The term sheet clarifies the initial terms of a possible deal between the buyer and seller. It is the first documentary evidence of a possible acquisition, and establishes the foundation for continued discussions between the buyer and seller that eventually results in a purchase agreement. The buyer controls this document, but accepts input from the seller as the two parties work together through several iterations to arrive at a mutually agreeable set of terms.
A term sheet is non-binding, so why issue one at all? There are several excellent reasons for doing so. First, it prevents misunderstandings. The buyer and seller are about to embark on a number of review iterations of a purchase agreement and a significant amount of due diligence effort. Given the amount of labor and related expense that the parties will incur, it makes a great deal of sense to mutually agree on the general outlines of the deal, and to put those terms on paper. This greatly reduces the odds that the parties will later have a falling out about general conceptual issues that would have otherwise appeared in the term sheet. This is especially important for an inexperienced buyer or seller (usually the seller), who is not familiar with the acquisition process.
Second, the term sheet creates a moral commitment for good faith efforts by both parties to complete the deal. Once the parties have agreed to the general structure of the deal, there is a tendency to assume that the deal will be completed, and that a party would be remiss if it did not take all reasonable steps to follow through on its “commitment.” For larger companies, where the various steps of the transaction are usually handled by a team of experts, a term sheet typically sets the acquisition bureaucracy in motion, which builds momentum to get the deal done, barring considerable effort by a top executive to stop it.
Third, if the seller is conducting an auction, the term sheet is used as an intermediate step to narrow the list of potential suitors. After potential buyers have had time to review a standard packet of information describing the seller’s company, the seller requests a term sheet from suitors by a specific date; anyone not submitting a term sheet is barred from further consideration in the auction process.
Fourth, some elements of the term sheet can be binding on the parties. It can define obligations for confidentiality regarding the information exchanged between the parties, though this is normally handled separately in a non-disclosure agreement. It can also specify that each party will bear its own expenses associated with the acquisition, or that each party will pay for a specific proportion of costs. The most common binding provision is a no-shop clause, where the seller agrees to deal exclusively with the buyer through a relatively brief negotiation period that typically lasts a few months. This reduces the buyer’s risk that the seller will shop the purchase price specified in the term sheet to other potential suitors.
Finally, the term sheet can even be structured as a fully binding document. Under this approach, the term sheet tightens the range of excuses that either party can use to avoid consummating the purchase agreement. This format is not fair to the buyer, who has not yet completed a due diligence review of the seller, and so has no idea of what undisclosed problems the seller may have. Consequently, a seller who insists on a binding term sheet may find that the pool of potential buyers has narrowed considerably.
In summary, the term sheet is primarily useful as an initial summarization of the terms of a deal. If the parties cannot agree on the contents of a term sheet, then there is no point in proceeding with any due diligence work or legal activity regarding the purchase agreement. By agreeing to a term sheet, there is a heightened probability that the parties will work together to complete the deal.
A term sheet outlines the general structure of a proposed deal. As such, it should mimic the more important elements of a purchase agreement, while avoiding an excessive level of detail. The letter usually begins by identifying the two parties, and then proceeds to the legal structure of the transaction.
The term sheet then reveals the expected amount and type of payment that the buyer intends to give to the seller’s stockholders, usually with a caveat that this payment is subject to adjustments, based upon what the buyer finds during the due diligence process. This is where the buyer will state if there is any restriction on sale of the stock being used as payment. The term sheet can also stipulate any adjustments, such as for reductions based on an excessive amount of outstanding payables or debt. Further, the term sheet can stipulate an “earn out” payment, where selling stockholders receive an additional payment based on the subsequent performance of the selling company. It can also describe a “true up” provision, where selling stockholders can receive additional shares if the buying company’s stock price subsequently drops.
There may be some confusion regarding the bearing of acquisition-related expenses between the buyer and seller. In particular, an inexperienced seller may attempt to foist its acquisition-related expenses onto the prospective buyer. A brief statement should clarify that each party is responsible for its own expenses.
If a publicly-held company purchases the selling entity with its stock, it usually does so with unregistered stock, which the selling stockholders cannot initially sell. The selling stockholders may insist on registration rights, which obligates the buyer to register their shares for sale. Since registration is a cumbersome and expensive process, buyers prefer to avoid this clause, on the grounds that selling stockholders can sell their shares under SEC Rules 144 and 144(k) within six and 12 months, respectively.
Of significant concern to the seller is how its employees are to be treated subsequent to the acquisition. This can be as simple as a statement that they will be retained, or can be expanded to discuss their compensation.
Many stock option plans automatically accelerate vesting in the event of a change in control. If not, the term sheet can specify how outstanding seller options and warrants are to be treated. A significant issue is to clarify how the exercise prices of options and warrants will change to match the price at which the seller is being sold. Alternatively, the term sheet can specify that all options and warrants will be exercised prior to the purchase agreement.
The term sheet should describe those conditions that must take place before the parties will agree to the purchase agreement. These “conditions precedent” reveal the general boundaries within which the parties are most likely to come to an agreement. The seller tries to reduce the number of conditions precedent, thereby giving the buyer fewer excuses to back out of the deal. However, this only matters if the clause is binding.
In addition to the conditions precedent, the buyer also wants to warn the seller that it will require additional representations and warrants as part of the purchase agreement. These are too numerous to mention in a term sheet, so a brief clause merely points out their existence. The clause states that representations and warranties apply to both parties (which is true), but the real liability rests upon the seller.
A key part of the term sheet is a statement that it does not bind either party to a purchase agreement. This is of particular importance to the buyer, since subsequent due diligence may reveal a significant flaw in the seller that will cause the buyer to stop any further negotiations. However, there may still be some sections of the term sheet that are intended to be binding, such as the no-shop or expenses sections.
The term sheet may also include an acceptance period, during which the selling entity must indicate its acceptance. By including this clause, the buyer is limiting the duration of its offer. This keeps the seller from insisting on retaining the general terms outlined in the term sheet during some later time period, when its financial circumstances may have changed significantly.
In addition, the term sheet may include a confidentiality agreement. However, this is generally handled in a larger, separate document that more thoroughly addresses every detail of what information the parties will not disclose, and how due diligence information is to be dispositioned following any termination of discussions.
The term sheet is an extremely useful document, usually just a few pages long, that outlines the basic points of a possible purchase agreement. It defines the boundaries within which the buyer and seller will subsequently negotiate, thereby controlling the expectations of both parties. As such, it is an inexpensive and easily produced document that initiates the acquisition transaction. A buyer with acquisitions experience will likely have developed a boilerplate term sheet document that it can easily modify to match the requirements of a specific seller.