term sheet terms
post #0005
december 4, 2022
In our prior post, we outlined the various high-level, key milestone steps involved with getting acquired. This time we are going to focus on one of the most critical steps, the engagement ring, Step 01. Specifically, we are going to unpack the key terms included in perhaps the most fundamental deal document, the term sheet or letter of intent (“LOI”) (note that we will use these terms interchangeably throughout).
Many founder-CEOs may have never seen a term sheet for an acquisition. And, depending on the deal type, some acquisitions may not even include such a document. For example, most talent/ acquihires will simply have offer letters, while other fast-moving, larger deals might even go straight to papering up the definitive agreement. However, more often than not, for a majority of acquisitions, there is a term sheet involved. Outside of an NDA, it is usually the first deal document that is negotiated between the companies involved in the acquisition.
First, a very quick refresher, the term sheet is a non-binding document which outlines the key business, structural, economic and legal terms of an acquisition agreement with the buyer. Importantly, this will include the deal consideration (i.e., valuation of the company being acquired), amongst other terms, to which this post is devoted to uncovering. If you are a CEO, these are the terms that you will spend time negotiating with the buyer, typically with their corporate development (“Corp Dev” or “M&A”) leadership team. Next post, I will go into more of a “who’s who” when dealing with strategic acquirers, but for now, know that the M&A team will be a critical point of direct contact with any acquirer.
At the point that a buyer issues a term sheet or LOI, they will likely already have done much of their first-order, primary diligence, and you should have clarity around alignment with a combined vision & roadmap, and perhaps even agreed to some of the high-level terms, including a potential valuation of your company. The buyer will have also received their internal approvals necessary to proceed with the deal at a proposed maximum valuation threshold and also have a very good sense for what both starting and ending terms might look like. These buyers have precedents of their own and likely established internal guardrails that serve as their north star for key terms. Your job is to bend their reality closer to your expectations, and to never settle by simply splitting the difference!!!
As mentioned in our prior post, before signing a term sheet, any seller should be sure to ask the buyer how many times they have walked away from a deal after signing a term sheet? If the number is non-zero, you better understand why! This will give you a good understanding of how seriously they are considering the acquisition. As importantly, be sure to find out how often have they changed either their terms, and potentially their deal valuation after signing a term sheet. Some do, most don’t, and again, if this number is non-zero, you should be concerned, dive in and understand how you can get comfortable together moving forward with these increased levels of uncertainty. Trust is critical at this phase, but so is staying paranoid.
Your job as selling CEO is to make sure that the buyer does not sign term sheets simply to perform primary diligence or to learn more about your business, IP or other competitive/ sensitive information (a.k.a. ‘tire kicking’). If they do, or if they change terms or pricing often, then there is significant reputation risk for them and their M&A brand/ program as a serial acquirer. There is also significant risk and uncertainty now for you and your shareholders, so be sure to get clarity prior to signing.
NOTE: One more thing… before signing any term sheet, or sharing any sensitive documents or information prior, you should ensure that you have an appropriate NDA in place with the company. Obvious, but just making sure the proper housekeeping is in order.
Okay, enough of a pre-amble, let’s get to the terms. Again, if you are fortunate enough to have gotten to this point, congratulations! Now, let’s get to the contents and nuances around what terms are included.
Let’s go through the looking glass of term sheet terms…
Deal structure
This describes the legal structure of the deal. Some common examples are stock purchase, merger (two-step, reverse triangular), asset purchase, waiver & release, etc. This is mostly a legal thing, but the deal structure does have real implications, for example, from a tax perspective.
Deal consideration (i.e. the purchase price)
This refers to both the currency that the buyer is using to finance the transaction (cash, stock, mix, etc.) and the dollar $ amount being paid to the selling company in exchange for the business, equity, assets, IP, etc. You can think of this as the total amount of value being delivered to you and the shareholders in exchange for the company’s equity. This is the amount or headline number for your business. For private company transactions, this is commonly described in terms of total enterprise value, and for public companies as a value per share.
Net Working Capital (NWC)
Net-working capital (“NWC”) is typically calculated as the current assets minus current liabilities, as of the closing balance sheet of the selling company. Some acquirers will assume a zero $0 NWC at closing, thus allowing the selling company to pay out any positive NWC or excess cash prior to closing. Mechanically, the buyer will then simply reduce the purchase price consideration on a dollar-for-dollar basis for any negative NWC at closing. If you are expected to continue running your business as a going concern post-acquisition, then you will have a need for maintaining the working capital needs of your business. Any acquirer will understand this, so communicating early and getting informed on these accounting needs is a must in order to properly negotiate NWC.
