M&A Series: Part II - Preliminary Documents

Introduction and Usage

Preliminary documents, often referred to as preliminary agreements or pre-contracts, are typically agreed upon by the parties involved in a share purchase deal during the early stages of a complex transaction, before the drafting of essential transaction documents like the share purchase agreement and shareholders' agreements.

In practice, these documents are known by various names, such as letters of intent, memoranda of understanding, heads of agreement, heads of terms, or term sheets. For instance, if the document is drafted as a letter, it is usually termed a "letter of intent"; if formatted as a contract, it may be called a "memorandum of understanding," "head of agreement," or "head of terms"; if presented as a chart or bullet point list, it is typically referred to as a "term sheet”. Despite their varied names, these documents differ more in form than in substance and purpose.

Purpose of preliminary documents and key considerations

Ultimately, they all serve the same objectives:

• to express a sincere interest from one or more parties in finalizing a binding agreement regarding the proposed transaction;

• to establish the key commercial terms of the transaction; and

• to identify and address any misunderstandings or differences related to the transaction as early as possible.

Preliminary documents often carry the notion that they are not legally binding, and the parties involved typically view them as low-risk legal instruments. However, this perception can sometimes be overly simplistic for several reasons.

1. Firstly, these documents invariably include certain provisions that are legally binding, such as clauses related to confidentiality, exclusivity of negotiations, standstill commitments, non-solicitation agreements, breakup fees, costs, applicable law, jurisdiction, and similar matters.

   
   

2. Secondly, under Malaysian law, simply stating in a preliminary document that the transaction is "subject to contract" or "non-binding" does not automatically eliminate its potential legal effect, especially if the terms suggest that the parties intended to form a binding agreement. In fact, decided cases have shown that the binding nature of an agreement is determined by the content rather than the label used. Malaysian courts focus on discerning the true intentions of the parties when interpreting an agreement, rather than strictly adhering to its literal wording.

   
   

3. Thirdly, if not carefully drafted, a preliminary non-binding document could, in certain cases, be reclassified as an offer or even a contract - although this risk can be said to be low due to the complexity of share purchase agreements, which typically include essential elements such as representations, warranties, and indemnification mechanisms.

Therefore, when drafting a nonbinding preliminary document, the author should take care to clearly define its legal scope and avoid any language that might suggest, directly or indirectly, that a final agreement has already been reached, either in whole or in part, regarding the proposed transaction. It is essential to clarify from the outset that the purpose of the preliminary document is not to establish any "agreements" between the parties but rather to outline "understandings" aimed at facilitating the negotiation and drafting process of the proposed transaction. Additionally, it is important to clearly distinguish and separate the nonbinding provisions from the binding ones, as both types of provisions are likely to coexist within the same document

 Are preliminary documents even necessary?

Preliminary documents are not necessary for every transaction. They should only be considered when a proposed transaction is complex and when the preliminary document can be negotiated within a reasonable timeframe. These documents are intended to expedite the transaction process, not to delay it. Therefore, if negotiating a preliminary document is likely to involve lengthy discussions or result in an excessively long document, the parties might be better off starting negotiations on the actual transaction documents—unless there is a legitimate concern about a party's genuine interest in closing the deal. Alternatively, the parties could focus on negotiating preliminary documents that avoid "deal breaker issues." As with many aspects of life, finding the right balance is key.

What should a preliminary document contain?

The content of a preliminary document will differ based on the specifics of each proposed transaction. At times, it may be brief, including only a succinct overview of the key commercial terms. In other cases, it might be more detailed and complex, depending on the interests involved. The nature of the preliminary document often reflects whether one party is attempting to "secure" the transaction by compelling the other party to proceed or to keep its options open regarding whether to continue with the transaction.

