The Term Sheet: Agreeing the Shape Before the Detail

A term sheet is a short document setting the shape of a transaction before anyone drafts it: the price and how it is struck, the structure, the conditions, exclusivity, confidentiality and the timetable. Most of it does not bind. A term sheet exists so both sides discover cheaply whether they disagree about something fundamental. Walking away at that stage still costs almost nothing.

One ordering runs through every transaction, and it is worth saying before anything else. Agreement comes before drafting. A transaction is not a document that gets negotiated into existence. A transaction is a shape that two sides settle in conversation, and then a document that records the shape in language precise enough to survive a disagreement two years later. The term sheet is where the shape gets written down for the first time.

Consider how a house is sold. The seller and the buyer settle the price, the date the keys are handed over, whether the fittings and the water tank are included, and whether the sale depends on the buyer's loan coming through. All of that happens across a table, in maybe two conversations. Drafting is the expensive part, so only then does anybody instruct a lawyer. Discovering across a drafted contract that one side assumed the fittings were included and the other assumed they were not would be an absurd way round. The two of them would have paid for a document to tell them something a two minute conversation would have told them for free.

A corporate transaction is that conversation, conducted between two organisations with advisers on both sides and a great deal more money moving. Harivansh Packaging Limited and Sundarban Polymers Private Limited, both invented, stand in for the two sides. The first is listed on both Indian exchanges and is buying 100 per cent of the second, an unlisted maker of flexible packaging films. Devyani Kulkarni is the chief financial officer of Harivansh Packaging Limited and Ashwin Rege leads its transaction team.

The milestones are fixed, and the same seven names describe them: approach and confidentiality, indicative offer and term sheet, confirmatory diligence, documentation, signing, the conditions period, completion. The second of those, the term sheet, raises a single question about what the document produced there has to contain before it is worth signing.

Why would two sides write a document that mostly does not bind?

Because disagreement is cheapest to find early, and there is no other instrument that finds it early. The cheapness of early disagreement is the whole economic argument, and everything else about a term sheet follows from it.

Consider what a transaction costs to run. Confirmatory diligence puts teams of people through a target's contracts, its tax position, its customer concentration and its plant. Documentation puts lawyers on both sides through weeks of drafting and re-drafting. Neither of those activities is cheap and neither of them is refundable. So the sequence is built to spend the cheap money first: a conversation costs nothing, a term sheet costs a few days of senior attention, and only after that does anybody switch on the expensive machinery.

A term sheet earns its place only if a disagreement it surfaces would otherwise have been found later at a higher cost. The test is a useful one to hold. Holding it settles what belongs in the document and what does not. A clause that could only ever be argued about after diligence is not doing that job. A clause that would stop the transaction dead if the two sides read it differently is doing exactly that job, and it belongs at the front.

The shape is identical, so run the household version again. Two households agree a price, a date and who pays for the repairs before anybody instructs a lawyer. If it turns out that one of them meant the price before the outstanding loan on the property and the other meant after, they find that out in the first conversation and either fix it or shake hands and walk away. Nobody has lost anything but an afternoon. Find the same disagreement on the day the papers are signed and one side has already given notice on their rented flat.

The elapsed weeks below belong to this transaction alone, and no two transactions run to the same clock. Twenty two weeks ran from term sheet to completion, of which the conditions period was nine. So signing fell in the thirteenth week and completion in the twenty second. Term sheet, signing and completion mark how much has been committed by the time a disagreement surfaces.

Notice what the picture leaves unsaid. The picture does not say the buyer loses the argument in week fourteen. The picture says the buyer argues it having already spent money and made a commitment in public, and those two facts sit on the table whether or not anybody mentions them. A term sheet exists to prevent that asymmetry, and it prevents it by moving the argument to the week where nobody has anything at stake yet.

What is actually inside a term sheet?

A short list of named sections, most of them a paragraph long. Parties and structure. Price and how it is struck. The assumptions about debt and working capital. Conditions. Exclusivity. Confidentiality. Costs. Timetable. Governing law. Nine headings are close to the whole of it, and the document is often called a heads of termsAnother name for the same instrument. Heads means headings: the headings of what has been agreed, without the drafting underneath them. for exactly that reason: it is a list of headings.

