What Founders Need to Know About Term Sheets in M&A/Private Equity

As a founder selling your business or raising capital, you may be unsure about what to expect and what to include in a term sheet.

Having represented 75+ software and internet companies through successful M&A and capital raise transactions, here is some guidance from our team about what a term sheet represents and what you should pay attention to.

What Is a Term Sheet?

A term sheet for an M&A or capital raise transaction (also called a letter of intent) is a document describing the proposed terms of a transaction. These terms are subject to change before signing a final purchase agreement. The term sheet will cover three aspects of the transaction, namely:

• Economics (e.g. valuation, security structure, working capital adjustment, take-home cash, etc.)
• Liabilities (e.g. reps & warranties, insurance, etc.)
• Go-Forward Operations, if applicable (e.g. board representation, veto/approval rights, anti-dilutive rights, redemption rights, etc.)

In addition to covering the above essential (albeit tentative) aspects of the transaction, a term sheet also outlines the provision for an exclusivity period during which the prospective buyer can further diligence the business.

What a Term Sheet Does and Doesn’t Represent

As a founder, you may consider the signing of a term sheet as a signal you have settled on the terms of the transaction and are nearing the close of the deal. Neither of these beliefs are true because:

• Term sheets are not binding (except for the exclusivity agreement)
• Term sheets represent the beginning of deep, confirmatory diligence (e.g. tax, legal, financial, tech, etc.)

Ideally, your term sheet will cover the issues you’re most passionate about regarding economics, liability, and post-deal operations. But when you execute a term sheet, the deal is not done. Even with a signed term sheet, you simply have a basic rubric from which to draft a purchase agreement.

So if the term sheet is just a non-binding rough outline of a final purchase agreement, how important is its role in the transaction?

For founders, it’s essential.

Your Point of Greatest Leverage

What many founders don’t recognize is that the term sheet (or more specifically, the process and timeline around creating a term sheet) represents your greatest point of leverage in a negotiation.

At the time you’re gathering term sheets, you’re not bound to any one buyer. Assuming you’ve built a competitive sales process, you should have multiple buyers bidding against each other, each investing considerable time and hard dollar resources to win the bid.

Under these circumstances, you’re in the best possible position to negotiate terms between buyers because competition incentivizes buyers to:

• Invest resources in diligence before exclusivity. Competition accelerates the deal dynamic, leading buyers to conduct diligence early. Any costly investment in diligence will place more pressure on a buyer to win the bid.
• Improve the terms of the deal. When buyers are pitted against each other, their recourse is to improve the terms of the transaction, reflected in the term sheet.

Considering these conditions, your goal should be to negotiate as much as reasonably possible in this stage, before you enter exclusivity and deep, confirmatory diligence.

Exclusivity and deep diligence come after signing a term sheet

Once you enter exclusivity for deep diligence, much of your prior leverage built through competition disappears. For the duration of exclusivity, you are bound to only negotiate with one buyer and your only leverage is the ability to walk away. (And while walking away can sometimes be necessary, it can send the wrong message to other prospective buyers who may assume the rejected buyer uncovered something serious in diligence.)

That your leverage slips away during exclusive diligence places even more importance on negotiating out an in-depth term sheet before signing one. When you request that each buyer in a competitive process create a favorable, in-depth term sheet before exclusivity, the result is:

• More informed bids. Because buyers will have conducted significant diligence before exclusivity, their term sheets will more accurately reflect the final purchase agreement.
• More qualified bids. If a buyer has to invest money to compete but doesn’t have a chance of winning, they’re more likely to excuse themselves from the process, leaving the qualified bidders to participate.
• Less issues during exclusivity. Because buyers are conducting more diligence earlier, they are more likely to surface issues before exclusivity, reducing the likelihood of a change in terms during exclusivity.
• Greater chance of a deal closing at original terms. When buyers have 1) invested significant resources in diligencing your company, and 2) already uncovered any potential issues, they’re more likely to close a transaction according to their term sheet.

How Founders Should Request Term Sheets

Several approaches a founder can take to make the term sheet a more reliable indication of the final purchase agreement include:

• Encouraging ad hoc diligence through competition
• Requiring an in-depth term sheet from each buyer
• Tightly controlling exclusivity

Encouraging ad hoc diligence through competition

As mentioned, a competitive sales process accelerates the deal dynamic. This acceleration leads buyers to conduct diligence early in the process before exclusivity, increasing pressure on the buyer to win the bid. That pressure on the buyer gives more leverage to the founder.

Requiring an in-depth term sheet from each buyer

In most cases, buyers will shell out a fairly vague term sheet that leaves room for interpretation. These term sheets are characterized by wide brush valuations, loosely defined transaction structures, and other vagaries.

An ambiguous term sheet gives founders little idea of what to expect in a final purchase agreement. As such, founders should outline in detail what they expect from buyers in a term sheet.

Being able to get specifics from buyers will largely depend on how competitive the transaction process is. The more buyers you have participating, the more successful you will be in getting highly detailed term sheets.

Tightly controlling exclusivity

One of the most important sections within a term sheet is the provision for an exclusivity period. As stated above, exclusivity gives a buyer the right to fully diligence your business with assurances that you won’t have side negotiations with other buyers in the meantime.

While buyers are certainly justified in expecting exclusivity, founders need to be careful about the scope of that exclusivity. To help retain some leverage, you should:

• Keep the exclusivity timeline short.
• Ensure the buyer meets specific milestones during exclusivity.
• Be prepared to walk away.

Learn more about how to properly approach the exclusivity period.

Hiring an Investment Bank to Manage the Process

As you may expect, applying the above while simultaneously attempting to run your business would be a herculean feat. Founders who try to do both often find they simply can’t—at least not to the caliber they would like.

Hiring an experienced investment bank to run your transaction will enable you to stay focused on the business while a professional banker structures the transaction and manages relationships with 20+ potential buyers.

Learn more about why you should hire an investment bank.