In recent weeks, there has been a lot of chatter about how M&As were shaping up to be one of the key strategic moves of 2024. Not everyone’s been through an M&A, and not everyone has dealt with Term Sheets in an M&A process.
What's at stake here, then?
Why do Companies Use Term Sheets in an M&A, and what is it good for?
A term sheet enables stakeholders to review and discuss crucial deal terms at an early stage of the transaction, which allows them to identify any major deal breakers or concerns before investing significant time and resources.
In addition, a term sheet provides a framework and assurance for the deal, giving both the buyer and target company a sense of security as they move forward with the transaction, knowing they have an agreed-upon document to refer back to throughout the process.
It’s important to note that a term sheet is a non-binding document, and does not represent a legally binding offer.
However, it usually prohibits the parties from disclosing any confidential information about the transaction, including the very existence of the term sheet, to any third party.
Here are some of the key terms that you may expect to see in an M&A term sheet.
Key Components of a Term Sheet
Purchase price
This section outlines the total amount that the buyer will pay for the acquisition, including any contingencies or earnouts.
Payment structure
This section details the payment terms, including the method of payment (cash, stock, etc.), the timing of payment, and any financing arrangements.
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Cash
The buyer pays the entire purchase price in cash at closing. This is the simplest and most straightforward payment structure.
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Stock
The buyer pays the purchase price in the form of stock in the acquiring company. This structure is often used in cases where the buyer is a publicly traded company and the seller is looking for a liquid form of compensation.
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Cash and stock
The buyer will pay a portion of the purchase price in cash, the remainder in stock. This structure is typically used to provide the seller with both liquidity and a stake in the future growth of the acquiring company. -
Earnout
The purchase price is contingent on the future performance of the target company. For example, the buyer may agree to pay an additional amount if the target company meets certain revenue or earnings targets.
Earnouts are commonly used to align the interests of both buyers and sellers and are meant to address uncertainties about the future performance of the target company.
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Deferred payment
The purchase price is paid over time, rather than one single payment at closing. This structure is used to spread the financial burden of the transaction over several years, which is interesting from the buyer’s perspective.
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Instalment sale
The purchase price is paid in instalments, with interest and/or a balloon payment at the end of the term. This structure can be used to provide the seller with an income stream over time while allowing buyers to conserve cash in the short term.
Escrow or Holdback
It is common for buyers to request a holdback or escrow provision in M&A deals. This provision enables the buyer to withhold a certain portion of the purchase price from the seller to secure against any misrepresentations, undisclosed liabilities, or breaches of warranties. In short, it prevents the seller from benefiting from well-hidden liabilities.
Typically, this amount ranges between eight to fifteen percent of the purchase price and is retained for one to two years.
Representations or Warranties
This section shines a light on the “promises” made by each party regarding the accuracy and completeness of the information provided during the negotiations.
Representations and warranties are statements made by the parties involved in a merger or acquisition (M&A) transaction that provide assurance to the other party about various aspects of the target company or its business.
They are common features of M&A transactions and are designed to provide a level of protection to the buyer in the event that the information provided by the seller is inaccurate or incomplete.
Here are some examples of common representations and warranties that may be included in an M&A transaction:
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Organizational information
The buyer is a validly organized and existing entity under its jurisdictional laws. -
Financial information
The buyer must present accurate and complete financial information.
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Contracts and agreements
All contracts and agreements of which the target company is a part must be reviewed by the seller.
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Intellectual property
The target company must own all of its intellectual property, or have a valid licence to use it. There must be no infringements or disputes regarding the ownership of said property.
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Litigation
The buyer must disclose any pending or threatened lawsuits, as well as claims against the target company that could have a material impact on its business.
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Environmental liabilities
The seller shows that the target company is in compliance with all environmental laws and regulations, and has not caused or contributed to any environmental damage.
It’s important to note that representations and warranties are not guarantees of the accuracy of the information provided. Rather, they are “promises” made by the seller that are intended to provide a level of comfort to the buyer regarding the information that has been provided.
If one or more representations or warranties are misleading, the buyer is usually able to reduce the purchase price or terminate the transaction based on the discrepancies.
It’s crucial to come clean from the seller’s perspective and to remain perceptive from the point of view of the buyer. Most of the leverage that can be applied during the negotiations is based on the difference between the warranties and the findings of due diligence.
Covenants
This section specifies which obligations and restrictions each party will be subjected to. Restrictive covenants come in many forms. It’s important to note that the timeframes these restrictions cover, as well as their extent, always vary from one country to the other.
It would be hard to make an exhaustive list of M&A covenants without crowding this article more than it already is. This list will therefore be limited to the most essential ones.
Restrictive covenants:
Non-compete
They are meant to protect the purchaser’s interest by not allowing the seller to compete with the buyer’s recently acquired company directly.
Non-solicitation clauses
They are meant to protect the buyer from poaching customers, clients, suppliers or even employees of the acquired business.
Conduct of Business
This covenant requires that the target company conducts its business in the ordinary course between the time the term sheet is signed and the closing of the transaction.
This covenant can also restrict the target company from taking any actions that could have a material adverse effect on the business.
Employment covenants:
Non-Disparagement Covenant
This covenant prohibits the target company and its employees from making negative statements about the buyer or the transaction.
Retention Covenant
This covenant requires the target company to offer employment to key employees for a certain period of time after the deal is completed.
Severance Covenant
This covenant requires the target company to provide certain severance benefits to key employees if their employment is terminated without cause after the deal is completed.
Closing conditions
This section outlines the conditions that must be met before the transaction can close: It mostly consists of regulatory approvals & shareholder votes.
Termination rights
This section outlines the conditions under which either party can terminate the agreement. There are many different ones that greatly vary depending on the jurisdiction.
Indemnification
This section outlines the liability and compensation arrangements in the event of a breach of representations and warranties or other obligations.
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