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As you plan the sale of your company, the term sheet (or letter of intent) is your best chance to negotiate the most favorable financial and other important terms for your M&A transaction.
Don’t Sleep on the Term Sheet When Selling Your Company
You obviously want to strike the best M&A deal possible for you and your stakeholders. So be smart during this critical first step and never agree to a term sheet without understanding what it entails and what comes next.
“We are successful deal makers. How hard can this be? This term sheet is only 8 pages long.”
Occasionally founders and executives try to negotiate and sign a term sheet for the sale of their company without first consulting with experienced professionals. We do not recommend this practice, given that the sale of your company may be the most important business deal of your career.
Sellers in private M&A deals rarely see improved terms once the term sheet is signed. As buyers do more detailed business and legal due diligence, they may find reasons to negotiate better terms for themselves, such as a lower purchase price or a larger escrow holdback.
Given this potential downward pressure on deal terms, it is in your best interests to invest appropriate time and resources and engage the proper professionals when negotiating the term sheet for the sale of your company.
Term Sheet as Part of the M&A Process
The term sheet usually comes after weeks, months or even years of interactions between the buyer and the seller. Before the term sheet stage of the deal, the buyer and seller typically will sign a Non-Disclosure Agreement. The buyer then will conduct high-level business and financial due diligence on the seller as a first pass in order to determine whether to pursue an acquisition.
Many companies engage in this extended term sheet dance, which can be nerve-racking for the seller and which ultimately may go nowhere.
The buyer usually prepares the first draft of the term sheet, as the buyer typically has more power and influence in the negotiation process. While most of the provisions of the term sheet will be non-binding (more on this below), its contents are critically important.
Receiving a term sheet from a buyer is a strong indicator of its interest in the acquisition, as the buyer now will invest more time and money in pursuing it. The term sheet also can show how the next steps of the M&A process (i.e., negotiating the definitive documents, legal due diligence, timing, etc.) likely will unfold.
Key Terms of the M&A Term Sheet
Almost all term sheets start with and include information about the purchase price. The purchase price is a fundamental term for sellers, and buyers know this.
The purchase price is often expressed as a headline number or valuation. However, this number is usually more complicated than it seems because there are other deal terms that will impact the final amount received by the seller.
Additional terms include escrow or holdback amounts, earnouts, absence of debt, working capital and transaction expenses, and other deal factors. As a result, the term sheet should include more detail about the purchase price and how and when the seller will be paid. The term sheet should specify who is responsible for the seller’s transaction expenses (e.g., banker, attorney and accounting fees, etc.) and how much working capital the seller is required to have at closing. The term sheet also should include certain basic information about how the sales price has been determined. For example, it is not unusual for the valuation of the seller to be tied to some financial metric such as a stated multiple of revenues or EBITDA (e.g., assuming your revenues are $X, we are prepared to pay $Y as some multiple of $X).
Lock-Ups Limit Your Sale Alternatives
In some cases, the first draft of a term sheet might not include much more about the deal than the purchase price (other than some flowery language about how the buyer is a great “fit” for the seller), with one important exception – the “lock-up” or exclusivity provision. This provision essentially provides that, for a specified amount of time (which should be negotiated), the seller will not use the buyer as a “stalking horse” or “shop the deal” by talking to other potential buyers.
The lock-up provision usually goes further and requires that the seller not respond to in-bound requests or offers during the lockup period (even if unsolicited). This term of the term sheet usually is binding on the seller and the buyer often will require a lock-up before it spends significant money trying to advance and close the deal. Having said this, the lock-up is critically important and thoughtful sellers should negotiate the lock-up and only agree to go “pencils down” with other potential acquirers once they have a “fully baked” term sheet with a credible purchaser.
Comprehensive Term Sheets Limit Surprises
The term sheet is intended to be the roadmap for the sale of your company and it should be comprehensive if possible. Even though the term sheet mostly is not binding, its terms typically hold up in the final acquisition agreements (unless there are due diligence surprises). Key considerations for the term sheet include:
- On price, what is the amount, timing and form of consideration (e.g., cash, equity or a promissory note from the buyer)?
- If and how much of the purchase price will be retained by the buyer (or placed in a third-party escrow account, which is better for the seller), and how long will it last?
- Does the deal include a working capital target at closing, and what is the related price adjustment if the target is not met? What is the working capital target based on (e.g., 6-12 months trailing working capital versus another metric)?
- What rights does the buyer have to “claw-back” the purchase price for indemnification claims? What are the seller’s indemnification obligations to the buyer? Will the seller be required to purchase “reps and warranties” insurance?
- Does the deal include earn-out or milestone payments? These future payments introduce important issues as earn-out and milestone payments are often ripe for disputes after the closing.
- Is the seller receiving equity securities of the buyer as part of the transaction (which also introduces other important deal issues)? Aside from valuation, what rights, preferences and restrictions apply to the equity consideration received?
- What closing conditions apply to the transaction? Is the deal contingent on the buyer obtaining financing?
- Will the seller(s) be subject to non-compete restrictions after the closing? If so, for how long and for what industry(ies)?
- What will happen to the seller’s employees post-closing and will they receive incentive compensation to work with the buyer after the closing?
In our experience, sellers often do not realize how many elements are involved in an M&A deal, or how much negotiating power they have before signing a term sheet. It is important to realize that this negotiation leverage typically shifts to the buyer once a term sheet has been executed, for various reasons including the existence of a binding exclusivity or lock-up provision.
As described above, sellers should push for a more detailed and comprehensive term sheet, in order to fully understand the buyer’s offer and to address any critical issues before agreeing to any binding exclusivity or lock-up provision. Achieving this goal obviously requires negotiation leverage, which can be difficult to harness, especially when dealing with a large and experienced buyer. Sellers that can create a sense of competition at the term sheet stage are best positioned to “move the needle” with buyers that might otherwise believe that they are the only game in town.
While each M&A transaction is unique, the term sheet is the critical first step in the sale process. If you are considering the sale of your company (or the purchase of another company), then contact us early in the process so that we can help you prepare for and optimize what can be a life-changing, M&A transaction.
