MODULE II: PRE- REQUISITES OF M&A AND JV – TERM SHEET AND DUE
DILIGENCE
Introduction to “TERM SHEETS”:
M&A or JV collaborations require detailed and substantive documentation as, even slight
ambiguity or vagueness can be the cause of deal falling apart. Typically, prior to the execution of
definitive written agreements (like shareholders agreements, share subscription agreements, joint
ventures agreements and such other agreements which are binding in nature), the parties which
may consist of the target entity and identified partners for JV, may execute a non-binding term
sheet or letter of intent, setting forth the key terms and conditions, which are mainly commercial
in nature, upon which such a commercial collaboration is proposed. A term sheet or letter of
intent is initially prepared by the investor (i.e. the acquirer) after preliminary discussions
regarding the proposed transactions have commenced but before significant time and money
have been spent on the process of conducting due diligence.
Term Sheet and/or Letter of Intent:
The terms “Term Sheet” and “Letter of Intent” are used interchangeably but may be different in
their structure. A letter of intent, as the name signifies, is written in the form of a letter whereas
a term sheet is more often a list, rather than a formal letter, both, stating the important parts of
the anticipated contract or agreement. Both, term sheets and letters of intent contain nearly the
same topics. Nevertheless, we shall be referring the term “Term Sheet” hereafter.
Enforceability:
It is a first formal handshake which sets out the contours for the deal that will follow and also
provides basis to draft the further definitive agreements, i.e. the definitive agreements are
broadly based on the term sheet points and if any party intends to deviate from the same, it does
not send across a healthy signal to the other side on account of which either the deal may fall
through or may take a longer time to materialize. It is therefore critically important to understand
its implications. The binding nature of the “Term Sheet” will depend on the intent of the parties,
the language and terms used. Typically, provisions related to confidentiality and exclusivity are
binding in nature and other provisions are non-binding in nature. If the intent of the parties
regarding the term sheet to be binding or not, is clearly stated in the term sheet (as binding term
sheet or non-binding term sheet), the courts may provide relief on such binding provisions.
However, if the Term Sheet is silent on its “binding nature”, the courts may draw inference from
the conduct of the parties and other provisions of such “term sheet”.
Features of Term Sheets:
As mentioned above, the Term Sheets covers all the important commercial points which are
explained broadly without going into the details, as the detailing of such clauses are done in the
definitive agreements. Although, there is on standard or uniform method to draft a term sheet,
but the usual and normal provisions of the Term Sheet are as follows:
1) Introduction of parties:
The details of the Parties such as name of the entities, details of registered offices,
registration numbers (CIN/ LLPIN as the case may be) and as to their role in the proposed
transaction (e.g. Buyer or seller).
2) Transaction Structure:
The proposed structure of the transaction, whether it is going to an asset purchase, stock
purchase, merger or Joint Ventures, as extent applicable, the specific assets that will be
purchased and not purchased, any liabilities of the seller to be assumed by the buyer, the
class or classes of seller’s stock to be acquired, the parties to the merger and the identity of
the survivor.
3) Current Shareholding pattern/ and Post Investment Shareholding Pattern:
The acquirer directly or indirectly owning [X] % of the share capital in the target co.; and
the Buyer intending to acquire [X] % of the share capital in the target co. Also, stake of the
parties (in value and percentage) concerned and their contribution upon closing the
transaction.
4) Consideration/ Equity Stake/ Ownership Stake/ Contribution (in case of JV):
The amount of money to be infused/invested by the Investor in the Company and if the
Investor is intending to purchase shares from the existing shareholders, then, the purchase
consideration to be mentioned.
5) Conditions precedent which shall include due diligence:
The obligations of the parties shall be conditional upon satisfactory results of due diligence.
In addition, there are some general conditions precedent to be completed by the Target
Company such as passing of board resolution, obtaining any government approvals etc.
6) Governing Law:
This Term Sheet will be governed by and construed in accordance with the laws of the
(place names)
7) Rights of the entities in appointment of nominee directors or directors for
representation to the Board:
On closing of the proposed transaction, the (specified party to the transaction) shall have the
right to appoint nominee directors to the board and if possible, certain agreed reserved
matters shall require their approvals.
8) Co-operation for undertaking the process of due diligence:
The target entity shall provide access to books, records and other details of for conducting
the process of due diligence satisfactorily and to reach a conclusion whether to go ahead for
the proposed transaction or not.
