LOI, term sheet, MoU, often binding for startups?

In hardly any other phase of a start-up is signing as fast as in the early phase of cooperations, investments or takeovers. An investor wants to “first establish the key points”, a strategic partner proposes a “non-binding memorandum”, a buyer asks for a “letter of intent so that we can make progress”. The tenor is almost always the same: this is not yet a contract, it doesn’t bind you, it’s just an interim step.

It is precisely this assumption that regularly leads to legal and economic problems. This is because German law does not recognize a magical category of “non-binding”. It is not the title of a document that is decisive, but its content, its context and the behavior of the parties. What is meant to be non-binding may very well have legally binding effects – precisely where founders least expect them.

The following article explains why LOIs, term sheets and MoUs are particularly risky for start-ups, which legal mechanisms apply, where typical points of dispute arise and why these documents in particular are among the most frequent triggers of early-stage disputes.

Why preliminary contracts are so dangerous, especially for start-ups

Start-ups operate in an environment of time pressure, dependencies and asymmetrical negotiating power. Anyone looking for capital or wanting to gain a strategic partner is rarely in a comfortable position. The willingness to “sign something first” in order to keep the process going is correspondingly high.

LOIs, term sheets and MoUs fulfill a psychological function. They signal progress, seriousness and exclusivity. For investors and partners, they create a sense of commitment without fully committing themselves. For founders, on the other hand, they often create a deceptive sense of security: they believe they can back out at any time as long as no “real contract” has been concluded.

This asymmetry is no coincidence. Pre-contractual documents are regularly drafted in such a way that they remain as flexible as possible for one party, while creating factual or legal obligations for the other. Those who fail to recognize this run the risk of maneuvering themselves into a dead end at an early stage.

Non-binding is not a legal term

From a legal perspective, LOIs, term sheets and MoUs are nothing more than agreements under the law of obligations. They are not non-binding per se and are not binding per se. The decisive factor is which specific obligations are assumed.

A common mistake is to infer the non-binding nature of a document from its name. Whether a document is called a “Letter of Intent”, “Term Sheet” or “Memorandum of Understanding” is almost irrelevant in legal terms. The only decisive factor is whether and to what extent the parties undertake to behave in a certain way.

A distinction must be made between two levels. On the one hand, a preliminary agreement may already contain individual binding provisions, for example on exclusivity, confidentiality, cost allocation or contractual penalties. These provisions are usually binding in isolation, even if the rest of the document is described as non-binding.

On the other hand, even the commencement of contractual negotiations can trigger legal obligations. With culpa in contrahendo, German law has a liability regime for pre-contractual breaches of duty. Anyone entering into negotiations must do so seriously, must not raise false expectations and must not harm the negotiating partner without objective reason.

This is precisely where there is a considerable risk for start-ups. While founders often assume that they can pull out at any time, courts take a more differentiated view. Anyone who negotiates for weeks or months, discloses internal information, ties up resources and commits exclusively cannot simply withdraw without consequences.

Culpa in contrahendo

Culpa in contrahendo is one of the most underestimated aspects of LOIs and term sheets. It always applies when a party’s conduct during the conclusion or initiation of a contract breaches a trust worthy of protection.

This is particularly relevant for start-ups because they often have structural disadvantages. If a founding team is persuaded to reject other investors, adapt internal structures or make significant upfront investments, for example, this creates a situation of trust. If the investor then breaks off negotiations without a comprehensible reason, this can result in liability for damages.

Conversely, the startup can also be liable. For example, anyone who signals to an investor or partner that only details still need to be clarified, while there have long been internal doubts, is exposing themselves to a considerable risk. The mere reference to the “non-binding nature” of an LOI does not automatically provide protection here.

The overall situation is decisive: duration and intensity of the negotiations, degree of agreement, specific commitments, economic dependencies and the behavior of the parties. The further the negotiations have progressed, the higher the requirements for a lawful termination.

Exclusivity and break-up fees

Exclusivity clauses are particularly prone to conflict. They are extremely popular in term sheets and LOIs because they give the investor or partner time and security. For start-ups, however, they often mean a de facto blockade.

Those who commit themselves exclusively refrain from talking to other interested parties at the same time. This may make sense in certain situations, for example if a specific offer is being seriously pursued. However, it becomes problematic if exclusivity is agreed without clear deadlines, conditions or exit options.

Even more controversial are so-called break-up fees or cost reimbursement regulations. They are intended to cover the expenses of one party if the deal falls through. In practice, however, they often lead to the startup coming under considerable financial pressure, even if the termination would be objectively justified.

Such clauses are not legally impermissible per se, but are subject to strict requirements. In particular, they must not lead to a party being de facto forced to conclude a contract that is disadvantageous to them simply to avoid costs. In the early phase of a start-up, such provisions can threaten the existence of the company.

Typical dispute constellations from practice

Most disputes about LOIs and term sheets do not arise because of spectacular breaches of contract, but because of supposedly self-evident facts. Founders assume that “nothing has been firmly agreed”, while the other party already considers itself to be in a binding relationship.

Frequent areas of conflict include the handling of confidential information, the use of know-how gained during the negotiations or the question of whether certain advance services must be remunerated. Internal restructuring undertaken at the request of the potential investor also regularly plays a role.

It is particularly problematic that these disputes arise at a time when the start-up should actually be growing. Instead of product development and market expansion, the focus is then on lawyers’ letters, damage calculations and strategic blockades.

Why these issues are classic mandate cases – and not a peripheral problem

LOIs, term sheets and MoUs are not an exotic special topic, but part of everyday life in the start-up world. This is precisely why they are so often underestimated. They seem harmless, are short and often only a few pages long. It is precisely this supposed simplicity that is dangerous.

From a lawyer’s point of view, this is a classic early-stage advisory case. Small differences in wording determine whether a document is controlling, protective or dangerous. If you structure things properly at an early stage, you can prevent escalations later on.

For start-ups, this means that pre-contractual documents are not a formality, but a legally relevant step. They deserve the same attention as the actual contract – if not more. Because they set the framework for everything that follows.

Conclusion:

LOIs, term sheets and MoUs are not a legal vacuum. They can be binding, obligatory and relevant to liability, even if they are expressly described as non-binding. For start-ups, the danger lies less in the document itself than in false expectations.

Those who use these instruments consciously and in a structured manner can use them sensibly. Anyone who signs them in order to “get ahead” without considering the legal consequences is exposing their company to unnecessary risks.

The early phase in particular often determines whether a startup remains capable of acting or becomes entangled at an early stage. Proper pre-contractual drafting is not a luxury, but part of entrepreneurial diligence.

Author: Marian Härtel

Marian Härtel ist Rechtsanwalt und Fachanwalt für IT-Recht mit einer über 25-jährigen Erfahrung als Unternehmer und Berater in den Bereichen Games, E-Sport, Blockchain, SaaS und Künstliche Intelligenz. Seine Beratungsschwerpunkte umfassen neben dem IT-Recht insbesondere das Urheberrecht, Medienrecht sowie Wettbewerbsrecht. Er betreut schwerpunktmäßig Start-ups, Agenturen und Influencer, die er in strategischen Fragen, komplexen Vertragsangelegenheiten sowie bei Investitionsprojekten begleitet. Dabei zeichnet sich seine Beratung durch einen interdisziplinären Ansatz aus, der juristische Expertise und langjährige unternehmerische Erfahrung miteinander verbindet. Ziel seiner Tätigkeit ist stets, Mandanten praxisorientierte Lösungen anzubieten und rechtlich fundierte Unterstützung bei der Umsetzung innovativer Geschäftsmodelle zu gewährleisten.