Negotiate Term Sheet or Letter of Intent

Negotiation is a process that begins with the very first contact with a potential buyer. Forthright personal interaction with all potential buyers is important to maintain mutual personal respect, save everyone’s time and get to the heart of whether a deal is possible and mutually beneficial.

When necessary, you should be prepared to use other members of your team or outside intermediaries (lawyers, accountants, or M&A professionals) to take the heat from contentious discussions.

This is the time when the objectives you set out in Step 1 come into play. You must establish your own priorities including understanding the type of deal structure you prefer. Here are some alternatives to think about:

Structure

What is being purchased (stock or assets)?
How much is being paid?
How and when it is being paid?
Are there other supporting items to consider, including contingencies?

10 Forms of Payment

Cash
Stock
Debt assumption
Employment
Stock options
Consulting
Non-competes
Earn-out
Retention pool
Profit sharing

How You Structure Your Sale Depends On

Your revenue, industry, age and profitability
Complexity of your ownership and debt situation
Dynamics of your ownership (Are there conflicts among various owners? Are there outstanding options, etc.)
How “Active” are some shareholders vs. other “Passive” shareholders
Buyer’s capabilities, capacity
Tax considerations of both organizations

There are many experts who believe that STRUCTURE IS MORE IMPORTANT THAN PRICE!

Stock vs. Sale of Assets

When Stock is Purchased:

All of the outstanding shares of stock are transferred
The buyer operates business uninterrupted
Seller has no continuing company interest or obligations
Often allows the seller to completely step away from the business
Seller is usually entitled to pay taxes at the capital gains rate
Assets and liabilities are sold
May include tax loss carry forward
Leases, loans, etc. may be transferred

When Assets are Purchased

No shares of stock are transferred
Liabilities and taxes remain
Company shell remains
The seller retains ownership of the company
The buyer must use another entity for the transaction
Only specifically identified assets and liabilities are transferred
Other assets and liabilities remain
Eliminates need to negotiate purchase of share for minority/dissident shareholder

Assets Purchased Complexities

Ownership of the assets and liabilities and any related contracts must actually be transferred
Fair market value gains must be determined
“Bulk Sales” rules may apply requiring notification of all of the creditors of a business
Possible transfer of the corporate name
Rehiring of employees by the buying entity

When Assets are Purchased

The purchase price must be allocated among the different assets for tax treatment, buyer deduction:
Tangible assets
Customer lists
Non-competes
Consulting agreements
Patents
Royalty agreements
Other intangibles
Goodwill

Tax Impact: Stock vs. Sale of Assets

The Structure you choose will have a major effect on how much you are capable of being paid for your company. In general, an “earn-out” will allow you to receive a higher overall price than receiving cash (which is least risky for a seller).

Earn-Out

Can be revenue or profit based
May take the form of royalties, commissions, OEM licenses, profit participation, etc.
Is often capped and may have “break points” which stipulate payment schedules
Can potentially be divisive and hinder integration because of conflicting goals

Earn-Out: A Potential Shareholder Dilemma

There are potential legal problems with enforcement (e.g. If the entity is dissolved)
Payout may be part of a key person’s employment agreement
Potential problems between “active” & “passive” investors
May involve performance stock options
Those staying with the company receive more than those who leave – or are no longer needed

Transactions that take place between a Seller and Buyer from different countries create Cross-Border Issues

Unique aspects of cross-border transactions can cause delays in closing
Stock Transferability (Listing problems)
Regulatory Approvals (Slow government review)
Foreign Exchange Limitations (Currency control)
Reduction in Force (RIF) (Local labor laws)
Tax may be deferred if shares are exchanged for foreign securities
You may need international counsel
Foreign Ownership Limitations: Some countries limit ownership to less than 50% or require at least some local ownership
Nesting/Tax Shelters: Many countries allow layers of ownership with capital gains exemptions and offshore holding company ownership
Reporting Periods: May be very different and permit long reporting delays
Quality of Reporting: Some countries are less strict on their reporting so the quality of data may be poor or misleading and not readily available

Closing Thoughts on Deal Structure

Structure is more important than price
Deal structures vary, based on revenue, industry, age or maturity of the company, profitability, etc.
Flexibility on deal structure increases potential of a successful deal and perhaps the price
Several forms of payment (stock, cash, earnout) are likely to be used in a transaction
Each payment form has advantages and disadvantages and should be evaluated in the context of your personal goals

In most cases as you negotiate the Deal Structure, you will have the most leverage early in the process of negotiating the Term Sheet. Make sure the potential buyer understands your basic deal parameters and try to understand the buyer’s wants and needs.

