Mergers in the education sector
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This article is written by Aswathy, pursuing a Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from Lawsikho.

Introduction

After setting up your business successfully, it is now time for you to move on and you have a potential buyer waiting around the corner. Or, it is time for you to bring in strategic investors and you finally have investors who are interested in your business. You may be the buyer/investor or seller/investee in the above scenarios. The next step for you as a buyer or a seller would be negotiation and setting out the key commercial terms for the proposed investment/sale. This article seeks to cover the key terms of negotiation and important things to keep in mind while negotiating the terms of a deal in order to ensure maximum risk mitigation for the buyer/investor and minimum risk exposure for the seller/investee company.

A term sheet, also known as a memorandum of understanding (MoU) is essentially a document that outlines the key commercial and legal terms of the transaction that the parties propose to enter into. It outlines the conditions or key terms of the investment such as pre-valuation of the company, investor’s rights, lock-in, degree of control, exit route, etc. Term sheets are mostly non-binding in nature, however, they may contain certain clauses which are binding in nature such as exclusivity or confidentiality clauses. The clauses of a term sheet must be carefully negotiated as it sets the tone for the deal. The important things to keep in mind while negotiating the key terms of a deal shall be delved into in this article. This will be addressed under the heads of fiscal aspects of the deal, investor’s rights, degree of control, and representations and warranties.

Fiscals of the deal 

Every investor’s core interest lies in maximising his returns from the company that he invests in, and every investee company’s core interest lies in the infusion of funds into their company. Therefore the economics of a deal are of primary importance. This includes pre-money valuation of the company, option pools, and dividends, etc.

Valuation of the company 

The amount of investment will be determined based on the pre-money valuation of the company. The primary aim of valuation is also for an investor to see how much a company is worth at the time and how much it will be worth after investment and the choice or decision of investment will be based upon this. There are various methods used for valuation, such as asset-based model, market-based model, comparable company technique, or the discounted cash flow model, etc. Determining pre-money valuation can be a difficult task, as there may often be disagreements on the price offered by the investors or the methods of valuation employed. This often becomes a tough negotiating point. Here are a few quick cues (QC)  for this stage –  

  • QC for founders/company – Know your worth, self-awareness is key. Be prepared for a fair fight for the right valuation whilst being aware of the market value of your company. This also includes being aware of everything your company brings to the table, including the factors which can be valuation subtractors as well as factors that you can use to leverage the valuation negotiation. Such self-assessment and awareness will also come in handy during the better/compromised terms for lower/higher valuation trade-offs.
  • QC for the investor –  The Right Offer/Lowball Offer – Although often frowned upon, the classic move of the lowball offer can prove to be useful if used correctly. The idea here is to start at a lower valuation and let that be the starting point of the negotiation. However, there are a few important things you must consider before fixing the lowball offer amount. Find out whether the company has other interested investors lined up who may potentially offer higher prices. Also, know the company’s market valuation or valuation based on any valuation model so that you can keep your low offer at a fairly reasonable level. These will ensure that you do not lose the company while maintaining your leverage. Lastly, be sure not to compromise too much on key terms in return for a lower price.

Option pool

Option pools are the set of stock set aside by the company to give to employees of the company and are often used as an incentive to attract talent into the company. These option pools are normally stock which will be given to the employees if and when the company goes public. Option pools are mostly part of the pre-money valuation. This assessment is valuable for both parties in order to understand how their individual stakes may be affected. When option pools are made a part of the pre-money valuation, it mostly so happens that the dilution of shares is borne by the founders of the company alone and the investor’s share remains unaffected. Although this scenario is not in favour of the founders, dilution of their stakes is not a favourable circumstance for the investors either, and therefore it is important to gain a middle ground here. 

  • QC for founders/company – You can protect your stake in the company from further dilution by pre-determining the hiring plan for the coming 12-18 months and sizing the option pool around the same. This way, you will be able to keep the option pool to the minimum and you can convince your investors of the same by showcasing your hiring plan in case they insist on keeping the option pool size larger than your estimate. Therefore, have a hiring plan to effectively negotiate on option pools. 
  • QC for investors – Including option pools in the pre-money valuation is all about yet another way of lowering the price. Although this effectively protects your interests, it is more advisable, to be frank about the price concerns with your founders and therefore keep the negotiation more transparent and conflict-free. If you are willing to settle for a lower price with a smaller option pool or no option pool, then do put this across! 