Indemnity Holdback
+/or Escrow -(+/ Insurance now)
This is the % or $ amount that is being “held back” for a period of time to protect the buyer from any claims that may arise post-closing of the acquisition. Buyers may express this as either a $ amount or % in their terms, such as 10-20% of the deal consideration. This holdback can also vary in its time period until release, such as from 12-24 months post-closing. The selling shareholders of the company will all contribute to this on a pro-rata basis. Of note, buyers will always want this protection in their agreements, so it is also worth asking them if they have always paid the holdback/escrow out in its entirety following the completion of the holdback/escrow period? Some buyers will utilize an escrow (third-party) agent for funding and controlling distribution of the funds. And, more and more sellers now are simply asking buyers to utilize insurance as a mechanism for general indemnity protection.
Employee Retention
(Stock/RSU Grants & Re-vesting)
As part of the deal, buyers typically will allocate incentive stock/RSUs to the continuing employees from the selling company. If significant, and these usually are, such amounts allocated to any Named and/or Key employees (see next terms), along with an additional stock/retention pool for other continuing employees will be outlined in the term sheet. Such allocations could also include specific amounts to certain individuals, and at times may even include custom vesting schedules. Ask to be treated fairly and similarly to other deals. Additionally, it is worth getting clarity around what will happen to stock/RSUs allocated for continuing employees who do not continue on as part of the transaction. e.g. Can you share that pro-rata across continuing employees or allocate to specific individuals through working agreement with the buyer?
Named & Key Employees
Typically founding team members and other employees that are identified by the buyer or key management are highlighted and even named directly in the term sheet using their proper legal names. Acquirers may also include as a closing condition that both the named & key employees as well as some % or absolute # of continuing employees sign and be expected to join as part of the transaction. They want to ensure that the pilots are coming over with the airplane.
General Indemnity
These are the categories of items that are covered as part of the holdback/escrow, and are ultimately represented & documented by the selling company in the final deal documents and disclosure schedule.
Fundamental Claims
While there is not typically a separate escrow/holdback associated with more fundamental claims (i.e. these are the more serious, thus “fundamental”, items such as fraud, misrepresentation, IP, etc.), Buyers may anchor and start by asking for full protection at the total deal amount of the full purchase price or deal consideration, and for an extended period of time, usually multi-year. There is often considerable flexibility. This is usually a term that is one of the last to be resolved, when negotiating a term sheet. Similar to the general indemnity protection, the buyer will ask that all selling shareholders contribute to any potential fundamental claims on a pro-rata basis.
IP “punch-through”
While protection around IP is usually encompassed as part of the fundamental claims, however, on occasion, through negotiation, many deals will have what is referred to as a “punch through” that separates that fundamental claims specifically on IP to a different threshold amount, time period or both. For example, this might be expressed as a percentage, such as 50% of the purchase consideration, and for a specific period of time, such as 24-36 months. Again, like other things, it is worth asking the acquirer how many times they have made or experienced an IP claim, if ever, and how quickly that claim was made post-closing. This will give you, as seller, a better perspective on how to find an appropriate risk-adjusted term, or get them to agree to eliminate it entirely :)
Non-compete
Depending on jurisdiction, named employee shareholders may enter into a non-compete agreement as part of the transaction. These are usually multi-year agreements. However, that timing may start as soon as you commencing employment with the acquirer post-closing, so you should not fret much. The legality and enforcement of such non-competes also vary by jurisdiction. Buyers may or may not specify the actual language of the scope of the non-compete at the time of the term sheet, but incorporate that later in the deal process during the definitive document phase. Understanding that the scope of the language will be specifically, appropriately and narrowly focused on the actual nature of your work and the business that the buyer is acquiring is important to get clarity on.
No-shop / exclusivity
This is really the only actual binding term in the mostly non-binding document, and it has two critical components: 1) the time period that the acquirer wishes to have exclusive access to the selling company, typically 30-90 days, and 2) a requisite and detailed amount of disclosure from the selling company regarding any other offers that it may receive, including the identity of the other suitor(s) and the terms of their competing offer.
…
Phew…that was a lot to cover, and we feel it just scratches the surface since every deal is going to be different. And, importantly, so many of these terms are inter-related so they function as a unit, not in isolation.
Hopefully, this has been a good primer for those that are looking to understand the anatomy of a tech term sheet. Some others have gone as far as listing their term sheets in the public domain. These can provide another perspective on other technology acquirer’s key terms. Atlassian, the software company, for example, offers up their term sheet online as well. We tend to agree with their sentiment regarding term sheets being “outdated, inefficient, and combative.” This is a BIG reason why we continue share as much visibility and transparency as possible with CEOs, re: term sheets as well as the overall M&A process more broadly.
As alluded to earlier, next post, we will go into more of a “who’s who” when dealing with strategic acquirers. Our hope is that these posts continue to provide greater visibility into what is often an opaque part of the tech and business world, navigating mergers & acquisitions.
If you are thinking about pursuing an acquisition, are in the middle of one, and need a world-class advisor to help you navigate, you can always reach out me - gary@kokua.ventures