Preliminary Transaction Documents in SMB Mergers and Acquisitions
Part One of a Series.
Author’s Note: This series of articles is being prepared to accompany and supplement the new DealSense Plus v4 that includes a term sheet that can be edited in Microsoft Word that can serve as a starting point for drafting a Letter of Intent or similar Preliminary Transaction Document.
If you have participated in the closing of a negotiated M&A deal of almost any size, you are familiar with the cornucopia of paperwork that is required to get the deal done. In addition to the definitive purchase or sale agreement between the buyer and seller, there are a host of additional documents that contain all of the approvals, consents, authorizations, permits, releases and other agreements that are necessary to close the transaction. This avalanche of documentation (in paper or electronic form) is collectively referred to as the Transaction Documents.
For the most part, the business interest and consideration paid are not going to be exchanged until all required Transaction Documents have been signed and presented. Before that can happen, the documents need to be drafted, negotiated, finalized and pass muster with each party’s internal approval process.
The process of finalizing Transaction Documents is complex and because it requires the involvement of paid professionals, can be very expensive. In addition to drafting and negotiating, there are due diligence requirements, which again require time and money. So, before committing to the time and expense along with putting their respective reputations on the line, the seller and especially the buyer will want to be sure that there is a basic understanding and concurrence on the key elements of the proposed transaction.
An Important Milestone in the Deal Process
A Preliminary Transaction Document is a major step forward in the dealmaking process and usually is presented after a prospective buyer has made an initial evaluation that indicates that the investment meets their business and financial criteria.
Preliminary documents provide a mechanism for buyer and seller to summarize and concur with the key points of a deal before proceeding to the due diligence and contract drafting phase and incurring the related expense. Preliminary Transaction Documents can take a number of familiar forms such as:
- Term Sheet
- Letter of Intent
- Memorandum of Understanding
- Agreement in Principle
- Memorandum of Interest or an Indication of Interest
- Heads of Agreement
- Proposal or Offer to Purchase
For purposes of this article, the entire group of Preliminary Transaction Documents will be referred to as Preliminary Doc(s). It should be noted that there are important differences between the types of Preliminary Docs. This series focuses on the strategic and tactical considerations of using Preliminary Docs.
Before presenting a Preliminary Doc to another party, you will want to consult with your legal counsel. They can advise on the best type of Preliminary Doc to use and then either prepare or approve it before submission.
Filling the Gap between a Handshake and the Closing
Preliminary Docs fill the void between a handshake and definitive purchase or sale agreement. They offer the parties a number of advantages and can also present a number of risks for both buyer and seller. This series of articles will explore the strategic and tactical uses from a business, negotiating and process management perspective.
Preliminary Docs are generally intended to be non-binding, agreements to agree. However, they can contain binding language, especially with respect to confidentiality, no-shop and break-up fees.
In addition, despite the generally non-binding quality of Preliminary Docs, a party might find that they have wandered into the area of a contract and might find themselves unintentionally obliged. For that reason, it is essential to have all Preliminary Docs prepared and approved by an experienced transaction attorney.
The objective of the Preliminary Doc is to provide a sufficient amount of information to begin the due diligence and contract drafting/negotiation process in detail. With the basic economics of the deal in place, the buyer can begin to put together their funding.
Key Points of Preliminary Docs
The elements that can find their way into a Preliminary Doc will be reviewed in greater detail in a future edition of this series. There are two general parts of a Preliminary Doc. The first part describes the contemplated transactions and includes:
- Identification of the parties.
- Business interest to be purchased.
- Purchase price.
- Method and form of payment.
- Terms of any seller financing.
- Additional considerations for such things as Covenant-Not-To-Compete, Employment and/or Management Agreements along with the amounts and payment terms.
- Terms of contingent payments such as earn-outs, royalties or commissions.
- The expiration date that sets forth how long the proposal or offer is on the table.
The Term Sheet created in DealSense Plus v4 addresses the above points and can be used as a starting point for drafting a Preliminary Doc that is symmetrical with the valuation and economic analysis of the deal. As a matter of policy, a buyer should continuously update their economic model as deal terms change during negotiations or as terms are adjusted based upon information discovered during the due diligence review.
The second part of a Preliminary Doc addresses expectations about going forward and can include provisions that address:
- The termination date and what happens if the transaction is not completed by that date.
- Earnest money to be deposited and how it will be treated.
- The confidentiality of information provided.
- Access to and the availability of information needed for a proper due diligence review and preparation of post-deal integration plans.
- Timeframe for due diligence and target closing date.
- Whether the deal may be announced or disclosed.
- No-shop provisions and walk-away fees.
- Notification of any “materially adverse” events or actions.
- Operation of the business while the contemplated transaction is pending.
- Maintenance of specific financial metrics or baselines for asset levels or earnings.
- The clauses or provisions that will survive termination or expiration.
Presentation of a Preliminary Doc is a major milestone in the M&A negotiating process. A Preliminary Doc is a multipurpose document. It records the highlights of the contemplated transaction and sets forth ground rules for moving forward. It demonstrates a desire by both parties to proceed to the next level of diligence and document drafting/negotiation.
A well-drafted Preliminary Doc brings the parties closer to a meeting of the minds with respect to the big issues of price, terms and form of payment. Aside from advancing a deal, a Preliminary Doc offers other advantages such as:
- Reducing a buyer’s business vision to writing tends to focus thinking and fosters clarity.
- Providing a framework and timetable for moving forward.
- It is a negotiation and communication vehicle.
- It facilitates decisions and encourages action.
- Provides a reference point for addressing any issues or surprises that are bound to surface during the due-diligence and contract-negotiation process.
There may be times when buyer and seller are sufficiently comfortable with each other and the proposed transaction that they may skip the Preliminary Doc and proceed directly to hammering out the details of the definitive purchase or sale agreement. However, in those instances where this is not practical or realistic, a Preliminary Doc is a tried and true way to advance the contemplated transaction to the next level: due diligence and contract drafting/negotiation.
While Preliminary Docs are generally non-binding, they can contain language that is either intentionally or unintentionally binding. Legal counsel will advise and prepare the document to avoid the unintentionally binding variety. From a business perspective, the issue is the degree, if any, to which the parties wish to be bound by the Preliminary Doc, and that will be one of many considerations that will explored in future installments of this series.
By Robert B. Machiz
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