Table of Contents
- M&A Transaction Structure:
- Asset Purchase:
- Stock Purchase:
- M&A Purchase Price:
- Continued Employment:
- Escrow Funds or Hold Back:
- Purchaser Indemnification:
- M&A Due Diligence:
- Breakup Fee:
- M&A Transaction Expenses:
- No Shop or Exclusivity:
- Confidentiality or Non-disclosure:
As a San Francisco, California Securities and Business Attorney I have reviewed hundreds of Mergers & Acquisitions (M&A) term sheets (also known as Letter Agreements or Letters of Intent (LOI) Memorandum of Understanding (MOU)).
If you are purchasing a startup company or if you are a startup founder selling a company let this article outline some of the key terms you will need to know when drafting and negotiating a Merger or Acquisition Term Sheet.
M&A Transaction Structure:
There are several complex company acquisition structures, however, for this article, we are going to concentrate on two common M&A structures, Asset Purchase and Stock Purchase.
Asset Purchase:
An asset purchase is where the acquirer only purchases the valuable assets of a startup corporation. Typically, this would be the startups’ intellectual property, real property, customers, good will, client lists, contracts, software etc.
The purchaser typically likes this structure because they can purchase the startup’s assets and not any of the company’s liabilities.
Furthermore, the acquirer of the startup will get to deduct the depreciation of the asset on their taxes.
This seems like a great deal for everyone, except, it’s not, the shareholders of the acquired startup company end up paying a harsh amount of taxes. Any good M&A attorney will urge the startup founders away from this structure.
Stock Purchase:
A stock purchase is just as it sounds, the acquirer purchases the entire startup company with all the assets, debts, and liabilities. By far this is the most favorable structure for the startup funders and startup investors.
The buyers are generally less than enthusiastic about this structure because they also purchase all the liability from the startup company.
M&A Purchase Price:
Rarely do the startup founders and/or shareholders receive all the money upfront.
No matter how hard your M&A attorney negotiates the typical structure is about 50% at closing and 50% released over a few years after the closing of the M&A acquisition.
The compensation can be all cash, however, there could be a mix of some cash and some stock in the acquiring company.
Continued Employment:
Another key term in an M&A Term Sheets is an Earnout of the purchase price based on the startup founding team’s continued employment with the purchasers’ company. You have probably heard of this before as an Earnout, or Golden Handcuffs.
The purchaser will require the startup’s key team members to continue working for their company for between 12-24 months as a condition to receive a large part of the purchase price.
The employment agreement will typically have a clause that protects the startup founder if the purchasing company fires the key employee without cause. If the startup founder is fired without cause, then the employee’s Earnout will be accelerated.
Escrow Funds or Hold Back:
As part of an M&A acquisition, the purchaser will withhold part of the purchase price, typically between 10-20% Held Back for 12-24 months to cover any unexpected cost, undisclosed liabilities, disgruntled employees, taxes, etc.
Purchaser Indemnification:
The purchase is happy to take the upside of a company, but reluctant to accept the liabilities and losses.
To compensate for this the selling startup (founders and shareholders) will Indemnify (meaning defend and pay any damages related to a loss) the purchaser for a period of 12-36 months.
Basically, if the startup company or the assets of the company are sued for anything that occurred before the closed transaction, then the purchaser can claw back some of the initial purchase price, the escrow, and/or the Earnout.
It is important to have your M&A attorney review this clause carefully, there is generally a lot of back and forth between the purchaser’s attorney and the startup seller’s attorney related to Buyer Indemnification.
M&A Due Diligence:
Due Diligence it the process where the M&A purchaser gets to look under the hood of the Startup company. Typically, the startup’s attorney will send a Non-Disclosure Agreement (NDA) to the purchaser.
This agreement at least on paper protects the startup’s intellectual property and trade secrets. This can be a touchy endive for a startup company, especially if the purchaser is a competitor.
Sometimes the seller and the purchaser will agree that some information will be withheld until after the Closing of the acquisition.
