What to look for when developing an M&A Term Sheet
17 July 2018
Having provided Corporate Finance services for more than 15 years in both Sydney and London, I have often fielded questions regarding setting up Term Sheets (known as Heads of Agreement, Memorandum of Understanding). I wrote the below to address the importance of Term Sheets as a step towards a successful M&A deal.
In many situations, the Term Sheet is often a delicate balancing act for the Buyer and Seller, enabling both parties to agree broad terms and ensure a degree of consensus on the deal early in the process. Negotiation of the Term Sheet flushes out areas of sensitivity for either side in the understanding of a deal that until now, may be primarily based on high-level discussions between senior executives.
While it is important to document an early understanding between the parties, it is also vital that the transaction is not delayed by negotiations of the Term Sheet or worse, that negotiation of the Term Sheet results in an irreparable deterioration in the relationship between the parties.
Fundamental difficulties agreeing a Term Sheet are a good indication of how difficult the transaction is going to be to complete. Negotiating issues on the Term Sheet are often amplified when it comes time to negotiate formal sale documentation.
Term Sheets vary regarding content and level of detail, below are the initial areas I typically look to if asked to help formulate or review a Term Sheet:
- Proposed transaction structure: Will the Buyer purchase shares (100% or otherwise) or the assets of the target business? Will 100% of the Purchase Price be paid at Completion or will a portion be deferred? Which target entities will or will not be acquired and what is the high level expected treatment of any non-core businesses that will not be acquired by the Buyer?
- Formulation of the Purchase Price: Quite often, the Buyer has formulated its offer price based on limited information available from the Seller, which may include the information memorandum or other briefing information. At the time of agreeing the Term Sheet, the Buyer will not have performed due diligence. Consequently, it is important that the Purchase Price is expressed in a way that allows flexibility subject to due diligence and the Buyer forming a view on the maintainable or forecast financial performance of the target business. Common examples of this are multiples of EBITDA or EBIT. The Purchase Price formulation should also identify a specific time period for the earnings metric if that is relevant to the offer. Examples of this include average historical earnings, audited earnings for the last financial year-end, earnings for the trailing twelve months, and forecast earnings for the current financial year.
- Composition of Purchase Price: If the Buyer intends on paying the Purchase Price entirely or partly in scrip, as opposed to cash, it is important that this is clearly set out in the Term Sheet.
- Proposed Purchase Price adjustments: Offers for the purchase of (100% of) shares are typically expressed on a ‘cash free, debt free’ basis, assuming a ‘normal level of working capital’ (i.e. the level of working capital required in the business in order to generate the level of maintainable earnings on which the offer is based).
Working capital adjustments are contentious and so the Term Sheet must provide a high level framework for this adjustment that is acceptable to all parties.
- In my view, the Buyer should not commit to a ‘normal’ level of working capital for the target business before completing its due diligence. Pre-Completion tax liabilities of the target are also worth flagging in the Term Sheet as being a liability of the Seller.
- Earn-out arrangements: Earn-out arrangement can take almost any form dreamt up between the parties. It is important that the Term Sheet clearly documents the intention of the parties regarding calculation and timing of earn-out payments.
- Expectations regarding Target Management / Key Persons: What is the intention for the key persons in the businesses, including potentially the Seller(s) in owner-managed private businesses?
- Exclusivity: On the buy-side, I normally seek an exclusivity period of a minimum of 60 to 90 days. Sellers often drive for a shorter exclusivity period however, a thorough due diligence process and arranging funding takes time.
- Key conditions precedent: Other than receiving respective board approvals and undertaking due diligence, key conditions to address in the Term Sheet include the transfer of intellectual property, approval of change of control in relation to any critical customer or supplier contracts, and there being no material adverse change in the target business prior to completion of the transaction.
While the above is not a checklist of all items to include in a Term Sheet, in my experience, it is important that the Term Sheet addresses these areas.