Take them one at a time. Each is answering a question that would otherwise be discovered late. Parties and structure says who is buying what from whom, and whether the thing being bought is shares or a business. On this transaction it is 100 per cent of the shares of Sundarban Polymers Private Limited, bought by Harivansh Packaging Limited. A purchase of shares and a purchase of a business behave differently in almost every respect that follows. One line therefore settles a great deal.

Price and how it is struck is where a term sheet earns or loses its money, and it comes back twice below. The assumptions about debt and working capital show how the headline figure turns into money in the hands of the sellers. Conditions name what has to be true before completion can happen. Here that means a regulatory approval, the absence of a material adverse change, and consents from two counterparties whose contracts change hands.

ExclusivityAn undertaking by the seller not to talk to any other buyer for a stated stretch of time. Exclusivity buys the buyer the confidence to start spending on diligence. stops the seller running a parallel conversation with somebody else while the buyer spends money on diligence. Confidentiality stops either side talking. Costs says who pays for what if the transaction does not happen. The timetableThe list of dates the two sides write down for the steps between here and completion. The timetable is a shared plan, not an obligation to hit any of the dates. names the milestones between here and completion. Governing lawThe legal system whose rules will be used to read the document if the two sides ever disagree about what it means. says whose rules read the document if the two sides ever fall out about what it means.

The list is short on purpose, and a term sheet running to thirty printed sides has stopped being a term sheet and become a draft agreement written by people who have not yet agreed the shape. Length is not a stylistic preference. A long term sheet is a symptom of drafting that began before the conversation finished, and drafting first inverts the ordering everything else rests on. Somebody is also now paying for detailed language about a transaction that may not survive diligence.

Which clauses bind from the moment it is signed?

Four of them, and it is worth being precise about why those four and not the others. Most of a term sheet is a statement of intention: this is what the parties mean to do, if diligence supports it and if the paper can be agreed. A non-bindingA clause that records what the parties intend without creating an obligation either of them could be held to. Walking away from it has no legal consequence. clause is not a weak promise. A non-binding clause is not a promise at all, and both sides know that when they sign.

Sitting inside that document is a small island of clauses that do bind. Confidentiality binds. Exclusivity binds. Costs binds. Governing law binds. Everything else describes a transaction that may never happen, and is written on that understanding.

Confidentiality, exclusivity, costs and governing law bind because they are the only clauses that have to work in the world where the transaction never takes place, and every other clause in the document assumes a transaction that may never happen. Read that as the test rather than as a list to memorise. Collapse is the moment somebody is most tempted to talk, so confidentiality has to work precisely when the talks collapse. Exclusivity has to work while the transaction is still uncertain. Otherwise it buys the buyer nothing at all. Costs has to work when there is no completion to settle them at. Governing law has to work in order to read the other three.

The price clause is the mirror image. If the transaction happens, the price will be set by the definitive agreement, not by the term sheet. If it does not happen, the price clause governs nothing. A binding price clause in a term sheet has no useful work to do in any state of the world, and no term sheet makes it binding. A binding clauseA clause the parties can be held to from the moment they sign, independently of whether the wider transaction ever completes. in a mostly non-binding document is always doing a job the rest of the document cannot do.

What does a price line have to say before it is usable?

Take a price line: the price is Rs 1,320 crore. Read slowly, it says remarkably little. The line does not say whether Rs 1,320 crore is what the sellers receive or the value of the business before its borrowings are dealt with. The line does not say what the figure was struck against, or for which period. And the line does not say what happens to the figure between now and completion, when the target's actual position will not be the position anybody was looking at when they agreed it.

A usable price line names four things, and a term sheet that misses any of them has recorded a number rather than a price. The first is the kind of figure, an enterprise value here. The second is how the figure was struck, at 10.0 times Sundarban Polymers Private Limited's earnings before interest, tax, depreciation and amortisation (EBITDA) of Rs 132 crore for the stated period. The third is the basis, cash-free and debt-freeA way of quoting a price for the business itself, as though it carried no borrowings and held no cash. Both are then dealt with separately in the bridge to what the sellers receive.. The fourth is the adjustment mechanismThe rule the document sets for moving the price between the agreed date and completion, so that the figure reflects the position actually handed over. that will carry the price to completion.

Put together, the usable version reads: an enterprise value of Rs 1,320 crore, being 10.0 times Sundarban Polymers Private Limited's EBITDA of Rs 132 crore for the stated period, on a cash-free and debt-free basis, with the equity value to be arrived at by deducting net debt at completion and adjusting working capital against a normalised figure. The usable version is one sentence, longer than a number, and it is doing four separate jobs.

