7 minute read | December.02.2024
Orrick’s Tech Exit Series suggests tips for tech companies looking toward an exit. Our market-leading London M&A and Private Equity team writes instalments in the series with contributions from specialists across our broader practice.
Once you’ve found a potential buyer and agreed a headline price for your business, the next step is to focus on the term sheet, also known as a ‘heads of terms’ or ‘letter of intent.’ The term sheet:
While it can be tempting to just agree a headline price and leave other terms for later negotiations, founders / sellers have the most leverage to agree favourable terms before the proposed buyer gains exclusivity. As a result, they should agree as many key commercial points as possible at term sheet stage.
A well-drafted and comprehensive term sheet can take a lot of the pain out of negotiating the definitive sale documentation. We recommend involving your legal team early in term sheet negotiations. Your legal team can assess whether indicative terms are reasonable from a sell-side perspective.
When negotiating a term sheet for the sale of a company, founders or the company’s board should consider the following key points.
A headline price usually will be agreed by the time you start negotiating a term sheet. Ensure you understand how the valuation was determined, whether it's based on revenue, EBITDA or another metric.
This price will usually be expressed on a ‘cash-free, debt-free’ basis. That means the headline price (also referred to as enterprise value) will be reduced on a £ for £ basis by the amount of debt or debt-like items in the company. Conversely, it will increase by the amount of cash or cash-like items in the company.
If the buyer does not want to buy cash (often as a result of difficulties in transferring that cash between jurisdictions), consider whether it can be extracted prior to the sale in a tax-efficient manner.
The headline price generally will be adjusted to reflect a “normalised level of working capital.” This is intended to ensure the business is operating as normal. Otherwise, the price could be pushed up by, for example, accelerating collection of invoices.
One item that can be worth raising at term sheet stage, particularly for SaaS or other subscription-based businesses, is the treatment of deferred revenue. In some cases, a buyer may seek to treat this as debt-like, which can substantially affect the purchase price. If this is a significant item on the balance sheet, this should be dealt with in the term sheet.
Some buyers pay the purchase price in cash. Others may rely on debt or equity securities issued by the buyer. Equity consideration offers upside potential but carries risks if the buyer's share value fluctuates. The buyer’s covenant strength and any security package should be considered if debt or debt securities are offered.
It may be possible to achieve a higher valuation if part of the purchase price is contingent on future performance. If an earn-out is to be agreed to, it is important to ensure the criteria are measurable and realistic. It is vital also to agree with the buyer (at least in principle) to include certain earn-out protections in the definitive sale documents. That will ensure the founders or the company’s management team retain sufficient control over the operations of the target business (through board seats or otherwise) to give the sellers the best chance of meeting earn-out targets.
Founders and senior management should consider whether they wish to remain involved in the business following its acquisition. Agree with the buyer as early as possible on terms regarding the founders’ roles post-acquisition, including terms of new employment contracts, retention bonuses, non-compete covenants and the length of required employment.
It is also important to agree (at least in principle) any incentivisation programme for employees of the target company, whether that be the creation of a new option or bonus scheme or the ability of employees to participate in pre-existing schemes of the buyer.
Warranties are assurances given by some or all sellers covering all aspects of the target company and its operations. The warranties usually run to tens of pages and will be negotiated as part of the definitive documents.
At term sheet stage, it is important to agree who will give the warranties. All sellers would be expected to give their own warranties as to title to their shares and capacity to sell them. Other warranties are generally only given by founders and key management.
Separately, parties should agree who will provide coverage for breach of warranties. All selling shareholders would normally be expected to take their pro rata share of this liability, with the caveat that the liability of institutional sellers will generally be limited to an escrow or holdback.
It may be possible to obtain warranty and indemnity insurance to cover off some or all of this risk. If insurance is to be obtained, this should be agreed with the buyer early as it will impact the warranty negotiation. The parties will also need to agree on how the premium (which will run to several hundred thousand pounds at least) will be funded.
Be clear about what conditions (if any) must be met before the deal can complete or close. Conditions should as far as possible be limited to required regulatory approvals or third-party consents.
Ensure the deal structure takes into account any requisite approvals, including from the board of directors and shareholders. Consider whether all shareholders are likely to support the deal or whether it may be necessary to invoke drag-along provisions under the company’s articles (if any) to compel any difficult or uncontactable minority shareholders to sell their shares.
Companies should seek advice on the transaction’s tax consequences for the company and founders. The structure of a deal can affect shareholders’ tax burdens, so consulting with tax advisors early is essential.
Discuss how the company will integrate into the buyer's organization, the strategic vision and any changes in company culture or operations.
The buyer will almost certainly require a period of exclusivity to assess the proposed acquisition and allow the parties and advisors to work toward agreeing the definitive sale documentation. During this period, the sellers and/or the company will not be permitted to solicit offers or engage in negotiations with other interested parties.
The exclusivity period should be long enough (with the possibility of extension) to allow for completion of the transaction but not so long as to give the buyer a long-term option to complete the transaction. The company’s financial position and prospects may change during the exclusivity period, and long exclusivity periods carry inherent risks.
Agree how to resolve disputes during or after the transaction. This could include arbitration, mediation or specific jurisdictional considerations.
Generally, each party will pay their own costs. However, a seller that has leverage may ask for an element of cost-coverage (or a break fee) from the buyer in circumstances where the buyer withdraws from the transaction or seeks to renegotiate agreed provisions of the term sheet.
A comprehensive and well-negotiated term sheet can protect founders and sellers on a sale transaction. It also can streamline negotiations on the definitive sale documentation, minimising advisor fees. Our London M&A and Private Equity team is well-equipped to advise on term sheet negotiations. If you would like to discuss your exit process, please contact James Connor, Katie Cotton or Dan Wayte.