Otherwise, there can be a Breakup Fee in the event that the negotiations break down (more on Breakup Fees below). The due diligence is threefold.
1) Legal Due Diligence:
This is an in-depth look at the startup company’s corporate documents, contracts, state and federal filings, patents, trademarks, copyrights employment agreements, consulting contracts, lawsuits, terms of service, privacy policy, licensing agreements, cap table, stock certificates, stock purchase agreements, board resolutions, shareholder resolutions and on and on, you get the idea.
The startup’s attorney will set up a data room and start updating the corporation documents. The purchaser’s attorney will then do a review of each and every contract going back for years.
2) Financial Due Diligence:
This is an in-depth look at the company’s books, earns, tax accounting, sales, and general projections. The startup’s CPA and tax attorney will submit all the relevant documents to the Purchaser’s attorney for review.
3) Technical Due Diligence:
This is a look under the hood at the startup’s company technology.
Depending on the total price the purchaser may hire an outside tech firm to review the technology the ensure that the code is scalable, unique, and does not violate anyone’s copyrights. If the startup is a tech company this will by far be the most intense and time-consuming part of the acquisition.
Breakup Fee:
You will not find breakup fees on all deals. The Breakup fees are typically between 5-20% of the total deal size. These fees are reserved for a few different seniors.
- If the startup company is receiving multiple offers with non-shop clauses. Under this scenario, the purchaser may offer a breakup fee if the startup company needs to reject another offer.
- If the startup company is going to reveal trade secrets or otherwise disclose confidential information to a competitor company.
- If the due diligence and negotiation are going to be costly and time-consuming.
M&A Transaction Expenses:
As a rule, the startup and the acquirer both pay their own M&A attorneys and attorney’s expense. The acquirer will pay for their attorneys to conduct due diligence and pay their attorneys to draft the documents.
However, the startup company will be on the hook for its own attorneys and tax reviews. When looking for an M&A transaction attorney or law firm it is important to find a person and firm that matches your philosophy and the deal.
Over the past 10 years working as a startup M&A attorney I have seen hundreds of deals; inevitably we have seen startups or acquirers hire an attorney that does not match the intent of the parties.
One common scenario we have seen is with a friendly M&A between two complementary companies, the founders both meet and decide to move forward with a mutually beneficial merger.
The acquirer hires an attorney with a big ego and plays a winner take all game, this attorney bullies the target startup company, push each term without mercy.
This type of attorney has its place in the legal community; however, they should not act as the lead attorney on a friendly M&A startup acquisition.
We have also seen large law firm that represent a small startup company which is being purchased by a large public corporation in an M&A.
In this scenario the large law firm is timid, there attorneys will not zealously represent the small startup, there attorneys have their eye on landing the public company as a client in the future, the attorneys are afraid that if they negotiate too hard against the public company that they will lose the change to sign them as a client in the future.
When interviewing attorneys for an M&A one should look for an attorney who has the knowledge and experience, yet also will zealously represent the purchaser and/or startup company.
No Shop or Exclusivity:
The no-shop or exclusivity clause limits the startup company’s ability to shop the terms or to accept other offers from other interested purchasers or investors.
This is a standard term and is in place to protect the purchase’s investment of time and money during the due diligence and document negotiation.
The Exclusivity generally starts when the term sheet has been signed and lasts for 30-60. During this time the startup company cannot disclose the terms of the deal and must notify the purchaser if the startup receives new offers.
Confidentiality or Non-disclosure:
Mutual Non-disclosure is a standard term in any Term Sheet.
This protects the purchaser’s financial information, marketing plans, and other information from being disclosed to the public.
More importantly, the confidentiality clause will protect the startup target company’s proprietary nonpublic information during the due diligence process. The terms of the are typically not boiled into the Term Sheet, but rather in a separate mutual non-disclosure agreement.
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By Eric Milliken, San Francisco Business Attorney.
