There is a lot of internal choreography that must take place before a company can issue a term sheet. For the startup, which has likely been left in a holding pattern while the wheels turn at the company, receiving a term sheet is usually a very positive development, as it unambiguously marks the real beginning of the acquisition process.
Term sheets normally require a response within a couple of days, so startup founders should take the time to familiarize themselves with the main terms of a typical term sheet in advance of actually receiving one.
It is not a long document, the format is pretty standard, and there is a relatively small set of legal terms commonly used. Unpacking the legalese and understanding what is meant is probably not a process founders want to undertake when big numbers are involved and there is time pressure to respond.
The term sheet’s function is to put the main aspects of the deal down in writing for both parties to agree on.
The balance sought is for these points to be detailed enough that both sides feel they understand the key elements of the deal while at the same time keeping them at a high enough level that both sides don’t immediately get bogged down arguing over the nitty-gritty.
On a positive note, recently, there has been a general push to make this process more transparent. In fact, Atlassian has recently openly published their standard term sheet, which is a good example that includes most of the common terms.
The first thing founders should be aware of is that term sheets are typically non-binding. This phrasing can feel ominously legal, but this is not something that should cause concern. The company is simply being clear that just by issuing this term sheet, it does not take on the legal obligation to buy the company quite yet.
Of course, the purchase price is the headline number most startup founders will jump right to, but it is important to keep reading.
While the purchase price does represent the amount that each of your shareholders will receive a share of after closing, it may not represent the total consideration for the deal. Some term sheets break up the payments into a purchase amount and a retention amount (or retention “pool”).
Other terms will outline how and when the startup founders (and the rest of the team) will receive their payment and what form this payment will take.
In virtually every case, it will be important to the company to ensure that the startup team is incentivized to stick around and be motivated to execute after the deal is closed. There are several mechanisms the company can use to accomplish this.
The most common one is to schedule the payment amounts to the startup founders over a period of time. The company will typically “hold back” a portion of the purchase amount and release it over time (typically two to four years).
For example, the company may offer to purchase a startup for $10M. The structure they propose is to pay the founders (+ team) $2M upon closing the deal and hold back the remaining $8M. They then intend to pay out the remaining amount at a $2M rate each year for the next four years.
This type of scheduling can give heartburn to startup founders, but they should understand that it is a fairly standard arrangement.
Another way to handle the scheduling of payments, or to ensure that the wider team is similarly motivated, is through the separation of the purchase price and a retention pool that will vest over time.
The critical distinction is that only the team members who will work at the new company will share the retention pool, not all the existing shareholders. So, some careful messaging for the investors and any departing team members may be necessary.
The form of payment is also important — i.e., is the company offering cash or equity, or some combination? Commonly, equity will form at least part of the consideration. Founders should be sure they understand the related implications around risk and liquidity — especially if the company isn’t publicly traded.
The term sheet will also include some reference to the due diligence process. In essence, the company needs to make sure that everything is as it appears — or rather, that everything is as the company currently understands it is. The company wants to ensure that they will not be surprised by any new and substantial information.
A vital issue for founders is to be sure they have clarity on whether or not the company intends to offer positions to everyone in the current team. If not, this is something that needs to be clearly understood and actively managed.
The founders, or founders plus “core” employees, will most likely have to sign non-compete agreements as well. This states that they won’t compete directly with the company in this particular business niche for a year or two after leaving.
Indemnification is the company is saying that they will not take financial responsibility for any damages until the relevant situation has been discussed and the best way to handle it has been clearly agreed upon. In other words, the founders agree to indemnify the company from this (currently unknown) risk.
The term sheet will also likely make a provision for some percent of funds to be withheld (or insurance that will need to be purchased) in order to deal with any claims that arise. This is the type of nitty-gritty that really belongs in the main document discussion. However, it is often best to be explicit and get it out into the open.
There will also be an explicit reference that the startup will also be responsible for all costs incurred in executing the deal. If the company covered all costs, the startup would then have an incentive to find the most expensive lawyers possible, who, in turn, would be incentivized to drag the process out as long as possible to maximize their fees. Dragging the process out is definitely something that both sides should want to avoid.
In signing the term sheet, the startup will likely be committing to a period of “exclusive dealing.” This means the founders plan to continue the discussions with the company in good faith and won’t “shop” the deal to other companies as the process evolves.
No company wants to incur the cost and disruption associated with initiating a deal if they don’t fully expect to see the process through to completion. By the same token, they are expecting a similar commitment to the undertaking from the startup.
Again, this is not really something to be worried about. If something causes the founders to re-evaluate the deal during the process, there is a mechanism to end the process.
Finally, a non-disclosure agreement (NDA) will usually accompany the term sheet. Finding the right time to sign an NDA can be a source of contention for both sides. For most deals, this is the first point in the process where an NDA really becomes relevant, so both sides can feel comfortable enough to start sharing proprietary information.
Click here to see the previous blog in this series, which brings some much-needed transparency to the M&A process for startup founders.
If an acquisition is a potential exit for your company, you should check out my book — “How to stick the landing: The M&A handbook for startups.”
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