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.

Business Transfer

Business transaction starts with due diligence investigation and negotiation. Usually the prospective buyer makes a written offer (Letter of Intent) that sets the broad parameters of the negotiated deal. The negotiated deal must include consensus regarding price, payment structure, price allocation and all other details that comprise the final deal.

Once all the terms of the offer are accepted by both parties a Purchase-and-Sales agreement is drawn up. The agreement must be drawn up by an attorney who specializes in commercial law possibly with the assistance of an accountant and business broker. The details of the Purchase-and-Sales agreement must be based on the accepted offer. Banks (lenders) also need the agreement signed by both parties to analyze the deal and issue loans.

PURCHASE-AND-SALE AGREEMENT (P&S)

 The Purchase-and-Sale (P&S) agreement is a contract that shows the buyer has decided to acquire the business and the seller has decided to sell the business for a certain price within a certain period of time. This document covers everything negotiated and listed in the letter of intent (term sheet).

The P&S agreement is legal and binding once it is signed by both parties.  It is the conclusion of in-debt investigation and due-diligence by the buyer and seller. At this point the seller has determined the buyer has the financial and business capability to see through the transaction. The Purchase-and-Sale agreement can be several pages with exhibits and attachments that address all the necessary points to be covered. It is important for the buyer and seller to understand the elements covered in the agreement. Listed below are a few items covered in the P&S agreement.

Buyer, Seller and Business Names Names of the business buyer, business seller and the name and location of the business.
Asset Inclusion and Exclusion List of assets included with the sale of the business.  Assets include equipment, machinery, inventory, accounts receivable (AR), brand (business name), goodwill, real estate and so on. The P&S agreement shall also list all items that must be excluded from the agreement cash and real estate.
Price The total purchase price for the business. This section must breakdown the price into its component including down payment.
Closing Date (Time frame) Closing date for the business transaction. It can take 3 to 6 months to get a commercial loan, so the closing date must be a few weeks away.
Liabilities (Accounts Payable) The business seller usually retains responsibility for Accounts Payable (AP). All current business loans must be re-paid by the seller so that the new owner has clear titles on all assets. If the buyer takes on any expenses it should be reflected in the selling price.
Accounts Receivable  Accounts Receivable (AR) that is money owed to the business is also typically retained by the seller. In some cases the AR may be sold with the business by adjusting the selling price higher. If the AR is sold with the business the seller must provide a detailed list containing amounts, counter party details and expected dates.
Payment Terms This section includes the amount of cash that will be paid on the closing day, deferred payment scheme and seller financing details.
Inventory Contains list of all inventory items included in the sale. The inventory should be counted when the agreement is created and once again just before the deal closes.
Seller Agreements This section usually includes non-compete covenant, inspection reports (federal, state and local, environmental) and other actions required by the seller such as repairs and transfer of licenses.
Taxes Taxes due should be paid by the seller before the closing date.
Escrow Agreements Escrow Agreements are created only if there is an outstanding obligation where some work needs to be done by the seller after the closing date. In this case money is held in an escrow account and released when the obligations have been satisfied.
Seller’s Representations and Warranties This one of the important parts of the agreement. It is used to ensure the seller has provided correct business information through the due-diligence process.

Sources of Financing for Businesses

Businesses for sale can be classified by deal-size. Businesses that are valued below $ 2 Million are classified as main-street businesses, businesses valued between $2 Million and $5 Million are classified as lower middle market, while businesses that are above $5 Million are classified as upper middle market. This blog tends to focus on main-street and lower middle market businesses.

Main-street and lower middle market businesses need to raise money for several reasons. Some common reasons are business growth and expansion, working capital fluctuations, refinancing existing loans, replacing existing equipment, and paying the owner. Financing for growth and expansion is the most common reason for main-street and middle-market businesses.

There are several sources for financing business operations or businesses acquisitions. Some of these sources are:

  1. Friends and Family
  2. Government grants
  3. Crowd sourcing
  4. Trade credit
  5. Personal credit cards
  6. Personal loans
  7. Business credit cards
  8. Lease
  9. Bank and Credit Union loans
  10. Asset based lender
  11. Angel Investment
  12. Venture capital
  13. Private equity investment
  14. Mezzanine lender

Bank loans are the most common source for financing business acquisitions and business operations. Asset based lending is also commonly used.  Asset based lending refers to lending secured by an asset. If the loan is not paid the asset is taken over by the lender.

Angel investment, venture capital investment and private equity investment plays a key role in raising money. These investors provide capital for ownership equity or convertible debt. Interestingly, business and personal credit cards are also commonly used for short-term financing of business operations.

Mezzanine lenders provide the additional (incremental) funding required for completing a business acquisition or business expansion project. It is usually structured as a hybrid between debt and equity financing for business expansion. Mezzanine financing may be debt financing, but gives the owner the right to convert debt to ownership equity in the company at a set price.