The term sheet: Where many M&A transactions are really negotiated

For many business owners, receiving an offer from a prospective buyer is an exciting milestone. Months, or sometimes years, of preparation may have culminated in meaningful discussions with potential acquirers. A preferred bidder has emerged. Commercial discussions have progressed. The buyer now presents a letter of intent, indication of interest or term sheet outlining the proposed transaction.

At this stage, many sellers make a critical mistake. They focus almost exclusively on the headline valuation. If the proposed purchase price appears attractive, the document is often viewed as a preliminary formality: a stepping stone towards due diligence and the definitive transaction agreements.

In reality, experienced dealmakers tend to view the situation differently. In practice, however, many of the most important commercial aspects of a transaction are often discussed, negotiated and agreed in principle before due diligence begins. For that reason, sellers should approach the term sheet stage with the same level of attention and strategic thinking that they would devote to any other critical phase of the transaction process.

What are a letter of intent and a term sheet?

Different transactions use different terminology. Some buyers submit a letter of intent. Others provide an indication of interest, a memorandum of understanding or a standalone term sheet. While the terminology varies, the underlying objective is generally the same: to record the principal commercial terms of the proposed transaction before significant time and resources are invested in due diligence and definitive documentation.

In many transactions, the letter of intent itself is relatively short and incorporates a more detailed term sheet setting out the proposed transaction structure. For sellers, the distinction is usually less important than the substance. The key question is not what the document is called. The key question is whether the parties are aligned on the principal commercial terms of the transaction.

The headline price rarely tells the full story

When sellers receive competing offers, the natural tendency is to compare purchase prices. However, experienced buyers understand that transaction economics are shaped by far more than a single number. Two offers with identical headline valuations may produce significantly different outcomes. For example:

• one buyer may propose a fully cash-funded transaction;
• another may require a substantial earn-out;
• one may request a significant escrow or holdback;
• another may seek a rollover investment by management;
• one may offer a clean exit;
• another may expect long-term involvement by the founder.

All of these elements affect the economic reality of the transaction. A transaction structured as a full cash exit may produce a very different outcome from a transaction involving rollover equity, deferred consideration or significant post-closing performance conditions, even where the headline valuation is identical.

A sophisticated seller therefore evaluates the entire proposal rather than focusing exclusively on valuation. In many cases, the quality of the offer matters as much as the size of the offer.

The transaction framework is often established here

Many sellers assume that the substantive negotiations begin once lawyers start drafting the definitive transaction documents. In practice, that is often too late. By the time the parties reach the drafting stage, important commercial assumptions may already have been established. These frequently include:

• the overall valuation;
• the transaction structure;
• the scope of the sale;
• management retention expectations;
• rollover equity arrangements;
• earn-out concepts;
• purchase price adjustment mechanisms;
• transaction timing.

While the definitive agreements remain subject to negotiation, parties are often reluctant to revisit commercial positions that were agreed in principle earlier in the process. As a result, decisions made at the term sheet stage frequently influence negotiations throughout the remainder of the transaction. The term sheet therefore serves an important purpose. It allows the parties to determine whether they are genuinely negotiating the same transaction before significant time and resources are committed.

Exclusivity is often more valuable than sellers realize

One of the most important provisions frequently included in a letter of intent is exclusivity. Under an exclusivity arrangement, the seller agrees not to negotiate with competing buyers for a specified period of time. From the buyer's perspective, this is entirely understandable. Once due diligence begins, significant resources are invested in reviewing the target business, engaging advisers and preparing transaction documentation. Buyers generally want confidence that the seller will not use those efforts simply to negotiate with competing bidders.

For sellers, however, exclusivity represents a significant concession. Competition is often one of the most powerful drivers of favorable transaction outcomes. Once exclusivity has been granted, the balance of negotiating leverage frequently shifts. This does not mean exclusivity should be avoided. Rather, sellers should recognize that exclusivity has value and should not be granted casually. The duration of the exclusivity period, the buyer's expected timetable and the scope of exclusivity all deserve careful consideration.