Investors’ rights : protecting your investment 

Once the economics of the deal are figured out, next are the terms that give the investor certain rights and ensure the protection of his investment in the company. These rights include founder vesting, right of first refusal or ROFR, and no-shop clause among others. Negotiations pertaining to these terms must be dealt with meticulously in order to ensure both parties’ interests are protected. 

  • Founder lock-in: Part of the reason that an investor chooses to invest in a company is in most cases his faith in the ability and talent of the management i.e founders of the company and therefore it is in their interest to retain the founders for the investment period. Founder lock-in clauses restrict the founders from selling, assigning, transferring, or pledging their shares. Typically, the period of this restriction goes on until the investor has completely exited from the company.
  • QC for founders – The founders can negotiate terms to be able to engage at least in the partial sale of their shares after a brief mandatory lock-in period during which shares cannot be sold. This will enable you to have some amount of personal freedom to manage your personal financial needs without getting into debt.
  • QC for investors – While negotiating terms of mandatory lock-in period and restrictions on the sale, it must be ensured that the lock-in restrains the founders from reducing their shareholding to below majority so as to keep them sufficiently interested and invested in the business.  

Right of First Refusal (ROFR)

A right of first refusal or (ROFR) clause entails that in the event that the founders decide to exit the company by selling off their shares to a third party, the investors should have the first right to purchase the founder’s shares. Typically in a ROFR situation, the founders, after receiving an offer on the shares from a third party, must offer the shares to the investor on the same terms and he can go ahead with the sale of the shares to the third party only if the ROFR holders refuse to buy those shares. This clause protects the interest of the investors in the event of the founder’s exit.

  • QC for founders/companies – Founders must ensure that the ROFR provisions are not overarching in nature and that they ensure the protection of their interests as well. For example, the founders can negotiate a term which states that the ROFR provisions cannot be exercised by the holders unless they agree to purchase all of the shares. Another option for founders is to try and negotiate a ROFO, that is right of the first offer instead of a ROFR. A ROFO entails that the shares must be offered to the investors first and the investors must make an offer price on those shares. If the founders find this price unsatisfactory, then the founders are free to accept a third-party offer which may be at a higher offer price. 
  • QC for investors – It is important to remember that the primary objective of the ROFR clause is to protect investor interest in the event that the promoters, who were the very reason for the investment in the company, chose to exit the company and not to gain any other kind of leverage and hence the negotiations must be carried out with this in mind.

No-shop clause

A no-shop clause, also known as the exclusivity clause, sets down that the founders of the company cannot enter into any negotiations or dealings with another investor while the deal is being negotiated upon. The clause essentially seeks to provide security to the investor that he can continue negotiations or dealings without the fear that the deal may fall through in the event that the founders receive a better offer. For eg. in the Microsoft acquisition of LinkedIn, the agreement they entered into contained a no-shop clause which additionally stated that in the event that LinkedIn solicited any third parties during the negotiations, it would be liable to pay a break-up fee of $725 million to Microsoft. LinkedIn in fact did receive an unsolicited bid from Salesforce, Microsoft’s competitor, and had LinkedIn accepted the offer, it would have had to pay the huge break-up fee. The nature and consequences of a no-shop clause differ on a case-to-case basis, and it is important to pay attention to the terms that are being agreed to.

  • QC for founders – There is no avoiding this standard clause. However, you can negotiate an exception that this shall not apply in the case of a bidder with whom discussions had already begun, if applicable. Another term that you could ask for is to require your buyer to also agree to exclusivity, preventing them from approaching other similar companies and thus protecting your interests.
  • QC for investor –  Along with the standard terms of the clause, it is advisable to also add that the founders notify the investor of any third-party offers received during this period by sending a written notice of the same. 

Degree of control 

While some investors may be investing for purely financial returns, some of them may be interested in exercising some level of control in the management and governance matters of the company. This is usually achieved through board representation, voting rights, and information rights.

