Tuesday, September 18, 2007

Selling the Startup: Providing Price Protection in the Term Sheet

According to a recent poll, the vast majority of entrepreneurs in Canada expect to sell their businesses in the next 5 years. Let's get down to business, then: if you are reviewing a term sheet, remember that while a term sheet is a general statement of intent, the broad nature of the language does not favor you. I have never had a purchase price go up because of a matter that the term sheet did not address. It is important to specify in a term sheet when and how a purchase price will be adjusted.

As a general rule, term sheets provide for price adjustment based on revenues and a closing balance sheet, and based on the results of the buyer's due diligence (this is really a price reduction clause, as no one ever finishes due diligence and concludes "By God, they're really onto something here. Raise the price!"). Here are three other areas where you, as seller, need to consider providing for some price protection:

1. Who is Paying for Employee Severance? In Canada, if a business or part of a business is sold, the employees are deemed terminated and are entitled to receive severance. The one exception here is if the buyer hires the affected employees on terms that are not fundamentally or radically different from the ones enjoyed prior to the sale. In that case, no severance is payable and the purchase price remains unaffected.

Buyer - generated term sheets are typically vague on the issue of employees, simply stating that the purchaser will interview employees and make offers to those it wishes to retain prior to the closing. Consider what may happen, then, if a large purchaser decides just prior to closing that it now wishes to run your old business out of its head office in Missouri? This would leave you with the severance costs for your entire staff. It is therefore important to allocate responsibility for potential severance costs in the term sheet, and any corresponding adjustment to the purchase price.

(Note to founders/executives: if you have been taking a below-market salary to conserve cash, consider increasing the salary to market rates before engaging with interested buyers. Ask yourself if it is appropriate that you end up negotiating a salary for a new role with the buyer, or your severance package, from a starting point that is artificially low.)

2. Customer Contracts. As a general rule of thumb, the bigger the buyer, the less interest it has in continuing to run your business as a going concern. As a successor to your business, a large purchaser often does not wish to incur any legal liability for future support of all of your customers, and it therefore insists in the term sheet that you terminate certain customer contracts before the deal closes. Be very careful here: the costs of termination need to be shared or taken into account in evaluating the purchase price. It is likely that you have no right to terminate a customer agreement for convenience, which means you will need to negotiate with your customers, and likely pay a break fee. You may also need to negotiate special rights to allow the customer to continually support your product yourself. Make sure your term sheet stipulates that any license back you require will not reduce the purchase price. A price increase to reflect breakage costs is also apporrpatie, although it rarely succeeds.

3. Sale of Shares. You've agreed on a purchase price for a sale of shares. This will put cash directly in the pockets of your shareholders, taxed at the lower capital gains rate. However, half way through the process, the buyer announces that its tax advisors insist that the deal be done as an asset purchase. Suddenly, the potential proceeds to shareholders are significantly less. When you discuss grossing up the price to reflect the less favourable tax consequences, your buyer refuses, saying it has already received the necessary board approvals and does not wish to ask for more money. It is therefore important to address the issue at the term sheet stage, before the buyer has run through its internal approval process. Make sure that your term sheet has a price adjustment clause in it that will take effect if the structure of the deal changes.

Next: Selling the Startup: Should Your VCs run the Process?

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