Letter of Intent, Term Sheet or Purchase Agreement: Which Document Does What

Business transactions in Ontario tend to move through the same three stages of paper. A short preliminary document records the deal in principle. A longer definitive agreement sets out every right and obligation. Closing documents transfer the shares or assets. The names people give the first document vary, and the variation causes confusion, so it helps to be precise about what each one is for.

A letter of intent is a letter, signed by both parties, that records the key commercial terms of a proposed acquisition and the ground rules for getting to a definitive agreement. It is the usual first document in the purchase and sale of a private business.

A term sheet does the same job in a different market. The phrase is standard in financing: a priced equity round, a convertible note, a venture loan. It is set out as a table of terms rather than a letter, and it is usually proposed by the investor or lender.

A memorandum of understanding is the same idea again, more common in joint ventures, government and cross-border deals, where "memorandum" sounds less like an offer. In Ontario law the three are treated identically. What matters is the content and the intention behind it, not the title.

A purchase agreement, whether a share purchase agreement or an asset purchase agreement, is the definitive contract. It binds both parties to close on the stated terms once the conditions are met, and it carries the representations, warranties, covenants and indemnities that govern the parties' relationship after closing.

A letter of intent settles the terms that would otherwise be negotiated twice: price and how it is paid, share or asset structure, the deposit, the length of due diligence, the conditions to closing, the treatment of employees, the seller's non-compete and the target closing date. Our clause-by-clause guide to a letter of intent covers each.

It also contains a small set of binding terms, confidentiality, exclusivity, expenses and governing law, and a clear statement that the rest is non-binding. That split is the defining feature of a letter of intent and the reason it should be reviewed by a lawyer even though it is short. A letter that drops the non-binding statement, or that the parties then act on as if it were the final deal, can become a binding contract. The Court of Appeal for Ontario enforced one in Wallace v. Allen, where the letter used the language of agreement and the parties then acted as if the deal were done. Our article on whether a letter of intent is binding explains the test.

What a properly drafted letter of intent does not do is oblige anyone to buy or sell. If due diligence disappoints the buyer, or the seller changes its mind, the non-binding terms fall away and each side bears its own costs, unless a break fee says otherwise.

A financing term sheet settles the economics and control terms of an investment: the pre-money valuation, the amount raised, the class and price of the shares, the liquidation preference, anti-dilution protection, board composition, investor consent rights, pro rata rights, founder vesting and the conditions to closing. For a convertible instrument it settles the discount, the valuation cap and the conversion events instead of a price. Our guides to priced rounds versus SAFEs and SAFEs and convertible notes explain the choices.

The binding and non-binding split is the same as a letter of intent. Confidentiality, exclusivity (often called a no-shop here too), expenses and governing law bind; the economics do not. One difference in practice is that institutional investors expect the company to pay a capped amount of the investor's legal fees at closing, and some term sheets make that a binding obligation, payable whether or not the round closes. Founders should read that clause before signing.

Term sheets also appear in commercial lending, where a bank's commitment letter plays the same role, and occasionally in M&A, where a buyer's indicative offer is set out as a term sheet before a letter of intent is signed. In each case the legal analysis is the one above: look at the words and the conduct to see what the parties intended to bind.

The definitive agreement is where every term becomes enforceable. A share purchase agreement or asset purchase agreement for an Ontario business runs from a few dozen to well over 100 pages and typically contains:

• The sale and the price, with the adjustment mechanics for working capital, the allocation of the price among assets for tax, and any earn-out or holdback in full detail.
• Representations and warranties by the seller about the business: title to shares or assets, financial statements, tax, contracts, employees, litigation, environmental matters, intellectual property and compliance with law. These are the statements the buyer relies on instead of discovering everything itself, and they are the basis of most post-closing claims.
• Covenants between signing and closing: ordinary-course operation, access, consents and cooperation.
• Conditions to each party's obligation to close, and what happens if a condition fails.
• Indemnification: who pays for a breach of representation, subject to thresholds, caps, survival periods and the holdback.
• Closing mechanics: the deliverables, the date, the place and the flow of funds.
• Restrictive covenants by the seller, confidentiality, and the boilerplate that decides how disputes are handled.

Where the transaction involves an interest in land, such as the assignment of a lease of more than three years or the transfer of real property, the Statute of Frauds makes the agreement unenforceable unless it, or a note or memorandum of it, is in writing and signed by the party to be charged. Where a corporation sells all or substantially all of its property, the Business Corporations Act requires a special resolution of shareholders, and the agreement will make that approval a condition.

Three other labels appear often enough to be worth a word. Heads of terms or heads of agreement is the English usage for the same document as a letter of intent, and arrives in Ontario deals through UK and Commonwealth counterparties. Memorandum of understanding is used where the parties are not buyer and seller: a joint venture, a distribution arrangement, a collaboration with a university or a public body. Indicative offer or expression of interest describes a buyer's first, usually non-binding, statement of price in an auction process, before the seller selects one bidder to sign a letter of intent.

The law treats all of them the same way. An Ontario court asks whether the parties intended to create legal relations and whether the essential terms are certain enough to enforce. A memorandum of understanding that fixes the parties' contributions, the sharing of revenue and the term of a joint venture, and that the parties then operate under, can be a binding contract no matter how it was titled. The reverse is also true: a document called an agreement that leaves price to be agreed later, with no formula or mechanism for fixing it, is usually an agreement to agree, which Ontario courts have long refused to enforce.

The practical consequence for drafting is the same in every case. Put the statement of what is and is not binding in the document itself, make the binding terms specific, and keep the parties' conduct consistent with the words until the definitive agreement is signed. A party that wants the flexibility of a non-binding document cannot also have the certainty of a contract, and should not act as if it does.

The letter of intent is usually prepared by the buyer, because it is the buyer's offer. Sellers sometimes issue their own form to control the starting point, which is sensible in a competitive process. Either way it should be reviewed by both sides' lawyers before signing, which takes days, not weeks.

The purchase agreement is drafted by the buyer's lawyer in most private deals. The buyer is the party relying on representations and asking for indemnities, so the buyer's lawyer produces the first draft and the seller's lawyer marks it up. The cycle takes two to six weeks in parallel with due diligence. Our legal fee estimator gives a sense of cost for each stage.

Closing documents are prepared by both sides according to a closing agenda: share transfers, resignations and appointments, assignments of contracts, bills of sale, the lease assignment, the section 167 HST election, releases of guarantees and the funds flow.

The order matters. Signing a letter of intent before due diligence protects the buyer's spend. Signing a purchase agreement before due diligence is complete exposes the buyer to a binding obligation it may regret, unless the agreement is conditional, which brings its own drafting. Skipping the letter of intent and going straight to a conditional purchase agreement is possible for a small, simple purchase, and sometimes faster, but it means negotiating every term at once with a larger bill at risk if the deal fails. For most owner-operated businesses in Ontario, the three-stage sequence is the efficient one. If you are not sure which document you are being asked to sign, send it to us before you do.