Negotiating a Term Sheet

The term sheet is not a legal document. It is used to negotiate the broad parameters of an investment. The actual agreement is set in several other documents including the stock purchase agreement and investor rights agreement.

Term sheets are non-binding agreement between parties involved except for certain terms that include confidentiality and no-shop provision. Most deals that get negotiated using a term sheet are finalized. Term sheets have an exit date and agreements must be signed before the expiry date.

Term sheets can be for a debt offering or equity offering. Terms common to debt offering and equity offerings include pre-money valuation, amount to be invested, post-money valuation and cap-tables. Debt-offering terms include convertible offering, fixed or indeterminate conversion price, automatic or optional conversion, assets used for security and interest rate. Interest rates are not usually negotiated if it is in a reasonable range. Anything between 3% and 8% is considered reasonable.

Equity offering terms include shares (common or preferred), liquidation preference, conversion price and valuation, automatic conversion, anti-dilution, pre-emptive rights, protective provisions, voting rights and shareholder rights.

Additional common terms in a term sheet include full legal name, type of security (debenture, common shares, and preferred shares), size of round, price per security, number of closings, number of tranches and milestones, targeted closing date, use of proceeds and expiration date.

A term sheet can be for a note deal (debt) or for an equity deal. Usually it is cheaper and quicker to do a convertible note deal because there are a lot fewer terms to negotiate and draft as compared to an equity deal. Additionally, a convertible note term sheet kicks the valuation can down the road to when the note matures. For example, in case of a convertible note deal if the investor invests in 100 thousand when the deal matures (say after 1 year) the investor will get $106 thousand worth equity at the negotiated equity price.

The convertible note puts a stop in the valuation discussion and frees up the business to go and get work done. In effect the valuation discussion is pushed to a later point in time when the business is more established. Convertible notes are only useful if it includes terms that protect the investor from runaway valuation. For example, the investor may invest $100,000 in a business at an early stage, but then if the company gets an investment in millions of dollars the original investor is completely diluted. Suddenly the investor who took the biggest risk has the lowest percentage in the company and correctly compensated for the risk. Convertible debt makes sense only if the term sheet has terms to protect the original investor investing through convertible debt.

The most negotiated terms in a term sheet are valuation, type of security, board of directors, significant financing threshold, IPO threshold, drag along threshold, anti-dilution provisions, pay-to-play and management carve-out.

The term sheet is usually served up by the investor to the entrepreneur. However, in case of a seed round or party round it may fall up to the entrepreneur to create and serve up term sheet and serve it to the investor. Both investors and entrepreneurs should take the opportunity to get legal advice before signing a term sheet.

Ideally, all inside rounds of financing should be shopped around using term sheets. Doing so facilitates a market check that helps determine the correct valuation for the business, which is the correct outcome for everyone involved. That said a term sheet may include a no-shop provision.  During due-diligence investors should be mindful of this provision because can affect the valuation of the company long-term.

Exploding terms sheets are term sheets that must be signed in a very short time. Ideally, investors should avoid exploding term sheets because it does not give them sufficient time to complete due-diligence on the company.

Role of intangible assets in Business Valuation

Business ValuationIntangible assets are assets that are not physical but have legal rights attached to them and create value for the owner. They sometimes make up a very large component of a business but are not factored into intrinsic valuation of the business. A lot of value is created out of the accounting system and intangibles assets could account to as much as 80% of the intrinsic value of a business in some cases. As important as intangible assets are, business owners usually do not have a clear understanding of these assets. While rule of thumb valuation techniques factor in some of these benefits, valuing intangible assets and then adding it to the intrinsic valuation should be the preferred approach to valuing a business.

The time spent in planning, marketing, human capital, building relationships and developing a corporate culture are expensed on the income statement to calculate net income or net profit. While this is appropriate and required from an accounting point of view, cumulative investment in areas like developing an agile and customer focused corporate culture must be identified recognized as intangible assets.

Intangible capital of a business usually falls in the following areas:

  • Brand value which is the Net Present Value (NPV) of the estimated future cash flows attributable to the Brand. A strong brand is a distinct asset owned by a business and can be easily monetized by keeping prices higher than the competition.
  • Systems of differentiation developed by the business to compete in its marketplace.
  • Customer relationships which includes a loyal customer base and loyalty systems. Businesses should leverage concepts such as customer acquisition cost (CAC) and life time value (LTV) of a customer to value its customer base.
  • Business Processes related to customers acquisition including paid and unpaid activities.
  • Internal Business Processes and technical expertise.
  • Favorable location for the business.
  • Patents, Copyrights, Trademarks, Trade names, Non-compete agreements and R&D.
  • Relationships with partners including supply chain related business processes.
  • Supply agreements, Licensing agreements, Service contracts and Franchise agreements.
  • Unique corporate culture and corporate reputation.

