Chapter 41Pre Term Sheet Negotiations with the Buyer
It’s been weeks with no replies after the latest request for information when due diligence feels like years ago. You are questioning whether the potential acquirer is still interested in putting down an offer. At last, you see a text message or email asking for your closest availability for a call or a face to face meeting. Now what is this all about?
Chances are, this scheduled call is to discuss the terms for an offer. It would be incredibly easy to pass on an acquisition via an email. In fact, I have been personally rejected probably a hundred times, and only one was a rejection via a phone call because the potential acquirer was asking for some metrics just hours ago. So if you made it this far into the game, and your point of contact is asking for a meeting, expect this to be a deal term discussion.
At this point, you have already had the expectation alignment meeting, and the buyer has had an idea on what you are looking for, so it is time for them to show their cards. The conversation would go something like the following:
Acquirer: Exchange pleasantries, talking about vacations, weekend plans, etc for 3 mins, then jumping into business… Obviously we looked at this opportunity and the entire executive team is very excited about the prospect of working together. We would like to put an offer together.
You: Okay, great.
Acquirer: We love the products, the team, and also we think it's gonna be a great fit. But still, there are a bunch of risks still involved with the strategy and given there needs to be a lot of integration work, we will be eating a huge amount of capex and also increasing our opex with little upside in the beginning. Plus the market has been volatile and investor confidence is mixed on future prospects. Plus, there are risks that we discovered from the due diligence on your customer churns, technology defensibilities, flight risks of key employees, etc.
You: Okay.
Acquirer: We are thinking of doing an Asset Purchase given that there are a number of liabilities associated with the company that we don't want to assume.
You: Okay.
Acquirer: So here's what we like to offer. For closing considerations, we are willing to pay $X in cash and $Y in stocks for the assets. As for retention, we are willing to offer $Z in cash and $W in stocks over a 3 year term for key employees.
That's it. The actual conversation literally lasts five minutes, and now you have to figure out whether this is worth negotiating or reject outright. So let's break down the key components.
1. Deal Type
In a nutshell, there are three types of deal structures. Stock purchase, merger or asset purchase. Stock purchase is typically avoided on both sides as this would mean the acquirer company would go and purchase every single share that your company has ever issued at an agreed upon price. The problem with that approach is that any stockholder could potentially hold up the deal, whether it's an investor that you are no longer on speaking terms with or a disgruntled ex-employee who holds very few shares. Instead, the ideal case is to push for a merger, where depending on where you incorporated, the threshold for approving the deal could only be the majority of the board along with more than 50% of the shareholder vote. In both scenarios, the acquiring company purchases the entire company. In both cases if it's a full cash deal, then the proceeds would be considered capital gain, which has more favorable tax treatment depending on the holding period.
The last class is an asset purchase, where the acquirer picks and chooses which parts of the company they want to acquire, and which ones they don't. The drawback of this type of purchase is that the proceeds paid for the assets are considered ordinary income, and are subject to corporate level taxes. And when the proceeds get distributed amongst the investors and the team, they are also considered as income, so it essentially becomes double taxed. Typically startups have R&D tax credits or carry losses that can write off some if not all of the proceeds, but the distribution to the team would get taxed as ordinary income regardless.
If your company still holds significant cash in the balance sheet, it is imperative to clarify whether the company cash is also included in the deal with the acquirer. Your cash balance will make a material difference to the closing considerations.
If you have gotten this far in the process, this is also where you need to get on the phone with your M&A lawyers and tax lawyers will help you a lot in navigating the complications of the potential transaction. The headline is to push for a merger from the acquirer as a seller.
2. Considerations
This topic was covered in the expectation alignment chapter. Again, fundamentally, this is what the acquiring company gives to your company at the close of the transaction. It could be cash, stocks, or a blend of the two. The main thing to consider here is alignment amongst your key stakeholders on the preference or blend of cash versus stocks. In most cases, cash is preferred over stocks but if you get acquired by a private company, they may not have much cash on their balance sheet. In certain scenarios, your investors actually prefer getting stocks over cash for a hot private company whose private stocks are difficult to access in the secondary market. It could also help your investor's brand for their fundraising purposes when they present to potential LPs that they hold certain stocks in their portfolio. Or it could be the scenario where it's more tax advantageous for the investors to take stocks than cash. Be sure to ask your board member investors explicitly what they prefer during the negotiations in order to minimize conflicts down the road when it comes to the actual vote of the final deal documents.
