Reading a Term Sheet
A term sheet, typically non-binding on either party, outlines the terms based on which the investor is willing to invest his money. This document is always provided by the investor. Ironically, the smallest among all transaction documents, the term sheet involves the lengthiest discussions. Once this bridge is crossed, its akin to a firm foundation that has been laid and the rest of the documentation process is considered a hop, skip and a jump (don’t literally skip anything though!).
First and foremost, it is necessary to determine the type of security the Company will be offering. The options at hand for an entrepreneur include equity shares, convertible preference shares or debentures. Certain types of investors are permitted to invest only in certain class of securities. In light of the fact that many start-ups these days receive funding from non-residents, it is important to highlight that a company is not permitted to issue securities in the form of an optionally convertible debt instrument due to restrictions by the Reserve Bank of India.
Most term sheet clauses can strictly be classified into economic terms and control terms. Economic terms may not sound greek and latin to many entrepreneurs; but the negotiation of the control clauses maybe the deal breaker. Economic terms include the valuation aspects, employee stock option plans and related terms including the mode of vesting, anti-dilution, and liquidation preferences. Anti-dilution clauses ensure that the investor’s shares are not diluted with the issue of more shares. Control related clauses include representation on the board of directors, drag-along and tag-along rights, and other protective provisions. Needless to say, many of these are structured to favour the investor. (And the lawyer helps you ensure equity related to rights.)
For instance, the idea behind a drag along clause is to also offer the investor shares to the new buyer so that the investor doesn’t retain an unwanted minority in the company. Such rights are triggered then the promoters initiate sale of their shares. Board seats are a contentious issue. Where the investor creates no hassles, there is an equitable distribution of seats, usually an equal number to both parties with the appointment of an independent director upon the mutual agreement of the investor and company. Some companies opt to have a point of reference to allot board seats. In one microfinance company, any investor that had over 7.5% shareholding was allotted a seat. Ensure this doesn’t exceed 15, the stipulated maximum as per the new Companies Act, 2013.
Other important yet standard clauses in a term sheet include Right of First Offer (ROFO), Right of First Refusal (ROFR), exclusivity clauses and protective provisions that require prior investor consent. The protective provisions are commonly referred to as affirmative vote items or veto items and include, among others, changes in equity capital structure, changes to the Memorandum of Association, Articles of Association, mergers, acquisitions, listing of shares, etc. Ensure the provision of the shareholding structure before and post the investment and specify a timeline to work this investment.
The term sheet is pretty much like an engagement before the formal wedding, i.e signing the shareholder agreements and the share purchase agreements referred to as definitive documents. Signing the term sheet means that the Company is open to the investor conducting a financial and legal due diligence to see if everything is in order. In fact the exclusivity clause in a term sheet ensures that the company is not open to other prospects and the term sheet itself signals the intent. The reality though is that investors have by and large standardized term sheets with boiler plate clauses, and since they are pooling in their money, many entrepreneurs are wary of being aggressive forcontrol specific clauses at the initial stage of funding.
The author is a Consultant at J. Sagar Associates. Views expressed here are personal.
About the Author
Harini Subramani works with the corporate commercial team at J.Sagar Associates in Chennai, and has assisted in strategic and private equity acquisitions. She also helps startup companies and emerging entrepreneurs address legal concerns. Harini also co-authors a blog www.indialawforindiastartups.wordpress.com along with Aarthi Sivanandh, a partner at J. Sagar Associates
Prior to joining the legal profession, she was a journalist and wrote for the Mint, and the Wall Street Journal, among others, on mergers and acquisitions.