The first two jobs have to reconcile before anything else does, so check their arithmetic. Ten times Rs 132 crore is Rs 1,320 crore, so the multiple and the measure produce the headline exactly. Sundarban Polymers carries net debt of Rs 180 crore, and Rs 1,320 crore less Rs 180 crore is Rs 1,140 crore. The Rs 1,140 crore, not the Rs 1,320 crore, is what reaches the sellers before any completion movement.

A price stated without its basis is the single most common cause of a renegotiation at completion. The two sides discover in week fourteen that they had been describing different numbers to their own boards since week one. Nobody lied. Nobody was careless in any way they would recognise. One side wrote down a figure and the other side wrote down the same figure meaning something else. The figure matched, so no conversation between them would surface it.

What did each clause of that price line actually buy?

The value of precise drafting is invisible until the alternative is priced. Take the purchase clause by clause. The sentence in the term sheet is the one written above, and it has four moving parts.

Because the basis names the multiple and the measure, nobody argues later about what the Rs 1,320 crore was. The figure is 10.0 times an EBITDA of Rs 132 crore for a stated period, and both sides can check that multiplication in a second. Because it names a cash-free and debt-free basis, the deduction of Sundarban Polymers' net debt of Rs 180 crore is agreed in advance rather than fought over, and the equity value is Rs 1,140 crore.

Because the basis names a working capital adjustment against a normalised working capitalThe level of working capital the two sides agree the business ordinarily needs to run, written into the document as a reference figure so the completion position can be measured against it. figure, the movement that arose at completion was computed rather than argued. The agreement sets normalised working capital at Rs 96 crore. Actual working capital at completion came in at Rs 108 crore. Rs 108 crore less Rs 96 crore is Rs 12 crore. The sellers left more in the business than the price assumed they would, so the price adjusts up by that amount.

Because the basis names net debt at completion rather than net debt at some earlier date, the second movement was also computed rather than argued. The transaction assumed net debt of Rs 180 crore. Actual net debt at completion was Rs 195 crore. Rs 195 crore less Rs 180 crore is Rs 15 crore more borrowing than assumed, so the price adjusts down by Rs 15 crore.

Put the two together. Plus Rs 12 crore and less Rs 15 crore is a net movement of Rs 3 crore against the seller, so the equity value paid moves from Rs 1,140 crore to Rs 1,137 crore. On the Rs 1,140 crore base the working capital movement is 1.05 per cent and the net debt movement is 1.32 per cent. On the Rs 1,320 crore enterprise value the same two movements are 0.91 per cent and 1.14 per cent. Naming the base is what keeps the two apart. Two different denominators, four different percentages, one set of facts.

Now price the alternative honestly. Suppose the term sheet had said: price Rs 1,320 crore, working capital to be adjusted for. The facts of the business do not care what the document says, so both movements are still coming. The movements now arrive as negotiations rather than as arithmetic, conducted in the fourteenth week by a buyer who has spent months on advisers and told its board the transaction is happening.

The net movement of Rs 3 crore is small, and its smallness is not the point: Rs 12 crore is four times the net and Rs 15 crore is five times it, so a term sheet that fixed only one of the two mechanisms would still have left real money open to argument. Both are therefore computed separately, and neither is netted away in the drafting. A buyer who checked only the net would have been wrong by Rs 12 crore or Rs 15 crore rather than by Rs 3 crore.

What is left open on purpose, and why is that not laziness?

Plenty is missing from a term sheet, and the good ones are missing the same things. The limits on the seller's warranties are not there. The indemnity package is not there. The exact language of the conditions is not there. A reader coming to this fresh often reads those absences as sloppiness, as though a more thorough team would have nailed everything down at once.

The absences are deliberate. Warranty limits, indemnities and the language of the conditions all depend on what diligence finds, and fixing them before diligence means fixing them on no information at all. Nobody knows yet whether Sundarban Polymers has a tax exposure, a contract that changes hands badly, or a customer who accounts for far more of its revenue than the buyer assumed. The whole purpose of confirmatory diligenceThe examination the buyer runs after the term sheet, to confirm that the business is what the seller has described. Confirmatory diligence is the third of the seven milestones. is to find out. Writing the protections before knowing what they are protecting against is not thoroughness. The result is guesswork with a signature on it.

