Join hosts Greg Hawver and Jeff Brooker for the second episode of a two-part series discussing critical issues and best practices for term sheets. This episode focuses on the equity term sheet between the independent sponsor and the equity capital provider. Learn about common pitfalls, what to keep in mind when negotiating terms and how to ensure alignment of investor interests.

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Name: Gregory Hawver

Title: Partner at McGuireWoods

Specialty: Greg represents private equity and strategic clients in a wide variety of change-of-control transactions, minority equity investments, domestic and cross-border acquisitions, recapitalizations, joint ventures, and corporate reorganizations, as well as advising clients on day-to-day corporate matters. 

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Name: Jeff Brooker

Title: Partner at McGuireWoods

Specialty: Jeff focuses his practice on advising private equity funds, venture capital funds, and other institutional investors and strategic acquirers in connection with mergers and acquisitions, early- and late-stage investments, leveraged buyouts, recapitalizations, management buyouts, and secondary transactions.

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action. 

You are listening to Deal By Deal, a McGuireWoods Independent sponsor podcast. Deal by Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join McGuireWoods Partners, Greg Hawver, Jeff Brooker, and Rebecca Brophy as they explore middle market private equity M&A to provide you with timely insights and relevant takeaways.

Hi, welcome to Deal by Deal, a podcast for independent sponsors and other private equity professionals, sponsored by McGuireWoods. This is Greg Hawver. I'm a partner in the private equity group at McGuireWoods. I sit in our Chicago office. And I'm joined by my partner, Jeff Brooker. Jeff, you want to give a quick intro?

Sure, yeah. My name is Jeff Brooker. I'm a private equity partner in McGuireWoods' Dallas office. I do a lot of work in private equity and a lot of work within independent sponsors within private equity.

Great, great. So, we are recording this episode right on the heels of our independent sponsor conference in Dallas, which was October 25th and 26th. Hopefully listeners were able to make it down for that. It was a fantastic event. We had right around 1200 registrants and two days of speed networking and panels. It was fantastic. And we hope to keep growing that conference in the years to come.

So, with that, let's move on to the topic for the day. Today's topic, Jeff and I are going to be chatting about term sheets between an independent sponsor and the equity capital provider for a transaction. Our prior installment of this series, so this is part two, part one, we talked about the term sheet between an independent sponsor and the acquisition target or the M&A letter of intent or LOI. So how it typically falls into sequencing is an independent sponsor will go out and form a relationship with a target and negotiate the terms of that M&A letter of intent. Again, you can listen to our prior podcast on that for those terms. And then once that term sheet is signed for the M&A deal, then the independent sponsor will go out to the contacts in its network for arranging equity financing. And as those negotiations progress, there is typically a term sheet that is entered into that outlines the terms of the capital provider's investment with the independent sponsor in the transaction. So that is the focus today. And Jeff, do you want to kick us off with some initial topics such as expenses and also exclusivity?

Sure, yeah. And I would just add that this document is hugely important in the grand scheme of things in your deal. And we do typically like to get this equity capital provider signed and agreed to before we really start the heavy lift on legal work because there's a lot of important things in here, expenses, which I'll talk about, but also just deal terms. And we want to know that we have a deal that both sides are seeing eye to eye on before we really start to incur significant legal expenses in engaging in both the negotiation and execution of these documents that are contemplated by this agreement as well as the underlying purchase agreement and other M&A documents. And so we really do kind of slow play the legal spend typically until this term sheet is executed. And then most often it's off to the races trying to do all the documentation in what is usually a fairly compressed timeframe.

And so there are a few binding provisions to this term sheet. And then most of what's in here are non-binding provisions. And if you listen to our first podcast, that's not terribly unlike the M&A LOI where the actual deal terms and the economics are not binding, but there are a few things that are binding. And so our term sheet starts out with the binding provisions. And the first one in sequence and the way we have this laid out is the expenses. And so typically, what we see is the independent sponsor will grant exclusivity to its equity capital providers, meaning they have a seat at the table, they're going to be able to participate with their contemplated piece of the equity, and the independent sponsor can't close the deal without that. But in exchange for that, the quid pro quo is that those equity capital providers will have to stand behind their portion of the expenses for the deal if the deal doesn't close.