Purchase price mechanics often begin here

Many business owners assume that purchase price mechanics are addressed later in the process. In practice, they are often introduced at the term sheet stage. A proposed valuation may appear attractive until the underlying assumptions are examined more closely. Questions that frequently arise include:

• Will the transaction be structured using a locked-box mechanism or completion accounts?
• How will cash and debt be treated?
• How will working capital be addressed?
• Are earn-outs contemplated?
• Will any portion of the consideration be deferred?
• Will part of the purchase price be reinvested into the buyer's acquisition structure?

These concepts may seem technical, but they can materially influence the seller's ultimate proceeds. For that reason, sophisticated sellers seek to understand not only the proposed valuation but also how that valuation will ultimately be translated into purchase price.

The right time to identify potential misalignment

The term sheet stage is also an opportunity to identify potential transaction risks before significant time and expense are incurred. Buyers and sellers may have fundamentally different expectations regarding:

• valuation;
• management retention;
• transaction timing;
• future involvement of founders;
• treatment of key employees;
• post-closing governance;
• growth expectations following closing.

Identifying these differences early benefits both parties. It is generally preferable to discover a fundamental misalignment before entering exclusivity than after several months of due diligence and negotiations. The most efficient transactions are often those in which commercial expectations are aligned from the outset.

Startups and growth companies require additional attention

For venture-backed businesses, the term sheet frequently raises additional considerations. The transaction may affect not only founders but also investors, option holders and management participants. Issues that commonly arise include:

• liquidation preferences;
• investor consent rights;
• drag-along provisions;
• rollover equity arrangements;
• retention incentives;
• future governance rights;
• treatment of employee participation plans.

In some cases, a transaction that appears attractive from a founder's perspective may have different implications for investors or employee shareholders. Similarly, a buyer may structure an offer in a manner that affects different stakeholder groups differently. Understanding these dynamics at an early stage can prevent significant complications later in the process.

Experienced advisers add value earlier than many sellers expect

Business owners sometimes assume that legal advisers become important once the definitive transaction documents are being drafted. In practice, many of the most important strategic decisions arise earlier. Understanding the implications of exclusivity provisions, purchase price mechanisms, earn-outs, rollover arrangements and transaction structure at the term sheet stage can materially influence the outcome of the transaction long before the share purchase agreement is negotiated.

By the time definitive documentation is being prepared, many of the key commercial parameters may already have been established. The earlier sellers understand those parameters, the better positioned they are to negotiate effectively.

A strong process creates leverage

Business owners sometimes focus on obtaining a term sheet from a buyer. Experienced dealmakers focus on obtaining the right term sheet under the right circumstances. The strongest transaction outcomes are often achieved through a competitive process involving multiple credible buyers. Competition not only influences valuation, but frequently improves deal structure, transaction certainty and negotiating leverage.

A seller who receives several attractive offers is generally in a stronger position to negotiate exclusivity, purchase price mechanics and other key commercial terms. For that reason, the objective should not merely be to secure a term sheet. It should be to create a process that allows the seller to evaluate competing alternatives from a position of strength.

Conclusion

Term sheets are often viewed as preliminary documents. In reality, they frequently play a far more important role. Many of the key commercial parameters of a transaction are often discussed, negotiated and agreed in principle before due diligence begins and long before the definitive transaction documents are signed.

For sellers, the lesson is straightforward. Do not evaluate a term sheet solely by its headline valuation. Consider the entire transaction framework. By the time lawyers are negotiating the definitive agreements, the commercial architecture of the transaction has often already been established. Sellers who recognize this early are generally better positioned to negotiate favorable terms, preserve competitive tension and ultimately achieve better transaction outcomes.

In the next article in this series, we examine what happens after the term sheet is signed and how buyers really assess a business during due diligence.

This blog post is for discussion and general information purposes only and should not be considered as legal advice.