So the term sheet may say that the definitive agreement will fix a limit on the seller's liability and will carry an indemnity package. The term sheet says that a limit and a package will exist and will be negotiated, without saying what either of them is. How those limits are set and what they do is set out under the definitive agreement.

Here is the test that sorts the two piles, and it is one question. Does what diligence finds have to inform this term? If the answer is no, fix it now. Nothing about the term gets easier later, and leaving it open only lets the argument grow. If the answer is yes, leave it open on purpose, name in the term sheet that it will be settled, and move on. Price passes the first test. The structure of the purchase passes it. Warranty limits fail it. The indemnity package fails it.

What changes in both organisations the day it is signed?

Almost everything about how the transaction feels from the inside, and the change is one way. Before signature, two small groups of senior people were having a conversation. After signature, there is a project.

Spending starts, on both sides. Advisers are instructed to run diligence and to draft, and from that moment the meter is running whether or not the transaction ever completes. The buyer cannot examine what the seller has not assembled, so a data room gets built, and assembling it takes people off their ordinary work. Internal teams are pulled in: finance, tax, legal, operations, and here the people who would have to make two packaging businesses run as one.

And the circle of people who know widens sharply. The widening matters more than it sounds. Before the term sheet, perhaps a handful of people on each side knew the talks existed. After it, the number is many times that, and it never comes back down. Somebody cannot be un-told. The consequences for confidentiality, for what may be said and to whom, and for what happens if the information escapes, are set out under confidentiality undertakings.

The consequence nobody prices is that a term sheet converts a conversation into a project with a cost, and both sides then want that cost to have been worth incurring. The wish itself is a real force acting on every decision after it. Nobody in either organisation is behaving badly. Organisations work that way. A team that has spent four months and a large adviser bill finds it harder to recommend walking away over a Rs 15 crore movement than the same team would have found it in week one, and the people negotiating on the other side know that perfectly well.

What is a timetable in a term sheet actually worth?

A timetable is worth a shared expectation and an early warning, and worth nothing at all as a promise. A term sheet that names a target completion date gives both sides the same picture of what is meant to happen when. A slip then becomes visible to everybody at the same moment, rather than being discovered by one side three weeks after it happened.

A timetable in a term sheet is a plan rather than a promise, and the useful version names the milestones between here and completion rather than only the end date. An end date on its own says nothing until it is missed, by which point the missing has already happened. Milestones give warning in week five that diligence is running two weeks behind. A warning that early can still be acted on.

Here is how the purchase actually ran, week by week. A regulatory approval alone can stretch the conditions period well past nine weeks.

The term sheet's timetable describes a period that ends nine weeks after anyone has committed to anything binding about the purchase itself. The conditions section of a term sheet matters for that reason: it is the earliest written description of a stretch of time in which the transaction is signed and still not done. The mechanics of that stretch are set out under conditions to completion, and the term sheet is where the stretch is first sketched.

How does a lender, an analyst or an investor read a signed term sheet?

Differently, and it is worth seeing that none of the three is reading it for the same thing. Start with the lender being asked to fund the purchase. A lender reads the price line first, and specifically whether it names an enterprise value or an equity value. Enterprise value and equity value are two different sums of money, and only one of them is what the borrower has to find. On this transaction the difference is Rs 180 crore, not a rounding. The lender then reads the adjustment mechanism. The mechanism sets how much the amount to be funded could still move between signature and drawdown.

An analyst covering the listed acquirer reads it for the effect on the acquirer, and the first question is the size of the target relative to the buyer. The second question is what has actually been committed, and the binding island is what answers it. A signed term sheet is not a signed transaction, and treating one as the other is the most common misreading of a transaction announcement. The disclosure a listed acquirer must make on entering into a term sheet, and when, is set by the Securities and Exchange Board of India (SEBI).

An investor already holding shares in the acquirer reads it for the conditions and the timetable. The two together say how long the uncertainty lasts and what could still end it. A transaction that is signed and conditional for nine weeks is a different thing to hold than one that completes on signature.

The household version of all three readings is the same reflex. When a relative says they have agreed to buy the shop next door, three questions follow without anybody thinking about it. How much, and is that before or after the loan on it? What could still stop it? And when will anybody know? The three are the lender's question, the analyst's question and the investor's question, and a term sheet that answers them is doing its job.