And so that is critically important for protecting both the independent sponsor as well as its advisors. Because you could get to a scenario where you are very close to finished in a deal, have significant expenses, legal, accounting, insurance, environmental, all sorts of different advisors, and then if your seller walks away, there's no fund for the independent sponsor to draw on to pay those expenses. And so getting those broken deal expenses paid is very important. And so we typically have that set up as a binding provision. If the deal doesn't close, the equity investors will step up and pay their portion of the expenses.

Now, the exclusivity piece of this then, we usually see that 90 days, 180 days, something of that nature, where the independent sponsor can't close his deal without the capital provider being part of it and getting to invest whatever his piece is. I like to put in here, when I can get it, a provision that allows exclusivity to break if the capital provider re-trades on this term sheet. That can be a bit controversial sometimes. But I have had circumstances where an equity capital provider signed a term sheet and we suspected didn't ever really intend to honor that term sheet, and then added a whole bunch of highly material terms after the fact and too late in the deal process for us to do anything about it. And so what I try to build in here is if that happened, the sponsor can notify the equity capital provider in writing that if there's been a material re-trade, and if that re-trade isn't withdrawn within a certain period of time, exclusivity can break. That isn't going to protect you necessarily, the clock can still be working against you as an independent sponsor, but it does give you some degree of leverage and protection that if the equity capital provider's going to re-trade on you, that there's at least that risk that they could lose their deal.

I think that's a great point, and it's highlighted an important dynamic, Jeff. And it goes to the overall approach you take to drafting one of these equity term sheets and how important they are. Here at McGuireWoods, when we're representing an independent sponsor, we want to put in as many of the important deal terms as possible into this equity term sheet so that you can understand philosophically where the capital provider stands on different points. And I think more commonly what I see as opposed to a re-trade where there's a specific term that's re-traded on, is just where a term sheet is silent. Maybe it's a very high level term sheet, and then you get an LLC agreement or a management agreement drafted by the equity capital provider with a bunch of onerous terms in it. And that's maybe just how they've always viewed the world and how they've always protected themselves with respect to independent sponsors. But if you have that conversation in advance when you still, as an event sponsor, have multiple parties interested in investing with you, then you can have those discussions upfront.

And another point is just always you want to address the expenses and how you're going to deal with the broken deal expenses. Because they're very important. And I think that, again, you have just kind of philosophical differences as far as how some equity capital providers view those deal expenses, and you just want to make sure there's a meaning of the minds before you proceed.

Yeah. And it can be hard to get. If it's a pass the hat kind of financing, it can be hard to get the equity capital providers to stand behind those broken deal expenses. If you're raising, let's say, %15 million and you're raising it in one and two million dollar chunks from a bunch of different small family offices or high net worth individuals or what have you, that's a tougher ask for sure. And I've seen it done in that case, but that's a tough road to hoe. But if you've got a large check writer or one or two large check writers that are more of the institutional variety, I think that's easier to get. And I think the argument's got to be, "Look, if this were your deal, you would be on the hook for these expenses. And we're giving you exclusivity. We don't have a fund to draw on. We expect that this is the arrangement." And we are the vast majority of the time able to get a hundred percent or the vast majority of the fees covered when there is kind of that 1, 2, 3 institutional check writer scenario. So it's an important critical piece of the negotiation.

And so the other binding terms here, confidentiality, applicable to both sides. We don't want folks blasting out to the world that this term sheet exists. There's got to be obviously some carve outs to advisors and other financing sources and such. But generally, this term sheet should not be out in the world floating around. And then the other point that if missed at the NDA stage, the independent sponsor should make sure that there is a non-circumvent in here. And the non-circumvent means that the capital provider can't go do the deal without the independent sponsor. Because if you don't have that as a binding legal provision, there is a risk that your capital provider could go directly to the target and negotiate a deal that does not include the independent sponsor and its economics. And so there's that risk that, "I love this deal, and I love it even better without your carry and your closing fee and your management fee," that risk you want to foreclose. And so if it hasn't been foreclosed at the NDA stage, it must really be built into the LOI to protect the independent sponsor.

Essentially going forward after the closing, you can think about the M&A LOI as everything leading up to closing for the acquisition, and then this equity term sheet talks about the post-closing arrangements between the independent sponsor and the equity capital providers. So we're going to be talking about the economics of those arrangements and governance and things of that nature and structure.

