M&A Series: What do I need in a term sheet?

A term sheet (after an NDA) is generally one of the first documents produced if you are buying or selling a business, and sets the tone for the negotiation.  It is not required, but can make the process much smoother because it raises disputes on the key terms much earlier in the process and determines whether you will be able to reach agreement on those before you incur the expense of negotiating the transaction documents.  The content and complexity of the term sheet will vary widely from deal to deal, but the length of the document is not what makes the difference.  The content as it applies to the particular situation of the transaction is what is important.  So what should be included?  The goal is to include just enough to cover the important deal points (such a lawyer answer, I know).  But here is what I mean. The term sheet is the agreement to agree, or the framework that will get you to the real agreements.  In many cases, the term sheet is non-binding (even if some provisions, like confidentiality, are), meaning there is no penalty if the deal does not go through for some reason.  In other cases, holding the parties to the agreed terms will be a critical part of getting through the due diligence process (to be discussed in a later post) to closing.  Either way, the term sheet needs to be specific enough so that the parties understand where they are headed as they embark on the diligence work, but within reason since the term sheet will be replaced ("superseded" in lawyer speak) when the final documents are prepared.  The larger the deal, the more provisions are generally going to be required; but for many smaller transactions, the goal is to keep it simple and straightforward.

Now lawyers will insist that they be involved in negotiating the term sheet, but sometimes this is done for the wrong reasons.  Many of them want to "lawyer up" the term sheet with a variety of legal provisions that will end up in the final documents (mostly to show that they are adding value).  Sometimes the legal provisions are critical to the deal and may need to be included (e.g. certain material business change provisions or legal conditions to closing).  But more often, legal "customary" provisions like representations and warranties and indemnification provisions will be negotiated with the final documents rather than at the term sheet stage.  The reality is that most of the key information in the term sheet will be business terms -- price, earnout terms, deal structure (cash/stock/assets), working capital requirements, status of employees, and the like -- with a few exceptions noted below.

That being said, I have had to renegotiate business provisions in term sheets after the fact because the the descriptions were too vague and the parties did not have the same understanding when the definitive documents were drafted.  For example, the calculation of an earnout (or payment of the purchase price over time based on earnings of the company after the closing) and net working capital requirements (how much cash has to be on hand after taking in to account certain expenses) are not only tied to very specific definitions, but poorly worded term sheets can provide either side with plenty of latitude to adjust the numbers any way that suits them.  In those cases, having a lawyer review your term sheet can prevent some drafting issues long before they have to be renegotiated, which costs the parties more time and money.

In addition to the business terms of the deal, we typically include the following legal provisions to help protect the parties form unintended consequences:

  1. Exclusivity and Good Faith: an agreement by the parties to negotiate with the other party exclusively and in good faith in order to complete the proposed transaction.
  2. Confidentiality:  in order to compete the transaction, each party will supply the other with confidential information that much be protected by the other party for a certain period of time regardless if the deal closes or not.  This provision must be specifically excluded from the non-binding nature of the agreement.
  3. Non-binding:  if the parties intend the term sheet to be non-binding, as is common, then a specific provision must be included to prevent a legally binding agreement from taking place at this stage.
  4. Material Changes:  a provision that bases the transaction on the accuracy of certain assumptions that, if not true at closing, give one or the other party a way to exit negotiations.

Again, there may be other provisions that you will want to include at this stage, but the best way to do that is to work with your attorney, which can prevent headaches down the road.