Bleeding Edge

The M&A process involves multiple steps. Each deal is different, and each process has its own twists and turns, but generally, deals follow a certain order and cadence we’ll refer to here as M&A dating, M&A engagement, and M&A marriage…

Perhaps it was love at first sight and you received one terrific offer, or maybe you’ve been playing the field and received multiple offers. Either way, you’ve been through the M&A dating process (i.e. developing your acquisition strategy, identifying potential buyers, signing NDAs, negotiating valuation, and vetting indications of interest), but you’re still not ready to get married.

The term sheet is the tool used to align the parties on the basic deal terms and streamlines the dating process, so your next stop in M&A engagement is the presentation of a term sheet.

This is the stage where you and the buyer make sure you agree on the key terms of the proposed marriage. The term sheet is the tool used to align the parties on the basic deal terms and streamlines the drafting process by providing a clear roadmap for the lawyers to follow. It makes the deal process more efficient, reduces risk, and can save both parties a great deal of time, aggravation, and money.

There are differing views on how comprehensive a term sheet should be, and different deals require different degrees of details. But once a term sheet is signed, it is difficult (but not impossible) to materially alter the terms. If you haven’t yet, this is the time to consult with your legal advisors—make sure you understand exactly what you are signing up for.

Although every deal and every term sheet is different, here is a summary of the most commonly negotiated terms:

Deal Consideration: Valuation is the name of the game, but there’s much more to it than just a stated purchase price; there are additional components and adjustments to purchase price that factor into how much shareholders actually put in their pockets when all is said and done. It’s critical you understand this: just because you have a cash offer for $500 million doesn’t mean (and in fact it is unlikely that) the shareholders will receive $500 million in cash. Typical items that affect the ultimate pay out include adjustments for debt and other variables, working capital calculations, transaction expenses, escrows, and holdbacks and earn-out provisions. These adjustment variables and mechanisms should be clearly laid out in the term sheet to avoid disagreements between the parties as to the business agreement when drafting the relevant documents.

Transaction Structure. At a high level, an M&A deal can be structured as (a) a stock purchase, (b) a merger, or (c) an asset purchase. Not all deal structures are created equal, and the deal structure that is right for you will depend on several factors, including your corporate structure, your cap table configuration, the economics of the transaction and your post-transaction goals, and of course, tax considerations. Each structure has its own nuances, tax ramifications, benefits, and risks.

Treatment of Stock Options and Equity Awards: You can approach stock options and equity awards in a number of ways. Depending on the underlying equity award documents, options and equity awards can be cancelled, accelerated, cashed out, or substituted with new equity awards issued by the buyer. Your capital structure, vesting provisions, employee retention goals, and tax considerations are all factors that may determine how to treat stock options and equity awards. In addition, warrants can involve complicated mechanisms that determine what happens to the warrant in an acquisition scenario and complex calculations that determine their cash value. Your lawyer can help guide you through the relevant considerations and explain the nuances of how these instruments should be treated in the context of an acquisition.

Employee Retention: A buyer typically wants to acquire a business that will continue to run smoothly post-deal. This may mean that the buyer will want to retain some or all of your employees. The buyer may condition the deal or part of the deal consideration on retaining select key employees. The term sheet should articulate how the parties intend to treat the employees at closing.
Tax. Tax treatment often drives the structure of the transaction and affects the deal consideration. Your lawyer can help you understand the relevant tax consequences of the deal based on your corporate structure and business model. Be sure to understand the tax implications of the deal before you sign the term sheet.

Indemnity Escrow and Holdback Consideration: Most buyers will insist that a portion of the purchase price be held back from payment at closing to serve as security for things such as shareholder indemnity obligations under the M&A agreement or for a future obligation such as continued employment of the founders or key employees through a defined period. The buyer will pay out that held-back amount at a future date only if certain conditions are met. The amounts held back, whether such amounts are placed in a third party escrow account or held by the buyer, whether consideration is held back from all of the shareholders or just certain shareholders, and the timing and conditions of payment are all negotiated points and should be part of the term sheet.
Closing conditions. Closing conditions are requirements that each party must fulfill before the other is obligated to close the deal. While there are some standard closing conditions, they can be customized depending on the specific issues a buyer or seller may face. These conditions influence the timing and likelihood of closing. Your lawyer can help you identify the kind of closing conditions typical for companies like yours and manage the risk of unduly and burdensome requirements.

Exclusivity: Exclusivity gives the buyer the sole right to engage you in discussions related to the sale of your company and prohibits you from talking to other potential buyers to in the hopes of obtaining competitive offers. This provision and a confidentiality provision requiring that the term sheet and related discussion be kept confidential are typically the only binding provisions contained in the term sheet. Violating this provision would be a breach of your obligations under the term sheet and may subject you to legal claims. Therefore, you will want the duration of the exclusivity to be short. The length of the exclusivity and the specifics about who you can talk to and what you can and cannot do during the exclusivity period is something that should be carefully considered and drafted in the term sheet.

Equity Hotel: Once parties to an M&A deal have a “handshake” on valuation and basic structure, there is often pressure to minimize time spent on a term sheet and rush to the altar (i.e. the definitive M&A agreement). But skipping or rushing through the term sheet stage may result in a protracted and expensive drafting process and substantive disagreements late in the negotiation process that may even lead to a break up. In almost all circumstances, you will be better off with a detailed and well-planned term sheet to guide and focus the negotiations on definitive agreements.

Yours,
Dr Churchill

PS:

All things remaining equal the M&A possibilities today abound…