The Acquisition Term Sheet (#85)
/This podcast episode describes the contents of an acquisition term sheet and some of the clauses contained within it. Key points made are:
The Term Sheet
The term sheet lays out the initial terms of a possible deal between the buyer and seller of a company. It’s the first time that the two parties get together to put terms down on paper. In case you haven’t figured it out yet, that means this is the starting point of acquisition discussions.
Just because both parties sign a term sheet, that doesn’t even remotely mean that there’s a deal. It just means that the parties are interested in delving into the deal a little deeper – and eventually, if everything works out, there’ll be a purchase agreement. And the purchase agreement is a legal document that can hold up in court. In most cases, a term sheet is not a legal document, and it will not hold up in court.
Why Use a Term Sheet?
So if the term sheet is non-binding, then why even have it? You can skip it and go straight to the final purchase agreement, if you’d like. However, there are some good reasons for having it.
First, it prevents misunderstandings. It helps to have the general terms of the deal laid out in a document that’s probably just a couple of pages long. Because of the simple layout of the term sheet, it’s not likely that the parties will have a falling out later on about general conceptual issues.
Second, the term sheet creates somewhat of a moral commitment to complete the deal. Once the parties agree to the general terms that are in the term sheet, there’s a tendency to assume that the deal will be completed. And if there’s an in-house bureaucracy that does acquisition deals, they tend to push them through once the term sheet is signed.
This does not mean that a deal is therefore inevitable. Far from it. A quality acquisition team is going to be highly critical of any possible deal, and they’ll keep probing until the last minute to make damned sure that this is really a good deal for the buyer.
A third reason for a term sheet is that it can be used just to narrow the field of possible buyers.
If a company is being sold in an auction environment, then potential buyers have to submit a term sheet in order to keep from being barred from the going further in the process.
And a final reason for using a term sheet is when you do make it binding. This normally only involves a few clauses, like a built-in confidentiality agreement. But, it can go a lot further. It can include a no-shop clause, where the seller agrees to deal exclusively with the buyer for a certain number of months. The buyer wants this because it reduces the buyer’s risk that the seller will shop the purchase price listed in the term sheet to other possible buyers.
When Used as a Binding Commitment
The term sheet can also be a fully binding commitment for the buyer to complete the acquisition – but the buyer would normally be an idiot to agree to this, since the buyer usually hasn’t completed much due diligence yet, and so doesn’t know if there might be some really serious problems with the seller’s company.
Term Sheet Contents
So, what’s in a term sheet? They vary a bit, but most have a group of common clauses.
You’ll probably see a paragraph stating the general structure of the transaction, such as the buyer only acquires the assets of the seller, or maybe wants to do a tax-free reorganization.
Then, of course, we have payment terms. It should state the amount to be paid, and the form of payment, such as cash, debt, or stock. It may also note the terms of an earnout, which is an extra payment based on how the company does after the buyer acquires it. The term sheet very likely also contains a statement that the purchase price is subject to adjustment, based on what the buyer finds during the due diligence process.
Also, if a public company buys the selling entity with its own stock, it may do so with unregistered stock, which means that the sellers can’t initially sell their shares. This could be quite a surprise to the sellers, so it’s best to make a statement about registration rights, which obligates the buyer to register the shares that it plans to use for payment.
The seller’s management may also have some compensation concerns, which can be addressed in the term sheet.
For example, the owner may refuse to sell unless his key staff are protected, so the term sheet could state that all designated key staff will be retained for a minimum period of time.
Along the same lines, the sheet can point out that the buyer will honor all outstanding stock options and warrants, though a lot of them may exercise automatically if there’s a change in control.
While all of this may sound quite positive, there’s also a piece that deals with the downside. This paragraph points out that the whole deal is dependent upon a variety of things, like audited financial statements, approval of the deal by regulatory agencies, approval by the shareholders or the boards of directors, getting outside opinions about the deal being tax-free, and so forth. In particular, the buyer can put in a clause stating that the whole deal is contingent upon it lining up the funding to pay the seller. They should just call this the “Comprehensive Walk Away from the Negotiating Table” clause!
And finally, there’s an acceptance period, which gives both parties a short period of time in which to agree to the term sheet, after which it’s automatically void.
There are a lot of additional clauses you can add to a term sheet, but most of them just add unnecessary verbiage. However, there are two additional ones worth considering. First, you may want to include an Announcements paragraph. This states that each party agrees not to make any disclosures about the prospective deal without the agreement of the other party. This can be good for both, since privacy is important. You don’t want competitors interfering, which can happen if the deal appears in the newspaper before it’s really closed.
The other optional clause, which I mentioned earlier, is the no-shop clause. It’s amazingly common for a seller to take the buyer’s offer and shop it around to everyone in sight to try and bring in a higher offer. This really undercuts the buyer, so a lot of them won’t proceed further with a deal unless there’s a no-shop provision in the term sheet.
So, in short, the term sheet is not a mandatory part of an acquisition, but it’s a useful tool, and I recommend using it.