What Elements of the Deal are You Negotiating?

Buyer

Price
Structure
Liabilities
Taxes
Employment
Non Competes

Seller

Price

You want the buyer to pay at least Intrinsic Value
The Buyer would prefer to pay less
You want the buyer to assume most, if not all, of the risk

Risk

Assuming you have a strategic buyer, you want him to share the delta between Fair Market Value and his Strategic Value; the buyer would prefer to keep it all
He would prefer that you take all the risk for an unlimited time.

Typical Negotiation Flow

Negotiation: The Basics

Negotiation is not an event, but a process that begins with the very first contact
Early and personal interaction is important
Use your intermediaries to take the heat from contentious discussions
Determine your own position before beginning
You have the most leverage early in the process
Make sure the potential buyer understands your deal parameters before you solicit an LOI
Try to understand the buyer’s wants and needs
Express appreciation for buyer efforts
Don’t offer a positive view of the buyer’s position in a way that implies your acceptance of it
Avoid buyer serial negotiation – agree on items, document them and move on to other issues
Build a negotiating framework leading to common ground
Deal honestly and openly – don’t get emotional
Be flexible and open-minded
If you encounter a “screamer,” have at least one additional person from their team present at negotiations
Include “straw men” to let the other side win; do not expect to win every point

When You Have to Dig in Your Heels:

At least agree with the buyer on what the outstanding issues are, before taking a break from the negotiating table
Do not walk away before reinforcing all of the reasons why the deal should proceed
Do not walk away without giving the buyer a clear path back to the negotiating table

Typical Buyer Tactics include

Hiding the true level of interest they actually have
Attempting to receive all the benefits of an acquisition
Disputing the quality of the valuation, e.g. “Your price is unreasonable – sharpen your pencil”

Typical Seller Tactics include

Creating competition – trying to move toward an auction process
Revealing problems early while leverage is highest
Being specific in the LOI (Letter of Intent)
Avoiding or limiting a “no-shop” condition
Tying exclusivity to buyer achieving milestones
Negotiating a creative structure to close the valuation gap between buyer and seller
Closing as quickly as possible

Key ingredients to Seller Conduct during the Negotiating Process

Understand your market value
Be transparent and responsive
Run a fair and efficient “auction” among prospective Buyers
Don’t be greedy

IF A BUYER SENSES YOU ARE PLAYING GAMES, THEY ARE LIKELY TO MOVE ON

Judicious Use Of “Outsiders” *

There are going to be times and situations when you will be well-served by having expert outside assistance. Here are a few examples:

M&A Lawyers’ Responsibilities

Corporate law – governance, rights & duties of board and shareholders
Contract law
Intellectual property – trade secrets, copyright, trademark, and patents
Tax law
Securities laws (public and private company stock)
Employment, pension, employee benefits, and ERISA

Note: AN INEXPERIENCED ATTORNEY CAN KILL THE DEAL*

The Role of Your Accountant

Review your business’s financial records to ensure GAAP compliance and assist in recasting financials
Assemble new or adjusted financial statements
Answer questions from buyer’s due diligence team
Address tax issues raised by either party
May supply staff to help with PQ

Advantages of an M&A Intermediary, Consultant, Wealth Manager or Banker

Provides a link to a broad base of qualified, potential acquirers (auction process)
Help you best prepare and position
Value the business and validate a fair price
Obtain a substantially better financial package
Have contract examples from other deals
Allow you to focus on running your business

LOI-to-Closing Process

PQ provides template LOI’s for reuse in your sales effort (must be reviewed and approved by your attorney).

Letter of Intent (LOI) Terms

Agreed purchase price – structure
The parameters and procedures to proceed toward a definitive agreement
Confidentiality
Rules for accessing due diligence materials
No shop – seller’s biggest control item
Standstill provisions
Conduct of business; Hire/fire; balance sheet, etc.
Breakup fees
Contingency price adjustments
Jurisdiction

Conditions for completing the deal

Successful completion of due diligence
Execution of the definitive agreement
Perhaps other milestones
Closing date

Example of LOI Evolution

PQ can provide a list of preferred third-party advisors for Step 10 including Merger & Acquisition Specialists, Wealth Managers, Tax Consultants, Lawyers, Accountants and more.

Phase 3 Step 10: Negotiate Terms