• A typical preliminary document will feature both nonbinding and binding provisions, often including standard elements. Besides identifying the parties involved in the proposed transaction (such as seller(s), purchaser(s), guarantor(s), target(s), etc.), the nonbinding provisions usually cover the following commercial terms:

• A description of the proposed transaction and its intended structure;

• An outline of the purchase price structure, including elements such as price adjustments, locked box mechanisms, earnouts, clawbacks, and escrow arrangements;

• The key conditions that must be met for the transaction to close, such as due diligence, obtaining governmental or regulatory approvals, maintaining business operations in the ordinary course, absence of significant adverse changes, notifying employee representatives, securing financing, and avoiding the dismissal of key employees;

• A tentative timeline for conducting the purchaser's due diligence, securing financing, drafting the transaction documents, and finalizing and closing the deal;

• A list of the main transaction documents to be prepared, including the identification of the party responsible for drafting each document;

• Other important terms of the transaction documents, which will vary depending on their nature.

• In addition, standard binding provisions in preliminary documents typically include the following:

• A confidentiality provision, unless a separate confidentiality agreement is already in place to ensure the confidentiality of the negotiations;

• An exclusivity provision that prevents the seller(s) from negotiating with other parties during a specified period and requires them to report any proposal that could impact or jeopardize the completion of the transaction;

• A non-solicitation provision designed to protect the target’s key employees, contractors, clients, and suppliers, especially if the prospective purchaser operates in a competing industry;

• A data room access provision to ensure the purchaser and its advisers have reasonable or full access to the necessary information for due diligence on the target and its business, typically for a period matching the exclusivity period;

• Provisions for governing law and jurisdiction that apply to both the preliminary document and the transaction documents to be drafted later.

• Although less common, an increasing number of private M&A transactions in recent years include preliminary documents with binding break fee provisions that apply in the event of a breach of any or all of the binding terms.

Preliminary documents are often undervalued as strategic tools in many transactions for the reasons mentioned earlier. However, when properly designed, drafted, and utilized, they can be powerful instruments for shaping the pace and outcome of complex negotiations, despite their typically non-binding nature. For example, a seller might use preliminary documents strategically to assess potential deal-breakers, before investing significant time and resources in making available documents for the due diligence process. Conversely, a prospective buyer can use preliminary documents to identify potential deal breakers early in the negotiation. Ultimately, such documents often help both parties save time in drafting the final transaction documents and provide an effective basis for guiding their advisers.

Sample Term Sheet

Below is a sample format for creating a term sheet. On the left side, you'll find the standard headings for terms and conditions. The right side is where these terms and conditions should be detailed.

In the provided template, we've included (on the right side) the aspects to contemplate when drafting these terms and conditions, thus aiding readers in the drafting process. Even if the parties have no plans to formalize a term sheet and instead opt to directly proceed with a sales and purchase agreement, the template below offers valuable guidance on the essential terms to reflect on before finalizing the agreement.

