Understanding An M&A Term Sheet

by Cooley LLP

Congratulations! You just received an offer to acquire your company.  A serious buyer will present you with a term sheet that covers the basic terms of the transaction.  Do not make the mistake of agreeing to a term sheet without consulting with your lawyer. You can almost always get better terms and circumvent many hours of difficult negotiation by spending a bit more time up front negotiating the term sheet.  But first you need to understand what you are reading and how the important points in any acquisition are reflected in the term sheet.  Here are key concepts that you want to understand before making a deal:

  1. Aggregate Value.   What is the aggregate purchase price?  Will debt, other liabilities or transaction fees be deducted?  What type of consideration will be used (stock or cash, financing)?  If stock is used, how will it be valued? Will it be registered/freely tradable?  If not, what Securities Act exemption is available for the issuance of buyer’s stock?
  1. Purchase Price Adjustments / Earnouts.  Will there be an adjustment to purchase price based on financial metrics, such as your working capital as of the closing? Is there an earnout by which the purchase price can increase based on the performance of the company following the closing?  If so, how is it defined?  What post-closing covenants will you need from the buyer in order to assure potential targets can be met?
  1. Map the Payout Mechanics. How will the purchase price be allocated?  Understand any liquidation preferences for preferred stockholders, warrant holders and other convertible debt or equity.  Will you have to use a portion of the proceeds to pay down bank debt or other liabilities? Ask your legal team or financial advisor to create a sample payout spreadsheet.  If the options held by key management team members are “under water,” what processes should you consider in order to motivate your management team to stay through the deal?
  1. Options and Other Equity Awards.  Will these be assumed by the buyer or cashed out?  Does the value get included in (or excluded from) the purchase price?  Consider the value of option strike prices – this should be a credit to the purchase price.  Do any of the awards accelerate by their terms?  If so, will buyer ask for waivers?  Are employees properly incentivized post closing?
  1. Escrow and Indemnity.  It is typical for buyers to ask for an “escrow” or “holdback” of a portion of the purchase price as security for potential breaches of covenants or inaccuracy of representations and warranties.  What is the size of the escrow?  Is this generally “market” for a deal of this size?  Will stockholders and optionholders both participate in the escrow?   Which the sellers’ overall obligations be capped at the escrow amount vs. the full purchase price?  Are any entirely uncapped?   How long do these obligations survive?
  1. Tax Matters.  Is this a taxable transaction?  If so, can it be structured to minimize tax impact?  Should your cumulative net operating losses (NOLs) be considered when determining value?
  1. Employee Issues.  Which employees will get offers for continuing employment?  Will non-competes be required?
  1. Parachute Payments.  Work with your accountants and legal counsel to determine if any 280G “parachute payments” arise in connection with the deal.
  1. Required Approvals and Consents.  What government approvals are required to complete your deal?  What third party contract consents are required?  Should any of these be conditions to closing?  Determine if any stockholders, lenders or other third parties have leverage they may try to use.
  1. Certainty to Close.   Be specific.  You want to know exactly what is required in order to close – e.g., employment agreements, non-competes, third party consents, antitrust approval, appraisal rights, lender payoffs, etc. Once you agree to a deal, you want to make sure it actually closes and that the prospective buyer does not have the ability to change its mind and walk away from the deal.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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