Term sheets are used in a variety of transactions, including commercial negotiations, mergers and acquisitions, joint ventures, and real estate. A term sheet is essential to effectively execute a transaction between two parties, usually a purchaser and a seller. The document will later serve as a guide utilized in drafting the definitive agreement(s). In terms of structure there is no “one size fits all” approach. The way you structure your term sheet depends on your company’s needs to clarify certain conditions.
This month’s Legal Risk Management Tip dives into the importance of developing a term sheet. Specifically, we will discuss terms to be considered for asset purchase and selling agreements when a company decides to sell its book or business.
What Is A Term Sheet?
A term sheet is a nonbinding outline of terms between and seller and a buyer about the material terms and conditions agreed upon for a proposed business acquisition. Even though a term sheet is non-binding, it outlines the basic conditions of the potential purchase agreement as to things such as valuation, purchase price, closing conditions, closing timeframe, restrictive covenants, and things to be determined in the future, post-closing.
A term sheet is similar to, but different from a letter of intent (“LOI”), which is a document that preliminarily commits one party to transact with another and is predominately used in acquisitions to stipulate specific deal terms in larger business negotiations. The main difference between an LOI and a term sheet is stylistic; the former is written as a formal letter while the latter is composed of bullet points outlining the terms.
Although term sheets and LOIs are often referred to interchangeably, they are indeed different yet accomplish similar goals and contain similar information.
What Should A Term Sheet Include?
Some of the key focal points of a term sheet include the following:
- Valuation: This is the formula used to determine the value of the business.
- Purchase price: This is the price an investor will pay based on the final valuation.
- Closing: The date the transaction must close by and any conditions, or things to be performed prior to closing.
- Promissory Note Terms: If the purchase price is not paid in full at closing, a Promissory Note outlining the payment terms of the remaining amount, interest rate, maturity date and default provisions should be provided.
- Lookback Provisions: Any claw back, purchase price adjustments or other similar conditions, should be included as applicable.
- Indemnification: This will outline potential liability for beaches of representations after closing.
- Expenses: Provide what expenses each party is responsible for and as applicable, the percentage of expenses each party is liable for.
- Dispute Resolution: In the event of any breach or disputes, will the parties seek mediation, arbitration or civil recourse.
- Governing Law: This is the state law that the parties will be bound to.
While this list is not exhaustive, it is important to incorporate all material terms that are most important to the buyer and seller. If done properly, a term sheet will help to add clarity to memorializing the essential terms of the asset purchase or selling agreement and may help to curtail further discussions and delays while drafting the definitive agreements prior to closing.
A. Valuation and Purchase Price
The company’s valuation, along with the amount of money invested, determines the purchase price of assets. The valuation should but does not need to be conducted by a neutral third party. In the event the purchaser is not buying 100% of the assets or the adviser’s business, the valuation is used to determine the purchase price based upon the percentage being purchased. For instance, if the valuation was $1,000,000 and the buyer wants to purchase 10%, the purchase price of that interest will be $100,000. The date of the final valuation is detrimental in the agreement since it affects the purchase price, payment terms, closing date, and other terms.
When the purchase price is determined, there are different ways you can structure the payment. Some of the most common methods include: (1) Cash up-front in full, usually with the assistance of bank financing; (2) Seller financing, meaning that the buyer pays all or a part of the purchase price with a promissory note that buyer gives to seller; (3) Stock in purchaser’s company; and/or (4) Buyer’s assumption or payoff of seller’s debt. The deal can also be structured to incorporate a mixture of the above.
B. Closing
Generally, you can expect closing to take about 4-5 weeks from signing the term sheet if the deal is on a normal pace. This assumes no significant delays, breaches, or amendments to the terms. Between signing the term sheet and before closing, any conditions to closing previously outlined or indicated in the term sheet should be performed, executed, closed, whatever the case may be. For instance, a closing condition may be that the buyer form the entity that will hold the assets post-closing, or perhaps establish the appropriate broker/dealer-custodial relationships, as necessary.
During this same time, attorneys for each side will be busy drafting, reviewing, modifying, and finalizing the definitive documents. Depending on the structure, the definitive documents usually include the Purchase Agreement (Asset Purchase, Share/Stock Purchase, etc.), promissory note, security agreement, bill of sale, spousal consent (as applicable) and any other exhibits, addendums, or other documents (which may include restrictive covenants, independent contractor consulting agreements and other contracts to help facilitate the transaction and deal).
When all the documents are finalized and closing conditions have been met, a date and time for closing shall be set. At this closing, all the definitive agreements will be executed, the purchase price payment will be made, and the deal is considered done. At that point, all the right title and interest in the assets (or other property subject to the transactions) will transfer to the buyer.
C. Restrictive Covenants
The term sheet and the definitive agreements generally contain covenants that will restrict one or both of the parties’ ability to solicit clients, employees, independent contractors or other agents of the other. In certain circumstances there may be non-complete clauses or provisions that would restrict the ability of a party to own or operate a business that competes, directly or indirectly with the business or assets that were just sold. Further, there may be confidentiality agreements and other provisions that protect the disclosure of trade secrets, client lists, vendor lists, contracts, and other key information of the business.
Generally, these provisions last for a finite period after closing (generally ranging from 2-5 years). Consequently, it is prudent for the party bound by these restrictive provisions to adhere to and comply with the conditions set forth or face potentially harsh consequences. Commonly, a breach of any of these provisions also could cause the other party to seek equitable remedies and trigger dispute resolution in the form of mediation, arbitration, or a lawsuit, which can be extremely costly. Ensuring these provisions are not only drafted correctly at the beginning but are also closely monitored post-closing is of the utmost importance.
Conclusion
A term sheet is essential for helping parties to outline the base which will form the definitive agreements. Having a term sheet solidifies the parties’ understanding on key terms before proceeding further in a transaction, potentially saving time, significant cost and efforts in negotiating an asset purchase or selling agreement and other related documents later on. A term sheet gives both the purchaser and seller peace of mind to proceed with a transaction, while negotiating final deal terms in an effective and efficient manner.
Authors: Michelle L. Jacko, Managing Partner. Editor: JLG works extensively with investment advisers, broker-dealers, investment companies, private equity and hedge funds, banks and corporate clients on securities and corporate counsel matters. For more information, please visit https://www.jackolg.com/.
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