By Jay Jung
When it comes to any big business deal, the aptly named “headline valuation” is what typically makes the headlines. But there is far more to the term sheet than the price tag. Non-valuation-related terms are just as important as the headline valuation; therefore, it is imperative to fully understand each of these before moving into the more serious due diligence and legal documentation phase.
What is a term sheet?
The term sheet is where the counterparties — whether they are buyers and sellers or investors and recipients of funds — lay out the most important terms of the transaction in layman’s terms. The term sheet allows both parties to ascertain whether they are in the same ballpark and if it makes sense to continue to devote time and resources to the transaction.
Term Sheets vs. Letters of Intent
Both term sheets and letters of intent outline a future agreement between two (or more) parties, but a letter of intent is written in the form of a letter. A term sheet, on the other hand, is typically a list of the major points of the agreement to be negotiated and is usually less formal.
Term sheets come in many forms. Often, they are composed as bullet point emails or word documents that simply lay out the terms succinctly, usually in layman’s terms — i.e., no legalese or corporate jargon. This is because term sheets are precursors to a more detailed Indication of Interest (IOI), letter of intent (LOI), or memorandum of understanding (MOU).
The LOI is the most detailed and its goal is to detail all of the key terms. The LOI will then serve as a blueprint for the definitive agreements to be written by experienced corporate attorneys.
What’s in a term sheet?
Term sheets typically include/elucidate the following elements:
- Headline valuation and investment dollars: the total value of the company and the specific dollar amount to be deployed.
- Terms of the security: not all equity or debt are the same; this may include any preferences, redemption rights, accrued/paid dividends, etc.
- Indemnity escrow or holdback: more relevant for M&A deals, the buyer may seek to hold back a portion of the purchase price to mitigate risk.
- Earn-out structure and terms: also more typical in M&A deals, an earn-out allows the seller to further capture the upside where they may be a gap in valuation expectations.
- Other fees: early repayment or management fees, etc.
- Warrants: additional equity value the equity or debt investor will receive when a transaction occurs.
- Equity roll over: more relevant for change of control transactions where large shareholders will have the opportunity to roll over their existing equity and participate as shareholders in the post-acquisition business.
- Post-transaction expectations for the seller: what roles and compensation can the majority shareholders or management team expect.
- Minority/Board rights: equity or debt investors may seek certain rights even if they do not control the company. These include board participation, access to information, etc.
- Due diligence period and requirements: well-defined term sheets will lay out what further diligence is required and how long it will take.
- Exclusivity terms and extension mechanics: as final diligence and legal document drafting requires considerable resources and expenses, counterparties will seek to be the exclusive counterparty at later stages of the transaction.
- Deal expenses: in certain situations term sheets will stipulate who will bear certain transaction expenses including break-up fees, legal fees, audit fees, etc.
- Many other bespoke components, depending on the security and/or transaction type.
1. Is a term sheet legally binding?
No. Most term sheets are not legally binding. Either party can simply walk away for any reason, and there are typically no penalties for doing so. In the case of LOIs, however, certain areas may be legally binding — e.g., exclusivity clause, confidentiality, and fees/expenses related clauses.
2. Who is involved in term sheet negotiation?
Who is involved in negotiating the term sheet for any major deal depends on the stage of the company and the type of transaction? In general:
- For startup capital raises, it is often the CEO or founder that leads the term sheet negotiations with the support of the Board and/or major investors.
- For M&A deals, an advisor may be involved as the front person with input from other major stakeholders.
- Large company capital raises (debt and equity) and M&A deals always involve and/or are led by an advisor.
Overall, it is better to have an experienced advisor support the negotiations. Despite many books and MBA classes on the subject, negotiation is a hard-earned skill mainly learned from many trials and tribulations. An advisor with a lot of deal experience should coach the principal or, better yet, directly negotiate at the forefront. That advisor can come in the form of a finance expert or a legal expert.
Aside from leveraging the skills and experience of the expert advisor, leveraging an advisor has several other benefits. For one, it keeps the principal one step removed, providing additional flexibility and more room to negotiate. Second, it removes emotions from the equation; a third party can keep his/her cool throughout the entire, often emotional, and (sometimes) personal process.
3. What are the steps in the negotiation process?
The main stages in the overall process are generally the same:
- An initial ask.
- The drafting of a term sheet.
- The review of the term sheet.
- The counter-offer.
- A resolution of differences.
That being said, the first rule of negotiation is to get the other party to take the first position. The best way to make this happen is to create competitive tension.
Ideally, an advisor or other dealmaker should bring in multiple term sheets. After this has been accomplished, a bid matrix is created in order to compare term sheets across the key terms. This matrix will identify where terms converge and where they diverge. Stakeholders should then use the matrix to identify the terms that are most important to them and their company. For example, one party may have an attractive headline valuation but more austere escrow terms or less-favorable security terms.
