The initial stages of a Merger and Acquisition (“M&A”) often involve parties trying to establish a meeting of minds on essential commercial terms, to determine whether or not a deal can be struck. Hence, it is common for parties to capture their key terms in a simple document. There are various names for this document, including “heads of terms”, “memorandum of understanding”, “letter of intent”, “offer letter” and “term sheet”.
While often overlooked, this apparently straightforward document holds the power to make or break an M&A deal. Importantly, it focuses both parties on key negotiation points and the overall deal structure, which ultimately provides clarity and saves precious resources for both sides.
This article explores the main elements of a term sheet, highlighting some basic and advance elements, and their impact in an M&A.
Click here to read up on the types of M&A and Deal Structuring in Malaysia.
Introduction
A term sheet serves as a roadmap for the entire M&A process. While often not legally binding, the term sheet serves as a powerful signal of intent. It demonstrates to both parties, shareholders, and internal stakeholders that earnest negotiations are underway.
The term sheet should outline the key terms agreed upon by both parties, acting as an instrument of good faith and a springboard for the deal to move forward. In its most basic form, the term sheet should have the ability to:
1. Align Commercial Expectations: It clearly defines the deal’s core elements, including price or valuation method, payment structure, subject matter of the transaction (i.e., what is being bought or sold), critical conditions that need to be met, and the deal’s overall sequence and timeline. This process fosters co-operation, trust, sets out expectations upfront, and reduces potential disagreements later in the process.
Click here for further information on the sequence of M&A.
2. Highlight Priorities: The term sheet serves as a compass, directing both the financial and legal due diligence efforts, as well as the drafting of the definitive document, towards the most critical areas of priorities to each party. A well drafted term sheet can highlight certain priorities in the M&A transaction which prompts the advisors to pay closer attention to. For example, in an acquisition of a “software as a service” business, a term sheet highlighting the importance of intellectual property rights ownership in the target business will invariably prompt the lawyers to prioritize verifying the chain of intellectual property ownership in the due diligence exercise.
Click here to access our article “Why You Should Never Skip Legal Due Diligence”.
3. Facilitate Negotiations: By establishing a clear starting point, the term sheet facilitates efficient negotiations. It provides a framework for discussing and resolving any outstanding issues, preventing the deal from derailing later due to entirely mismatched expectations. Parties ought to bear in mind that the term sheet itself will often go through several rounds of negotiations and drafts. The definitive sale and purchase agreement will be drafted based on what was agreed upon in the term sheet, so the term sheet is essentially where the critical terms are negotiated.
Beyond the Basics
For a more sophisticated transaction involving a higher level of complexity, a term sheet can or should contain the following key terms, which go beyond just the basics:
- Purchase Price: This is the monetary heart of the deal, outlining the exchange of value between the purchaser and seller. The purchase price in a term sheet can be expressed in the following common ways:
- Lump sum fixed price; this approach is suitable for simple and quick deals. This price remains fixed regardless of the lapse of time, from the start to completion of the transaction.
- Method of valuation to derive an enterprise value (e.g., stating a PE multiple of EBITDA, Discounted Cash Flow or Net Asset Value methods); this approach allows for the purchase price to be computed based on the target company’s actual audited accounts. There will usually be a price adjustment at completion of the deal to account for the lapse of time and changes in financial situation of the target company.
- Locked box price mechanism; this approach allows parties to fix the purchase price based on a historical financial point in time before the deal is completed, known as the “locked box date”. On the locked box date, a set of financial accounts is “locked,” meaning that any cash, debt, or working capital changes after this date are for the account of the seller. The seller continues to operate the business as usual until the deal is completed, subject to certain adjustments for exceptional events.
- Payment Structure: In terms of payment structure, a term sheet can and should describe whether payment involves:
- a straight-up cash payment;
- a staggered payment in tranches or instalments over a period of time;
- a share swap / rollover shares issued by another entity; or
- a strategic blend of both cash and shares.