9) Confidentiality Clause:
The terms and conditions of the Term Sheet, shall be confidential information and shall not
be made public or otherwise be disclosed to any third party, except as consented by the
parties or required under legal obligations.
10) Exclusivity Clause:
Immediately upon the execution of the Term Sheet by both parties, the Company shall, and
shall cause its directors and other representatives, to refrain from having or shall be free
to have any discussions and negotiations with any third party concerning any alternate
acquisition or collaboration proposal, whether by way of purchase of shares, all or
substantially all assets, merger or otherwise, for a period of [X] days.
11) Dispute Resolution:
Any and all disputes arising between the parties shall be resolved solely and exclusively
through confidential binding arbitration in [place] through the commercial arbitration rules
of [Rules of Arbitration recognized] in existence at the time of the commencement of the
arbitration, heard before one arbitrator.
12) Fees and Expenses:
Each party shall be responsible for their own internal costs and any legal, accounting and
other professional fees incurred in connection with this term sheet and the negotiation,
preparation and execution of the documents in relation to the Transaction.
13) Validity of Term Sheets:
The period for which the Term Sheet shall be valid (usually 2-3 months) or any other
condition.
14) Termination:
Each party shall have the right to terminate the term sheet if the other party is in default of
its obligations under this term sheet by giving ‘X’ days notice. The defaulting party shall
have [X] days, to cure any default and provide documentary evidence of resolving the
relevant circumstances that caused such default or otherwise legitimately cure the default
within the above defined period.
DUE DILIGENCE:
Introduction to “Due Diligence”
Once the “Term Sheet” is executed, the incoming investor/ acquirer or the partner, as the
case may be, will conduct legal due diligence on the Target Company. Due diligence is the
deciding factor of the success of any corporate merger & acquisition or joint venture
transaction. The process implies checking the health of the target company in legal, financial
and other required areas by the acquirer, by assessing various kinds of records, to evaluate
and realize the advantages and detriments of the proposed transaction.
Why is it needed?
In any sale and purchase of goods, even though the seller is under a duty to sell the goods
which are genuine, as per the specifications and of merchantable quality, however, the
principal which works in favour of the Seller is “Let the Buyer be aware”, i.e. the Buyer
should be provided with an opportunity to conduct its own diligence and inspection of the
goods before buying the same. Based upon this concept of the “Due diligence” in M&A and
JV deals as well, it is important to know that the “pros and cons” of the affairs of target
entity with whom the acquirer/partner intends to collaborate, from legal, financial and
business point of view. For eg. If there is a company named “A Ltd.” which intends to
acquire/ collaborate commercially with a company named “C Ltd.” they will first execute
the term sheet as seen above. Then proceeding towards due diligence, “A Ltd.” scrutinizes
the legal documents of “C Ltd.” pertaining to tax returns, legal disputes, compliances with
corporate law and securities law, status of ownership of various assets, various licenses and
certificates and deeds, financial standing (balance sheet, income and expenditure statements,
cost accounts, cash flow statements, etc.) Now if on scrutinisation it is found that “C Ltd.”
has more debts to be paid or it has pending commercial litigation or there is default filing of
annual statements of accounts with the registrar of companies, “A Ltd.” can decide on
whether to go ahead with this deal or not. If both agree to go ahead with this deal, “A Ltd.”
may accept certain liabilities and ask for certain representations and warranties (promise to
indemnify for the losses/ liabilities which may crop up in future during the deal and post
closure of deal). Also, effective consideration (purchase price of shares/ assets in case of
acquisitions and swap ratio in case of mergers/ amalgamations) can be calculated or
negotiated on the basis of the findings of the due diligence results. Thus, the process of due
diligence is extremely vital before signing the definitive agreements.
Types of due diligence:
There can be various types of due diligence depending upon the nature of the transaction.
However, the usual three different types of Due Diligence undertaken by the acquirer are
“legal due diligence”, “financial due diligence” and “business due diligence”. In addition to
this, the acquirer may undertake a detailed and separate “environmental due diligence”, “tax
due diligence” etc.
Some of the due diligence undertaken are explained broadly as follows:
1. Legal Due Diligence: Legal Due Diligence is conducted in order to identify legal issues
in buying a business or investing in it. This diligence is conducted by the lawyers, and in
such, diligence, the lawyers review the important legal documents of the target company
such as articles and memorandum of association, commercial contracts to identify the
legal viability of such contracts, employment contracts, board meeting minutes, patents
and copyrights or any other property related documents, litigation documents etc.