A caveat: it is almost always unproductive to lob back and forth red-lined term sheets. The proficient way to negotiate a term sheet is to align verbally and then confirm in writing. Thankfully, Zoom has made it easier to do this “face to face,” with the following being the major steps involved:
- Step 1: Hear the other side out. Rather than making assumptions, let them walk you through their term sheet. Ask about areas of ambiguity. If they missed an area of importance to you, ask them to provide color on those aspects. For example, if the valuation is lower than expected, ask them what are the main factors driving valuation. This could provide fodder for future negotiations or an earn-out structure.
- Step 2: Listen and digest. Resist the urge to respond on the spot or off the cuff. Let the other side know that you will further digest what’s been discussed and deliver a comprehensive response. Sometimes, there could be a deal-breaker term such as warrants or post-transaction roles, etc. Rather than calling out the most important issue, reverting with a comprehensive response provides the counterparty additional flexibility to find a compromise. It also does not expose your most critical points, which would result in lost leverage.
- Step 3: Revert with a comprehensive response. Posturing and bluffing is typically not an effective negotiation approach, though both are common. Go through your list of requests, looking for the other side to reciprocate, and listen through the whole thing first. Then, ask for feedback on possible sticking points and form a consensus on what is achievable.
Ideally, after these steps are complete, you should send back a final redline which both parties can agree and sign. This seldom occurs after just one back and forth, but keeping written back and forths to a minimum allows for a faster and smoother path to agreement. Keep in mind that people have a tendency to stand firm on things they write down whereas verbal discussions tend to show more flexibility.
4. How long should a term sheet be?
The best term sheets are concise and to the point. Some may add a cover letter pitching the rationale for the deal, such as why their firm is ideal or how it is differentiated from other buyers or sellers. Everyone is chasing the same commodity, capital, but companies all want to be seen as uniquely valuable.
5. Why is negotiation necessary for a term sheet?
The term sheet is arguably the most important piece of paper in the deal process. A well-negotiated term sheet virtually ensures smooth sailing from laying out the initial contours of the deal to closing. It is therefore worth spending the time and effort to negotiate the important terms in advance.
Anything with economic value should have alignment between the buyer and seller at the term sheet stage. It is extremely difficult for the company or the seller to improve terms after the term sheet stage, and for good reason — nothing material should be left ambiguous. Do not assume that things will work out because your counterparties are “nice guys.” Ask the hard questions and get the answers you need upfront before the details are ironed out.
6. What terms can be negotiated?
Everything is negotiable, but what you negotiate will depend on how skillful you are and how strong of a hand you have. Before submitting a term sheet or LOI, understand the industry norms so you don’t ask for something that is completely out of place.
Finally, the tone and manner of the ask are often just as important as the substance of the ask. Terms that may be negotiated include:
- Percentage shares.
- Liquidation preferences.
- Responsibility for legal fees.
- The venue for any disputes to be litigated.
- Walk-away fees.
- Future management roles and titles.
7. How long does the negotiation process take?
Remember the saying: “time kills all deals.”
Move swiftly, but make sure you take the time to digest and get the input and/or advice needed. During the negotiation stage, executives, board members, and advisors will need to give it all they’ve got, which includes their evenings and weekends.
8. What’s at risk during term sheet negotiation?
M&A is a high-stakes game. Potential losses of a poorly-negotiated term sheet include undervaluation, mismatched partnerships, a loss of investor interest in the resultant enterprise, litigation, and ruined reputations. The biggest risk lies in moving past the term sheet stage with a misaligned understanding of the deal.
Another major risk is leaving things on the table that you will regret later. The term sheet is an opportunity to gain clarity on the important deal terms in layman’s language before going into legal drafting. Thus, it is critical to gain absolute clarity on any important terms, especially those related to the economics between the buyer and seller. Sometimes, it is uncomfortable to ask the prodding question, but that’s the nature of the beast. I’ve often seen people say “we’ll figure it out later” and “I’m sure it will be fine” at this stage, but this is never a good approach in retrospect.
If there are ambiguities, do not “assume” that the buyer is looking at the issue the same way you are. Usually, it is the opposite. We all tend to assume what is better for us, and negotiations are often a zero-sum game. That makes it difficult to reach a consensus, but failing to get alignment on the issues at this important juncture will “bite you in the behind” at a later stage of the process.
Remember that term sheet negotiation is the stage of maximum leverage for the business owner/seller. After it is signed, the pendulum swings to the buyer/investor.
9. How can advisors secure a successful negotiation?
Whether a capital raise or an M&A deal, the reality is that founders, entrepreneurs, and CEOs do not negotiate deals on a regular basis. At best, they may have done it a few times in their entire career. A seasoned advisor will bring a wealth of experience and provide absolutely essential expertise at the negotiating table.
As noted above, there is much more to the negotiation process than headline valuations and media headlines. Retaining an advisor who understands the intricacies and interplay among all of the terms and elements is not only helpful, but invaluable.
Moreover, advisors are one step removed and can therefore be objective, which is vital to success during what can be an emotionally charged and sometimes grueling process. Simply put, negotiations are marathons that often occur at a sprint’s pace.
To learn more about term sheet negotiation or any other aspect of M&A, or to learn more about how we can add value to your business combination, please visit the Embarc blog or contact one of our advisors at https://embarcadivsors.wpengine.com.