Term Sheets for the Buying or Selling of a Business
By Matt Dickstein
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In this article, I explain term sheets for the buying or selling of a business. A term sheet is also called a letter of intent (LOI), or a memo of understanding (MOU).
A term sheet is a non-binding outline of a deal. Its purpose is to let the buyer and seller see if they can make a deal, before they spend big money on lawyers, accountants and due diligence. It’s better for a deal to die early at term sheet stage, not later on, after you’ve paid real expenses.
The most important negotiation occurs at term sheet stage, before the deal is fixed. For this reason, a lawyer is most useful at this stage. Once a deal is fixed in a term sheet, there is less room for negotiation. Although term sheets are non-binding, they still create a moral obligation on the buyer and seller. It’s not easy to renegotiate a term sheet.
Now I’ll explain the essential terms of a term sheet:
Most term sheets start by stating who will buy what from who. The “what” is either the assets of seller’s company, or seller’s stock in the company.
The second hardest thing to negotiate in a deal is the down deposit (the first hardest?– contingencies; see below). Some sellers want a deposit so that if the deal falls apart, they keep the money to compensate for their lost time and expenses. Deposits are standard in real estate deals, but less so in business purchases.
I give no legal advice regarding the amount of the purchase price; that’s a job for business appraisers. My job begins with the structuring of the payment of the purchase price. A buyer can pay the price with any one or a combination of the following:
(1) Cash up-front, usually 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 buyer’s company; and/or
(4) Buyer’s assumption or payoff of seller’s debt.
Purchase Price Adjustments
The buyer and seller might agree to adjust the purchase price at closing or soon after closing, to account for numbers that change day to day. For example, they might adjust the purchase price up or down to account for inventory on-hand at closing, working capital or accounts receivable, because these numbers change between the time the parties agree to the purchase price and the later closing.
Purchase Price Earnouts
Buyers love earnouts. With an earnout, the buyer increases or decreases the purchase price based on the performance of the company after closing. This gives the buyer security that it isn’t overpaying. Sellers hate earnouts because it puts their purchase price at risk based on the buyer’s operation of the company after closing — what if the buyer doesn’t know how to run a business?
Sometimes a buyer demands an escrow (a holdback of money from the purchase price), which will be security for the buyer if the seller breaches any of its covenants or representations in the Purchase Agreement. Sellers clearly don’t want any of their sale price escrowed. A seller can limit the damage by setting a deadline for when the escrow must end and the money given to seller, or by requiring that the escrowed amount be the buyer’s maximum recovery from seller for covenant or representation breaches.
A term sheet should allocate accounts receivable, for example, A/R for pre-closing work belongs to seller, and A/R for post-closing work belongs to buyer. Also discuss who will collect seller’s accounts receivable, and if buyer will do so, the collection fee that buyer will take.
The term sheet should discuss how the seller and buyer will transition clients, for example by a joint announcement to clients of the sale. Also state how much transition assistance the seller will give to the buyer after the closing, and how much the buyer will pay for the assistance.
Most sellers will be bound by a non-competition covenant for a term of years, within the geographic locality of the business. This is standard.
I save contingencies for last. A contingency permits the buyer to call of the deal if a required event does not occur. For example, the buyer might want a contingency for getting a loan to finance the purchase, or for getting a new office lease with the seller’s landlord. Contingencies are the hardest thing to negotiate in a deal. Like deposits, contingencies are standard in real estate deals, but less so in business purchases.
Contingencies only arise if the parties sign a binding Purchase Agreement before the closing. With a signed Purchase Agreement, the buyer is contractually obligated to close, even if it can’t get the loan or the lease. The contingency enters here to permit the buyer to walk away.
The parties don’t need to fight over contingencies, however. Instead, they can finalize the Purchase Agreement before closing but only sign it after the buyer has received its loan or lease. In other words, before closing, the buyer will go about getting its financing or new lease, and only when the contingencies are satisfied will the parties sign the Purchase Agreement and close. I prefer that deals do not have contingencies.