The other dynamic in play here is that the acquirer would want to maximize the incentives for you, your cofounders, and your team and not pay a dime to your investors or ex-employees on your cap table if they can get away with it. The reason is simple: to the acquirer, the value is all in the team that is absorbed to their company, there is no value from your investors or ex-employees. So, what they would potentially do is minimize the considerations and instead load put the main payout in the retention.
This would put you and your investors in an adversarial position. Nevertheless, even if you have supervoting rights or hold a majority of the board, make sure the deal you get is fair for everyone involved. Silicon Valley is a small place, you never know the next time you'll be starting a company and need to raise money again. Take care of your investors and value all the relationships you made.
3. Retention
Retention is a combination of cash and stocks that the founders and team would get spread out over typically a two to four year period. If it's cash, it typically follows the structure of some amount payable at deal closing, and then evenly paid out on an annual basis until the conclusion of the retention period. And if it's stocks, it typically has a one year cliff and then vests either on a monthly or yearly basis until the end of the retention period.
And that's all there is to it when it comes to an offer. Now here comes the difficult part of negotiating this offer with the acquirer. Now here are a few things to keep in mind:
1. Don’t negotiate at this meeting, instead, ask for clarifying questions, and make sure you write down all the key terms and considerations. Do not show any reactions even if it’s a really great offer or a super bad one. Simply ask all the clarifying questions and let your point of contact know that you discuss this with your board and get back to her. Also, do not just accept the offer on the spot, this type of decision will almost always require board approval.
2. Make sure you have a waterfall ready along with a precise set of revenues and expenses factored in so you know exactly how much each employee will get at closing from the considerations. Triple check these numbers as you don’t want the nasty surprise that any key stakeholder is getting significantly less than what she anticipated at the moment when you sign the term sheet.
3. This is one of the rare occasions that having bankers actually adds value as they take the role of negotiating. By this point, you could be already exhausted by the process and wanting to get a deal done to take a bad deal, or you could be having unrealistic expectations and pass up on a great deal. Having bankers who have done these negotiations in the past can serve as a buffer between you and your future employer, where there is no ill-feelings when the negotiations get contentious and potentially acrimonious.
4. Your negotiation leverage is ultimately a function of how important your company is to the acquirer and if there are competing offers. Even if you do not have other acquirers in the mix, your runway, cashflow, quality of your product, expertise of your team and potential future fundraising prospects can serve as your leverage.
5. M&A valuations are rarely based on sound math or robust calculations. You can take any spreadsheets made by an analyst and change one single cell and the final output would be off by a mile. Instead, valuations are based on emotion. So the best way to manage that is to have a bottom line for what you are willing to take, and be prepared to walk away if that number is not met. Of course, don’t just come up with any arbitrary number as your bottom line. Make sure you can provide some justification whether it’s opportunity cost, comparable transactions, or price of remaining independent.
6. Typically a term sheet does not need to be produced by the buyer until the deal type, considerations and retention are all agreed upon.There is no need to rush the buyer to put everything on paper, as having these terms on paper gives these numbers a certain level of legitimacy, and hurts your chances of negotiating for better terms. Instead focus on negotiating the key terms with the acquirer over the phone or face to face.
7. Understand that whatever numbers you end up agreeing with at this point, they will be the best possible outcome you could get when it comes to closing. As the deal progresses past the term sheet phase and more negotiations and diligence are done, typically the buyer would find and take discounts on any missed quarters, key employee departures, or other business events that put you in a weaker position.
8. A book that I found useful when it comes to negotiations in general is Chris Voss’s book “Never Split the Difference”. There are tactics in the book that could be helpful for your negotiations.
9. Keep your board in the loop during the entire negotiation process. Ultimately, they need to approve the deal. If there is any feedback from the board regarding the economics, make sure to get alignment quickly and then pass those expectations back to the acquirer in the negotiations.
10. Because the cap table waterfall governs how the proceeds will be distributed at closing, there is often no ambiguity on how that money or stock gets divided up, and typically the acquirer would have already had your waterfall at this point. You will realize that how retention bonus is dispersed amongst the founders and employees are not yet discussed, this will typically be negotiated after the term sheet is signed.
11. Finally, don’t short change yourself or your team when it comes to this negotiation. Presumably everyone has worked super hard to get to this point, and unless you have absolutely no options but to sell, hold your head up high and act as equals at the negotiation table to get the best possible deal for your team and investors.
Now after rounds of negotiations, you and your acquirer have finally agreed on the deal structure, considerations and retentions, they are ready to send you the term sheet. Let’s look at how to study a term sheet in the next chapter.