- Escrow: In some instances, an escrow clause can be built into the term sheet to govern the responsible handling of funds throughout the process and to mitigate risks for the buyer. For an M&A deal which has the purchase price payable in stages, parties might feel more comfortable with an appointed independent escrow agent holding onto a portion (say, 10%) upon signing of the agreement. The buyer places the deposit sum into the escrow account while due diligence is being conducted or while the condition precedents are fulfilled. This deposit monies do not belong to the seller just yet; it is held in trust by the escrow agent as stakeholder, and released back to the buyer immediately if the deal does not complete successfully. An escrow provision must be drafted carefully and unambiguously, as omissions on such a clause could result in legal disputes and deadlocks down the road.
- Conditions Precedent: Events or milestones that must be met (or waived) for the deal to complete. These are the non-negotiable conditions, typically imposed by a buyer on a seller to meet, that must be fulfilled before the deal can officially cross the finish line. Think of them as checkpoints, covering crucial aspects such as obtaining regulatory approvals, obtaining shareholders’ consent, securing financing arrangements, transferring of property or assets which are not part of the purchase, no material adverse changes, or other critical prerequisites.
- Exclusivity / No-Shop: Typically requested by a buyer. If an exclusivity or no-shop clause is granted, it prevents a seller (or both parties if mutually applicable) from engaging in negotiations with other parties over a specific time period. This simple but powerful clause allows the buyer a specific timeframe to negotiate a deal with the seller exclusively without the threat of having other competing buyers engaging the seller in a bidding war concurrently.
- Representations and Warranties: Think of these as promises whispered at the altar. Each party provides promises regarding their financial health and legal compliance, essentially assuring the other that they are entering the deal in good faith. This transparency builds trust and reduces the risk of hidden problems down the line. For example, the seller might represent that the target company’s financial statements are accurate and free from material misstatements. If an audit later reveals discrepancies, the buyer could seek legal remedies including damages, based on this breached representation. That said, a basic term sheet will typically state that “customary representations and warranties” are expected, and the full extent of detailed representations and warranties will often be negotiated in the sale and purchase agreement itself.
- Termination / Break-Up Fees: These are essentially a pre-agreed sum of liquidated damages payable if a party terminates the deal without any breach by the other party. They are typically intended to cover the costs and damages incurred by the non-terminating party that would have benefited from the completion of the deal. This might involve forfeiture or refund of any deposits made during the signing of the term sheet phase. Setting these expectations upfront discourages frivolous exits and incentivises commitment on both sides, especially after much time and resources have been spent in discovery and negotiations.
- Legally Binding Clauses: A term sheet generally states at the outset that it is not legally binding. This means that the parties are not legally obliged to obey or follow through with the obligations contained in it, until such time that a full definitive sale and purchase agreement is signed. Nonetheless, it is prudent for selected clauses within a term sheet to be legally binding on both parties, and continue to be, even after the M&A transaction is terminated or aborted. A common example would be the confidentiality obligations not to disclose sensitive information shared with the other during the preliminary stages of discussions.
- Dispute Resolution & Governing Law: Establishing clear mechanisms for resolving disagreements that might arise during the deal’s progression. Specifying the jurisdiction and governing law under which any disputes will be settled provides a clear framework for resolution. While this clause might seem straightforward, there are various strategic factors and far-reaching implications to consider in negotiating this clause, particularly in an M&A deal which involves a foreign buyer.
Conclusion
A term sheet drafted by a skilled and experienced M&A lawyer at the early stages of the deal is worth its weight in gold. By crafting a document that is clear, comprehensive, and strategically sound, parties can embark on their M&A journey with increased certainty, reduced friction, and enjoy a higher chance of a smooth and successful M&A transaction.
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This article was written by Sylvia Lock (Senior Associate) from the corporate practice group of Donovan & Ho. Shawn leads the corporate practice group of Donovan & Ho, and has been recognised as a Notable Practitioner, whilst the firm has been recognised as a Notable Firm for Corporate and M&A by Asialaw Profiles 2020 and 2021. We are also ranked as a Recommended Firm by IFLR1000 2020 and 2021.
Our corporate practice group advises on corporate acquisitions, restructuring exercises, joint venture arrangements, shareholder agreements, employee share options and franchise businesses, Malaysia start-up founders and can assist with venture capital funds in Seed, Series A & B funding rounds. Feel free to contact us if you have any queries.