Yeah. And you've got two choices on how you structure this. I guess in either structure you're going to have a management agreement. And that's going to provide for your closing economics, so your due diligence fee, as well as your ongoing management fee. And so those are both going to live in the management agreement. And then the carry and the terms of governance and the economics of the securities, you construct that in two ways. One is it can all be in one level, in one LLC agreement at the Holdco for the portfolio company. The advantage of that is it's all in one place, we don't have to worry about the interplay between the Holdco and other entities in the structure. But the disadvantage there is that your carry is going to sit in the Holdco waterfall, making that waterfall both more complicated but also transparent to anyone who owns equity in the Holdco, which is going to include the rollover holders as well as the management incentive equity holders. And so everyone can see the deal that the independent sponsor is getting.

Oftentimes, the independent sponsor does not like that. And so what we do is we structure it in two levels. The there's still the Holdco. And then the Holdco will an Investco or a Carryco that invests into it. And so the independent sponsor and the capital provider invests through the Carryco. And then the other holders in the Holdco continue to be the rollover holders and the management incentive equity holders. In that Carryco, we address how when the money is upstreamed from the Holdco to the Carryco, how is that allocated among the independent sponsor and the capital provider? And so really that provides for the carry. But it does create a little bit of complexity with making sure that the Holdco LLC agreement and the Investco or Carryco LLC agreement are working together, that governance is lined up, that economics are lined up, and that the party who controls those entities is not in a position to use corporate mechanics or things that are not illegal and not prohibited by the document in ways that could break the true business deal between the parties.

Yeah. An underlying principle in what you just said Jeff, but just to highlight it, is that it would be very atypical for the independent sponsor to earn, promote the rollover equity. So when a seller receives instead of cash, equity proceeds for a portion of the purchase price in the M&A deal, that is typically not subject to a promote. If it were, if there were special circumstances for that to be subject to a promote, which is atypical, that would argue for all of the economics to be in one document.

Yep, that's right. And that's a good point. That's a good observation. I have seen an independent sponsor negotiate carry on the rollover, but it's certainly a minority position. And you may not even call out, frankly, the structure, whether you're going to use Holdco versus Carryco at this stage. That may be an open point. Or it may be a point that the parties address directly. I think if it's an open point or if there will be a Carryco, I think you do want to at least reference some points that are going to be relevant about having a dual structure or a potential dual structure. But then other than that basic structure, you want to lay out what's the kind of securities that the parties are going to hold at the Holdco, and then we'll talk a little bit about the carry waterfall. Is the rollover equity going to be pari-passu with the equity that's held by the Carryco or the investors? You typically want to address those kinds of things. And most of the time, I do see that in today's market, but those kind of basic economics.

And then moving into governance, what I usually see is governance follows the investments. If you've got a single large check writer, most of the time that check writer is going to expect to control the board, especially if it's a private equity style investor. There are some family office types or some wealthy individuals or maybe an insurance company and some type of institutions that may not expect to control the board and will yield board control to the independent sponsor, notwithstanding that fact. But most of the time, that's not what I see. And then if there's a pass the hat financing where there is no large single holder, I would expect an independent sponsor to have board control. In any event, the independent sponsor will sit on the board with at least one seat.

Yeah. I would echo that I think it depends on the philosophy of the capital provider as far as governance, and this is something that should be addressed at the term sheet stage. I do see when control is yielded to an independent sponsor to control the board, there are two things, there are two governors on that. The first is a long list of approval rights that the equity provider will have as far as major decisions go. And the second governor on that is that there's usually a small list of bad acts and other terminating or triggering events where if those occur, then the independent sponsor will lose control of the board. Some of those include bankruptcy, commission of fraud, and other bad acts of that nature. And also the departure of the key person, for example, that led the independent sponsor if they depart and go to do something else.

And sometimes I see performance metrics on there too as well, that if the independent sponsor drives the company into a ditch, that they can lose board control. And it's usually at the option of the capital provider to take that back. And examples would be missing budget, negative EBITDA, going into some type of covenant default under the credit agreement. Usually they are black and white objective metrics that are built out with specificity in the documents.

Yeah. And those will also typically play into the management agreement and the management fee, which we'll talk about later. And if those events occur, there's typically a termination or a pause of the fee that the independent sponsor receives.

Yeah. So I typically like to build out the actual waterfall that is going to sit in the Carryco or at least be the... Typically, when it's in a Holdco structure, when it's one level, there's just the regular waterfall, and then there will be an override on that waterfall. And it will say the money that was distributed in that first waterfall will be further reallocated among the independent sponsor and its capital provider as follows. And so that waterfall, whether it sits at Holdco or whether it's just upstream at the Carryco, I like to lay it out. I think if business guys draft something in kind of business speak that is shorthand, the possibility that the sides are not truly aligning and thinking of the waterfall, the carry in the exact same way is very real. I've seen it plenty of times before, which is why I like to build it out with not exactly the same precision we'd see in the actual legal documents themselves, but with adequate specificity that there's really no room for the parties to disagree later. I think it's just in everybody's interest that everybody knows exactly how the money's going to go out. And it's just up to the lawyers at the documentation stage to build it out in a way that works within the legal documents.