When a buyer, seller or investor is conducting due-diligence on a company, he/ she must value at intangible assets in addition to calculating the intrinsic value of the business. All parties must be aware of all intangibles and know if the company has low intrinsic valuation with high intangible assets or vice versa. That said there may be an arbitrage opportunity if one party recognizes an intangible asset that the other party has discounted or not identified. Understanding intangibles also provides a view into the health of an organization.

The process of valuing intangible assets starts with first identifying and listing all intangible assets, which requires thorough understanding of the business. The next step is to attach a fair value to each intangible asset and to estimate the economic life of each intangible asset. Finally, businesses can get a value by using the company’s discount rate to calculate the present value of all intangible assets listed.

Other approaches to factor intangibles into the value of a business are to add a premium to the intrinsic value of the business. The magnitude of the premium will depend on the industry and the sector. Alternatively, a few intangible assets like patents can be added as assets to the balance sheet as long as it allowed by the accounting standards.

Primer on Business Due Diligence

Business Due DiligenceDue diligence is the process of finding out undisclosed information and confirming that the information provided is accurate. For a business buyer, it is the process of working through all the details provided by the business seller.

During the due diligence phase the business buyer must access to all the businesses books, financials statements and other records. The due diligence phase provides the business buyer with a window to determine if the information provided is accurate. The process can take several days and sometimes up to a month. The Due diligence process is broad and must include financials, marketing and strategy amongst other things. Financial due diligence also includes business-valuation, identifying undisclosed liabilities and a lot more.

Due Diligence Approach

Due diligence is the process of systematically evaluating the target company’s documents and other artifacts. If significant discrepancies are found it can result in being a deal breaker or result in the deal being re-negotiated.

Overall, due diligence can be classified in the following categories:

• Management Due Diligence
• Legal Due Diligence
• Financial Due Diligence
• Marketing Due Diligence
• Operational Due Diligence

Information required within each category must be acquired through interviews, financial statements and legal and other documents. The person conducting the due diligence may need to contact the target businesses lawyers, bankers, accountants, clients and suppliers to gather details about the business.

Financial Due Diligence

Financial due diligence requires the business buyer to look into the financial health of the company. It provides the business investor or acquirer information on the debt of the company, capacity to expand and more. Understanding the capital structure of the business is a critical element of financial due diligence because too much debt or poor cash flow can prevent growth and sustainability of a business.

Typically financial due diligence involves review the following documents:

  1. All published financial statements for the last 4 to 5 years including balance sheets, income statements and cash flow statements. This includes interim financial statements for the current quarter.
  2. All tax returns and tax payment schedules
  3. Appraisals on tangible assets including real estate owned by the business

Cash Flow (Financial) Due Diligence

Cash flow is the amount of cash being generated or spent during a specific period of time. It is the change in cash position or in the cash account due to revenue, expenses, operating costs and investments. Cash flow is typically impacted by:

• Accounts Receivable  (AR)
• Accounts Payable (AP)
• Capital Expenditures (CAPEX)
• Debt Servicing
• Tax Payments and other timing issues

Managing Cash flow is of paramount importance to operating a business on day to day basis. Accounting rules that govern the creation of financial statements are used to measure profit and loss. Therefore Balance Sheets and Income Statements do not provide an accurate and timely view of a company’s cash position. Not managing cash flow can result in a cash crisis. For example, if cash is blocked in accounts receivables (AR) and investments, a business can find itself in a cash crisis even though the balance sheet is healthy.

Cash flow can be classified as:

• Cash from Operations
• Investment cash flow
• Financing cash flow

A Cash flow statement is a financial statement that shows companies incoming and outgoing cash for a specific duration. When buying a business, studying the businesses cash flow statements (3 to 5 years) plays an important role and must be completed during the due-diligence process.

Marketing Due Diligence

Marketing Due diligence involves the review of the overall marketing strategy and marketing plan of the business being acquired. Typically a summary of the marketing plan is provided in the investment proposal.

During the Due diligence process the investor or the acquirer must review the underlying market research including the size of the market, market segmentation, competitive pressures, threat of new entrants into the market, threat from substitutes and more. It is important to understand the overall size of the market (industry) the business operates in, the size of the market for the business and more. Reports provided by external agencies provide significant credibility to the marketing plan.

• Review marketing plan and marketing strategy documents
• Marketing material for last few years
• Interviews with the marketing manager or the person involved with marketing
• External and internal research data

Legal Due Diligence

Under legal due diligence the business buyer needs to make sure the business does not have legal problems and is being correctly operated. Legal Due diligence requires the business buyer to review all legal contracts and agreements made by the firm. Several legal artifacts must be reviewed including:

• Review all contracts. A company in business can have several contracts in place including contracts with suppliers, customers, employees and others.
• Agreements with employees
• Corporate charter and bylaws
• Non-Disclosure Agreements (NDA) with employees
• Patents, copyrights and other assets in the company
• Minutes and consent from board of directors and shareholders
• Litigation related documentation and summary of current and pending disputes
• Review tax documentation from a legal stand point
• All artifacts related to the issuance of securities

There are several checklists available online to guide you through the process of conducting legal due diligence.