusive copyright license to use a software platform. In addition, industry norms influence expectations about how the terms of a license proposal should look. These templates can be a useful starting point. But there also needs to be a departure from a standardized one-model-fits-all framework to fit the needs and constraints of each specific deal.

Setting Expectations

The structure and pace of the license negotiation can have a significant impact on the terms of the final agreement and on the relationship between parties going forward. License negotiations are driven not only by business needs and financial considerations, but also by a complex set of environmental, interpersonal and institutional factors. These factors need to be managed and integrated into the negotiation strategy. A term sheet can help.  

Term sheets can be used for setting the agenda and controlling the pace of the negotiations. They can be used to set expectations for getting to a final deal. A term sheet can include a timetable for conducting any necessary diligence. It can indicate which party will prepare the first draft of an agreement and the expectations for the time periods for review and comment on drafts. It can include a timetable for signing a definitive agreement, including an outline of the lines of authority involved in the approval process.  

Binding Term Sheets

Term sheets should specify what terms, if any, are binding. The term sheet, for example, may bind the parties to confidential and/or exclusive discussions.

In some cases a term sheet could constitute a binding agreement, even inadvertently, unless steps are taken to make it clear that the written document is for discussion purposes only. For example, there may be an exchange of emails together with an exchange of draft term sheets which could result in a binding agreement. Always be clear that the exchanges are for discussion purposes only if you do not want to inadvertently have a binding agreement.

Pitfalls

If not used with care, term sheets can throw a deal off track. For example, a term sheet with ambiguous terms can result in a lack of trust. One party almost always feels that the other party must have known what was meant. A term sheet with the wrong focus can shift attention away from important deal terms and toward relatively unimportant areas of difference. A term sheet lacking critical terms can result in frustration and delay, as the deal which the parties thought they had now needs to be rethought and renegotiated to take into account the misunderstanding.  

Conclusions

A term sheet can be a significant and integral part of a successful negotiation strategy. It can shape the pace and structure of the negotiations, lay a foundation for obtaining key terms, and provide an advantage in the negotiation of a definitive agreement.