Board representation 

This is one of the primary ways in which an investor exercises control, through a seat on the board. Although they may or may not participate in the day-to-day activities of the company, they can still exercise voting rights and other rights that come with being a director. 

  • QC for founders – Ensure that while the investors have board representation, one or more of the founders are also on the board and have control of the board. Say for example in a board of five directors, at least two of the seats must be occupied by the promoters themselves.
  • QC for investors – Being a director of a company is not an easy job and comes with its own liabilities and responsibilities. It is important to consider what exactly you are looking for while deciding the type of board representation you seek. Unless you are seeking to have director voting rights, you can also choose to have the right to appoint board observers on the board. Board observers appointed by the investors or the investors themselves as board observers shall be allowed to be present at all board meetings and gather information, and in some occasions even provide valuable insights or comments if required. Board observation rights can be considered as it is a safe and effective alternative to a seat at the table.

Voting rights (affirmative) 

Affirmative voting rights are essentially a list of mutually agreed ‘reserved matters’ in which the board or the shareholders cannot make a decision without the investor’s consent through an affirmative vote. These are not day-to-day matters but mostly key issues that are outside the ordinary course of business such as the fresh issue of shares, incurring loans or debts, dividend declaration, initiation of legal proceedings against another entity etc. Although most of these matters are standard for every deal, stipulations of the investors may differ depending on the extent of their involvement in matters concerning the business, their faith in the management, etc. 

  • QC for founders/company – The list of reserved matters may be brief or maybe a long list depending on the investor. In all cases, founders must look into the reserved matters carefully and check if matters that directly involve the ordinary business activities of the company are a part of the list. Further, there are certain matters, wherein it qualifies for an affirmative vote if it crosses a minimum threshold. For eg., an affirmative vote may be required to incur a loan whose value exceeds INR 15,00,000, then INR 15,00,000 is the threshold. In such cases, founders must lookout to ensure that these thresholds are not kept so low that it obstructs operational flexibility of the business activities of the company. 

Information rights 

Investors typically require the company to provide information relating to the affairs of the company and periodical performance reports as well. This may include periodic financial statements, projected budgets, etc. This helps the investors stay updated on the affairs and performance of the company.

  • QC for founders – Preparing financial statements and periodic reports is a time-consuming and expensive affair and therefore founders must try to negotiate the frequency and number of statements required to be furnished. 
  • QC for investors – Along with financial statements and reports, you could also ask for business and marketing plans and even an explanation statement explaining any deviations from projected statements and figures. This will enable you to have a more realistic and holistic idea of the performance and growth of the company. 

Representations (reps) and warranties

Although reps and warranties are mostly a standard clause, it is also one of the most negotiated clauses in an M&A deal. Representations and warranties are provided by the seller to the buyer or the investee. It is basically a statement of facts on the current state of affairs of the company which they accept as true. It could also be a statement which states that as of date there are no pending liabilities or obligations or even pending litigation against the company. These clauses are important due to the serious consequences they could entail in the event of their breach. Upon the occurrence, of such ‘breach’ the seller is required to indemnify the loss suffered by the buyer or the investor.

  • QC for founders – Founders can ask to include a ‘knowledge qualifier’ to warranties. For eg., ‘there is no pending litigation against the company to the best knowledge of the promoters.’ Further, founders must also ensure that the obligation to indemnify should not be in the nature of personal indemnification. Since the investment is in the company, the liability to indemnify should also be made applicable only to the company.
  • QC for investors –  Considering the objective behind a reps and warranties clause, it will be more useful to make the terms of the clause as wide as possible covering all important matters such as ownership and capitalization, legal compliance, material contracts, intellectual property, litigation, etc.

Conclusion 

The term sheet negotiation is one of the most important stages of an M&A deal and could even make or break a deal. Being the first formal document for the transaction, the term sheet sets the basis for the definitive documents that will follow. Definitive documents are extensive and rigid and once entered into are almost irreversible and therefore, the term sheet is the pre-transactional document that can be properly debated and negotiated upon. All terms must hence be well negotiated, preferably with proper legal guidance. 

References 


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