Typical Terms in an M&A Term Sheet

A potential sale is one of the most important events in your entrepreneurial journey. But, while potential buyers usually have deep financial expertise and the experience of handling multiple transactions, owners often are at a disadvantage as they don’t have the same level of exposure to financial transactions. However, thorough preparation can significantly bridge this knowledge gap and contribute to a successful sale.

Let’s demystify the process of selling a business by examining the key components of an acquisition offer, also known as a Term Sheet. The key aspects we’ll cover include, understanding the potential acquirer, rationale for acquisition, and the key elements in the transaction structure.

Understanding The Potential Acquirer and Their Rationale

Understanding the potential acquirer and their rationale is essential when negotiating the transaction structure. 

Strategic buyers are companies in your industry or related fields seeking to enhance their current operations or expand into new areas critical for growth. They aim to achieve synergies through increased operational scale, a broader customer base, an expanded product portfolio, market entry, or enhanced market share.

Financial buyers, typically private equity firms, pursue acquisitions to realize substantial financial returns. Their goal is to enhance your company’s revenue and margins, ultimately aiming for a profitable exit in the future.

Recognizing what attracts these buyers to your company can help you emphasize its appealing features and negotiate more effectively. Understanding whether it is access to new markets, proprietary IP, customer base, market position, scale benefits or other strategic rationale, helps you understand their incentives during the negotiation process. 

We have detailed the motivations, typical transaction structures, and advantages and disadvantages of strategic and financial acquirers in a dedicated article here. 

‍Negotiating The Transaction Structure

Acquisition Price : The valuation method plays a critical role in determining the seller's final payout in a transaction. There are two primary methods: fixed price and valuation based on financial multiples.

Fixed price: This method involves a set amount proposed for the transaction that remains unchanged, regardless of any fluctuations in the underlying business's performance until the deal closes.

A valuation based on financial multiples : This method calculates the valuation using a multiple of financial metrics like EBITDA, revenue, or profit after tax, allowing adjustments based on the company's performance up to just before the deal closes.

Enterprise Value (EV) - The acquisition price in a term sheet is typically based on Enterprise Value (EV), a financial metric that reflects the intrinsic value of the company alone, excluding any cash or debt. This metric facilitates the comparison of similar companies with varying cash and debt levels. Often described as "cash-free, debt-free" in term sheets, this approach implies that the acquirer is offering a price for the company assuming it will be transferred without any cash or debt on its balance sheet.

This means that the final acquisition price paid to you as the owner of the company (Equity Value) is calculated as:

Enterprise Value (EV) + Cash in the company - Debt of the company + Adjustment for Net Working Capital (could be positive or negative) = Equity Value

If the company has a significant amount of cash that you have not taken out as dividends as a seller, then the acquirer should pay you for this cash on a 1-to-1 basis based on the final amount in the business at the closing date. If the company has significant debt, then the acquirer will reduce the purchase price correspondingly. 

Normalized net working capital - Typically, term sheets will include wording to the effect of “price is based on a normalized level of working capital at close”. Net working capital is simply the difference between current assets and current liabilities. This metric is particularly important for businesses with significant and fluctuating levels of receivables, payables, and inventory. During deal negotiations, it is standard practice to agree on a normalized working capital level that the company must uphold through the completion of the transaction.

Payment terms : Payment terms in acquisitions often involve an earn-out mechanism, where a portion of the purchase price is deferred and contingent on the acquired company achieving specific financial or operational milestones. This strategy allows buyers to mitigate risk by linking payment to the company's future performance, while sellers can potentially negotiate a higher price by sharing in the future performance risk.

For a successful earn-out agreement, it's essential for both parties to clearly agree on specific milestones and timelines, such as revenue or EBITDA targets over a period ranging from one to five years. It's also crucial to have a clear understanding of the methodology used to calculate these financial metrics. Revenue targets are typically less ambiguous and are commonly used. Use of EBITDA which is a better reflection of company value is also common, but EBITDA can be sensitive to minor company or accounting decisions. 

It’s essential to ensure you as a seller have some degree of influence over the operations of the company post the sale. This is to ensure that if you are agreeing to an earn out, you also have the ability to influence strategic or operational decisions which can influence the likelihood of you receiving your earn out. If the acquirer has full control and you are expected to completely exit the business, then it’s difficult for the acquirer to push for an earn out structure.

Payment in cash vs stock : Cash is the most common method of payment as it is the easiest to structure for the seller. 

Stock payments are much more common when the acquirer is a publicly-listed company and therefore has liquid stock with which to pay the seller. The value per share of say Amazon is readily available along with its historical performance. Even in these cases, the seller is still exposed to the risk of share price volatility of the acquirer, especially after accounting for the lock up period (180 or 365 days when the seller is  prohibited from selling the stock). 

Accepting the shares of a private company acquirer happens rarely in M&A transactions. This is because the seller has to deal with an additional layer of uncertainty around the true performance and potential of your acquirer which leads to it being tough for the seller to understand the value of the payment being received. Also liquidity becomes a challenge as selling private company shares is difficult due to the lack of an open market. 

Stock vs Asset transactions: Transactions are typically categorized as either "stock transactions" or "asset transactions," each with distinct implications.

In a stock transaction, the acquirer buys the company's shares, taking over all assets, liabilities, and any post-sale issues. This approach often favors sellers by providing a clean break from the business.

In contrast, an asset transaction involves the acquirer purchasing specific assets, which are then transferred to a new entity, allowing the buyer to avoid assuming any unwanted liabilities. The original entity may continue operating without these assets or may be dissolved if the transferred assets represent the entirety of its operations. This method generally benefits buyers, as it enables them to acquire only the parts of the business they value, leaving behind any problematic aspects.

Management Team:  The management section of a term sheet outlines the future leadership structure post-acquisition, highlighting the importance of retaining key management to maintain company knowledge, customer/supplier relationships, and reputation. It typically discusses retaining or removing management members, altering roles, or introducing new team members. Additionally, it should detail revisions to employee agreements, including bonuses, incentives, and non-compete clauses, crucial for maintaining employee morale and company performance. A clear plan for management and employees aligns both parties on future responsibilities, preventing future complications.

Conclusion

Evaluating a term sheet from a potential acquirer can be a tricky exercise, with attention to detail to ensure clarity and alignment on the different aspects of a transaction critical to success. It’s better to be pedantic and ensure that the written agreement lays out things as clearly and as specifically as possible, than deal with potential ambiguities down the road.

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At Alehar, we're deeply passionate about M&A and fundraising, equipping us with the expertise and extensive network needed to carry out transactions efficiently and represent the interests of our clients effectively. Our expertise is particularly valuable for transactions ranging from USD 3m to 200m, as we guide companies through every step of their M&A and fundraising journey (including both equity and debt transactions)