1	Sale and Purchase	This part is meant to explain the nature of the sale and purchase, which could involve either the assets of a business or the shares of a company (referred to as the "Target").
2	Purchaser	Insert identity of the purchaser including name, company number or NRIC/passport, etc,.
3	Seller	Insert identity of the seller including name, company number or NRIC/passport, etc,.
4	Consideration	his part is designed to outline the terms and conditions regarding the payment for the transaction. This includes the following aspects: (a) the specified payment amount; (b) the method of fulfilling the payment, which could involve cash or issuing shares; (c) the consideration of any required deposit; (d) whether the payment is divided into multiple installments; (e) the possibility of a retention sum, where a part of the payment is held after the completion of the transaction, contingent upon meeting agreed-upon conditions; (f) the timing of the payment; (g) whether the payment is a fixed sum or is subject to modification based on the Target's financial status as of a designated date
5	Profit Guarantee	When applicable, this part is used to detail any assurances provided by the seller concerning an agreed-upon profit target that the Target is expected to achieve within a defined timeframe. It includes the agreed schedule and compensation to be given to the seller should the profit target be fulfilled. Moreover, it covers the rules and methods for calculating the profit and the outcomes if the Target fails to meet the profit guarantee (if any consequences apply).
6	Earn-out	When applicable, this part is meant to define the sum of the earn-out that the seller is eligible to receive. It also outlines the agreed-upon schedule for disbursing the earn-out and the guidelines and process for establishing the seller's qualification for the earn-out (if any such criteria exist).
7	Definitive Agreements	This part is intended to outline the contracts that must be established for the transaction. Usually, the final agreements encompass the sales and purchase agreement, a potential shareholders' agreement, if needed, and a service agreement with the Target's crucial management, if necessary.
8	Conditions Precedent	This part outlines the prerequisites that must be met before the agreement becomes final. Generally, the agreement states that once it becomes unconditional, failing to proceed with the transaction could result in the defaulting party being held accountable for any damages incurred by the other party. The common conditions that must be satisfied beforehand include: (a) In the event that the seller is a corporation, the passing of a board of directors' resolution approving the transaction and the execution of the final agreements. (b) If the purchaser is a corporation, the passing of a board of directors' resolution endorsing the transaction and the execution of the final agreements. (c) If the transaction involves the sale and purchase of shares, the approval of the Target's board of directors for registering the share transfer in the purchaser's name. (d) If the transaction involves the sale and purchase of business assets, the approval of the Target's board of directors for transferring the business assets. (e) A comprehensive review, including legal, financial, tax, environmental, and operational due diligence on the Target, with the findings being satisfactory to the Purchaser. (f) Obtaining necessary authorizations from pertinent authorities in relevant jurisdictions, if needed. (g) Gaining approval from the Target's financiers for changes in shareholders or the disposal of business assets, if applicable. (h) The establishment of service agreements between the Target and its key management, if necessary. (i) Fulfilling any other required approvals, notifications, or registrations.
9	Employees	This portion allocates the responsibilities of both the seller and the purchaser towards the employees of the Target once the transaction is finalized. This aspect is subject to the laws applicable in the relevant jurisdictions. As specified in Regulation 8(1) of the Employment (Termination and Lay-off Benefits) Regulations 1980 ("Employment Regulations"), if a change in business ownership occurs, affecting an employee's employment, the employee might not be entitled to termination benefits if, within 7 days of the ownership change, the new business owner offers continued employment to the employee under terms that are as favorable as their previous terms. If the employee unreasonably declines this offer, the employee is not entitled to termination benefits. However, if the new business owner does not present such an offer in accordance with Regulation 8(1), the employment contract of the employee is considered terminated, and the employer prior to the ownership change is obligated to provide all termination benefits mandated by the Employment Regulations
10	Restrictive Undertaking	This part outlines the commitments made by the seller, which prevent them from engaging in competitive activities with the Target for a mutually agreed duration following the completion of the transaction. The extent of this restrictive commitment might encompass the seller's related parties, subsidiaries (if the seller is a corporation), or even the seller's family members (if the seller is an individual), subject to applicable laws and the relative bargaining strength of the parties involved.
11	Confidentiality	This part aims to establish the obligations of confidentiality that both parties must adhere to in order to protect sensitive information.
12	Exclusivity	This portion outlines the designated timeframe for exclusivity, wherein the seller commits to not engaging in discussions with any other external parties regarding the sale of the specific business assets or shares. During this period, the purchaser holds the sole privilege to engage in negotiations with the seller.
13	Cost	This part is intended to outline the expenses that each party is responsible for in relation to the transaction. These costs could encompass legal fees for both parties, as well as stamp duty incurred upon the execution of the sales and purchase agreement and the transfer of shares or assets.
14	Governing law and dispute	This part is designed to establish the jurisdictional law that will govern the agreement and the preferred method for resolving disputes, which can include either court litigation or arbitration.

The content presented in this article is meant solely for offering general information and should not be considered as legal opinion or professional advice.

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