A common question I hear from many clients in a merger or acquisition involves what to look for in a term sheet. What are the key components besides the cash, stock, and earn-out?
In evaluating a term sheet, for the buyer, there should always be some “hold back” in terms of the upfront consideration. A promissory note or seller paper is a key component of most asset and stock purchases from a buyer’s perspective. Here is why:
- For the most part, a buyer is paying for a future revenue and earnings stream to enhance the overall value of the buyer’s business. Yes, as the buyer, there are hard assets you are acquiring and you need to allocate the purchase price and calculate the goodwill (the excess value of the fair market value over the hard assets). Most of the key metrics are ROE (return on equity), IRR (internal rate of return), and total payback in after-tax dollars. So, if you, as the buyer, are investing in or speculating on the future, then why let the seller completely cash out a closing, leaving them little motivation to stay? They may not fully believe in the earn-out as they may have guided you to too-high of expectations in hopes of getting a better valuation for their business.
- There are other considerations such as a breach of representations and warranties. If there is no “holdback,” then it will be difficult to go back to the seller other than through litigation, which can be challenging and contentious. Such breaches could include uncollectible receivables, undisclosed liabilities such as upcoming litigation, taxes, and issues with the seller’s real estate (e.g., environmental issues).
The promissory note (holdback) can be used to hold the seller accountable for future earnings forecasts, including the upcoming year, especially if the seller is coming off of a tough previous year. It could also be used as an offset against future years’ earnings forecasts if the seller wishes for a healthier upfront multiple again.
The buyer should also always have several contingencies or “subject to’s” in their term sheet, such as the following:
- Subject to board approval. This is a must, as it gives the buyer an out if they are not comfortable with the deal.
- Subject to legal and accounting due diligence. Again, this is a must. The buyer should have a “thorough, but reasonable” checklist and be able to move forward in a fairly expeditious manner. Meaning, once a term sheet is signed, the buyer should be able to move forward with this part of the process, including negotiating all other definitive documentation in about six to eight weeks, unless there are regulatory, legal, or accounting issues that come up during the process. The seller needs to be ready to move forward expeditiously to show that they are acting in good faith. Dragging the process out can wear down and defeat the seller. Then the buyer runs the risk of the seller walking and pursuing other options.
- Subject to bank approval. This may or may not be critical for the buyer, but I like to include it in case something was to come up, such as the seller having significantly lower assets than represented. A good advisor for the seller will want the buyer to remove this contingency as soon as possible as they will want to know the buyer is for real and able to finance the transaction.
While there are other contingencies that could be added, these points really cover the buyer. And, having too many more contingencies could turn off the seller especially if it is a competitive situation.
Properly evaluating the term sheet can be the difference between a win-win deal and a significant loss. An experienced M&A consultant can provide an objective view of the offer and help negotiate a winning agreement.
Steve Pomeroy is the founder of Big Change Advisors, an M&A consulting firm in Los Angeles focusing on middle market companies in the IT services space. Since 1992, Big Change leaders have completed over 36 transactions including M&A, Capital Sourcing, and Public Offerings representing over $800 million in total transaction value. Big Change Advisors donates a percentage of all fees to help serve the homeless through the Los Angeles Mission. To request a free consultant, contact us.