Hey, Jeff, how do you feel about modeling this out in Excel at this stage?

I've seen it. I think it's a good idea to have it. One thing I've seen that you need to be really careful of is don't assume that those models are only for the business folks because they're numbers and not words on a page. I've seen scenarios where the business guys have shared a waterfall among themselves, never made us as the lawyers aware of it, and the words on the page don't match what's in the actual Excel file waterfall. And typically in that case, the numbers are going to win because that's the way that the business guys were thinking of it, or at least certainly the equity capital provider. And even though there may be holes in it, it may not be working exactly correctly, it may not be market, etc., that ship has probably sailed for me to be able to weigh in and help get the benefit for the client of what is market, is this holding together, etc. And so I would caution against that. But it's not a bad idea at all that there is an Excel file that matches the words on the page, but we need to make sure that they do in fact line up exactly.

Yeah. You're increasing the amount of work that goes into it at this stage, and so I don't see it all the time, but at times it can be a good idea. The one other point I'd make here is this is very much a business negotiation as far as what are the real economics that are in the promote. It's probably the most important economic provision in here. I would refer listeners back to the McGuireWoods independent sponsor deal survey where we surveyed what is market with respect to promote terms. And also feel free to give myself or Jeff a call on what's market economically. And that also goes for the management fee and the closing fees that we'll talk about it a bit. We're going to talk about how to describe them and structure them in the term sheet. But the data is in a separate document that we distributed last year.

Yeah, that's right. There's a lot of nuance here to economics. So I would encourage anyone who is looking to structure something and want some input to contact us because the survey is great and is super helpful, having one of us be able to give you a little guidance through that as well, I think, I think probably will yield the best result. One thing on the promote, so it's pretty common for especially private equity type actors and even more especially, the ones who either don't do a lot of this with independent sponsors, or tend to view the independent sponsor world as an executive with a deal, rather than a separate private equity actor, to ask for some type of termination or forfeiture on the promote in certain scenarios, like a termination of cause and etc. I don't view that as the market answer here. And anytime someone has asked for it, we've made sure that if we absolutely have to give it for the independent sponsor, that the cause definition is as tight as possible. But the way I view that is it's effectively a liquidated damage, where you say, "Okay, well now one of these things happens and it may cause no damage or it may cause a very small amount of damage. I now have a nuclear option to get what is potentially a very large windfall."

And so I think building out legal remedies for things is appropriate, but I have a lot of heartburn when the capital provider... When I'm on the independent sponsor side and the capital provider is trying to argue for some type of forfeiture of the promote, I'd say as an independent sponsor, if you have any leverage to resist that, to negotiate that term out. I would counsel you to do so. The risk of losing that is very real and those edges can be hard to negotiate. And it does make for a very difficult negotiation, because we now have to drill down really tightly on pretty much every provision in here because everything is now fraught with so much peril that if you make a misstep, you could potentially lose everything.

It's a great point, Jeff. It's something that you and I have both seen on recent deals. And I think it illustrates a broader point that we raised at the beginning of this podcast, is it's important to talk with a lawyer who has seen all the different contours of these deals and can put those terms into this term sheet so that you have the conversation at the outset and you have more negotiating power. Because I'll tell you, these points, it's a totally different negotiation when you have them at the term sheet stage, when you have an exciting deal as an independent sponsor in hand and you're talking to multiple equity capital providers, as opposed to 60 days down the road when you've incurred $500,000 in fees and you're having to negotiate these and the deal is at risk. So I think it illustrates a broader point that you just want to cover all these critical topics at the outset.

Yeah, that's a good point, Greg. Greg and I fashioned this term sheet specifically with that in mind, that once the independent sponsor provides exclusivity to the capital provider, the leverage decidedly shifts in favor of the capital provider. And so if you're ever going to be able to get independent sponsor favorable terms, it's going to be prior to granting exclusivity. And if you do have options as an independent sponsor, your leverage to be able to negotiate out some of these terms is better. And so that's why we try to flag them here now rather than kick the can down the road when you've got less leverage. Even though it does make the negotiation upfront a little bit more difficult, you are eyes wide open and maximizing leverage.