2. Financial Due Diligence: This is conducted by the financial professionals, wherein, the
team studies the financial documents of the Target company such as balance sheets,
profit and loss accounts, ledger accounts and all other financial documents to understand
whether the Company has stated its correct financial position in the books of accounts
and to identify any potential liability which has not been recoded. This is important
because the valuation of the company will depend upon its financial books in addition to
other information.
3. Business Due Diligence: This is conducted by financial/business consultants wherein
they understand the business strategies, relationship with customers, possibility of
growth of business in the future, any competing threat etc.
4. Tax Due Diligence: This is conducted by tax experts (either tax lawyers or financial
experts in taxation domain) and is aimed at identifying tax liabilities of the past, any
non-compliances in tax, potential tax liability which may arise etc..
5. Operational Due Diligence: Operational due diligence (ODD) is the process by which a
potential purchaser reviews the operational aspects of a target company during mergers
and acquisitions. The ODD review looks at the main operations of the target company
and attempts to confirm (or not) that the business plan that has been provided is
achievable with the existing operational facilities plus the capital expenditure that is
outlined in the business plan.
6. IP Due Diligence: IP due diligence is focused on establishing what rights the company
may have in various intellectual property and where it might rely on the intellectual
property of another entity. Typical areas of interest are patent, copyright and trademark
filings; descriptions of the company’s IP protection processes; licensing agreements.
Process, Planning and execution:
Though conducting due diligence is not mandated by any law, it is rather a voluntary task
undertaken as a preventive measure. However, certain corporate actions like IPO needs the
company to attach a due diligence certificate signed by merchant banker as per the SEBI norms.
Lawyers are involved in legal due diligence whereas accountants and auditors are required to
conduct financial and tax due diligence. The professionals undertaking due diligence need to be
skilled and specialsied and should be capable to analyse the facts beyond mere checking of
records. Though there is no fixed method of conducting due diligence as every transaction is
different and so are its goals, the following are the general steps in a due diligence process:
Step 1: Hiring the experts: First and foremost, the entities to the proposed transaction must hire a
firm of experts (legal and financial experts) who shall be co-ordnatng and conducting due
diligence.
Step 2: Due Diligence checklist: The entity required to conduct a due diligence, will prepare a
check list which are basically the list of information and documents required by the entity to
conduct the diligence. This check list is sent to the Target Company.
Step 3: Response to check list and Data room Preparation: Once the check-list is received by the
Target Company, the Target Company will collect the information from various departments
based upon the check list items and then collate them in one place in physical copies which is
called “Data Room”. Sometimes, in order to save cost and time, Target Company also prepares a
“virtual data room”, i.e. it will scan all the documents and upload them on a server which can be
accessed on-line by the entity performing the due diligence.
Types of data (examples): The information may be gathered from the external as well as internal
sources. Below is a general list of areas on which the questionnaire/ checklist is to be prepared:
• Corporate (regulatory and compliance) records
• Share capital break up and promoter’s holding
• commercial contracts
• history of litigation, pending litigations, a description of any threatened litigations
• Details of insurance
• Financials and leases.
• employee data
• IP contracts
• Union Contract, copies of collective bargaining agreements, description of all employees
problems within last five years including the alleged wrongful termination, harassment
discrimination, etc.
• Workman’s’ compensation claim history
• Major sales agreements
• Distribution channels
• Product Profile
• Tax matters
Step 4: Setting-up time frames: Along with allocation of responsibilities, the team members are
required to complete their piece of work in a specified time because the entire deal has to be
completed within the “exclusivity period” as per the executed Term sheet.
Step 5: Review and analysis: based on the information received and analysed, the due diligence
team prepares a due diligence report. This report contains the analysis of the data obtained, the
reviews and observations of the due diligence team regarding the data provided and analysed.
The due diligence report thus becomes a lengthy document containing a 360 degree review.
Step 6: Deciding on the deal: after due consultation with the professionals, the proposed enttes
decide on whether to go ahead with the deal or not. If they do decide to go ahead with the deal,
the due diligence report s used to draft the conditions precedent, representations and warranties
and special indemnities clauses in the definitive agreements.