Great. Yeah. And so we'll try to move through the rest of the points in here at a relatively high level to keep this concise. But you'll want to address the diligence fee, sometimes known as the closing fee, in the equity term sheet. There is a lot of regulatory complexity to this topic. I would just advise you before even putting anything in writing to chat with your lawyer, discuss whether you are a registered broker/dealer, discuss other ways to describe and to essentially structure this in a way that's compliant. But essentially, this is economics that are paid at the closing and potentially rolled into the go forward platform. They could also take the form of profits interests in the go forward platform. And Jeff, do you want to talk about some of the other ways that these can be structured and other pitfalls involved here?

Yeah, sure. So the profits interest option is a way to defer taxes on the diligence fee. Because the diligence fee is really... It's a fee paid by the portfolio company to the independent sponsor. Capital providers typically like to see meaningful portion of that rolled back into the deal. And so if that fee's paid in cash, there is then, in the year of the closing, there is an ordinary income on that closing fee. And so then rolling that back into the company means that you have to pay a tax bill. If you were to roll a hundred percent, for instance, you'd have whatever your tax rate is times the amount of that fee and no cash to pay it because you had reinvested a hundred percent of the cash. So sometimes what we'll do is we'll structure these as a profits interest, which can give you good arguments that it's not a taxable fee. And so there are ways to do that. There are tax strategies to pursue. I would say if you're going to do that, you'd probably want to engage us at that point to really structure these and think about... Because there's advantages and disadvantages to that approach.

And then the other piece of these diligence fees, is there going to be a diligence fee on future transactions, on add-ons, on credit facility closings, on the exit transaction, etc.? Typically, yous would want to address that upfront right now in the LOI. The next piece of this is the management fee. And Greg and I talk about this in our deal study. Typically, the most common result here is 5% of EBITDA, paid typically on a quarterly basis payable to the independent sponsor. There are private equity actors that typically take a management fee or a closing fee. And oftentimes, they're going to expect to take some level of closing fee or management fee here as well. And so the negotiation about who's going to get what and how much is the aggregate going to be and how's that going to break down, all that needs to be addressed in here.

And then I typically like to address in here what happens if the credit agreement blocks payment of the management fee. Because the credit agreement will not allow payment of the fee if the company is in breach of its covenants under the credit agreement or if there would be a proforma breach assuming payment of the amounts. And so talking about if that can't get paid, does it accrue, how long does it accrue, etc., those are all things that I think are worth addressing here.

The next important point here I think is tax distributions. This is less important if you're in a blocked structure. It's frankly not that important in a blocked structure, meaning you've got a C corp that sits below or in your structure is blocking the flow through of allocation of profit and loss. But if you are in a partnership structure, a flow through structure here, I typically like when I'm representing the independent sponsor to get tax distributions counted as advances because it gets the independent sponsor further into the carry quicker. Meaning if tax distributions are not counted as advances on ordinary distributions, then all that money that's flowing out to pay tax is not applying against the waterfall and not applying against the carry. Whether they count or not should be considered, and it should be considered when you think about the promote, the hurdle amounts, the break points, and the sharing percentages, and be included in the way that you're modeling out and thinking about this because it can move the needle in favor of one party or another.

And then the last big piece here that I like to address is the negative covenants. The party that does not control the board will need some negative covenants to protect themselves. And so if the majority equity holder is not the independent sponsor, typically that independent sponsor is not going to get what I think of as operational style negative covenants. The negative covenants instead are typically more limited to things like affiliate transactions and then other transactions that could be used to break the economics or break the deal.

Great, Jeff. Well, thanks for all of your insights on this one. Thanks for your time. It was good to chat through the equity term sheets on this episode. It's one of the most critical points for our clients in this space. And so hope everyone finds this useful. Again, if there are follow up questions, I'm available, Jeff's available to answer those. And this episode will be released towards the end of the year, so we wish everyone a happy holidays. Good luck with Q4 deal closing craziness if that's where you're at on your transactions. And we'll look forward to the next episode of Deal by Deal.

Thank you for joining us on this episode of Deal by Deal, a McGuireWoods independent sponsor podcast. To learn more about today's discussion and our commitment to the independent sponsor community, please visit our website at mcguirewoods.com. We look forward to hearing from you. This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state, and should not be construed as an offer to make or consider any investment or course of action.