Journey from term sheet to shareholding agreement – Startup Funding

13th Aug 2015
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The journey from a term sheet to a shareholding agreement is exactly the same as that from betrothal to marriage. The deal is on the moment you sign a term sheet with the investor. However, the deal is only consummated once you sign a shareholding agreement with them. In the course of this journey, there can be a number of changes in the agreed terms and conditions. This is where most startups get confused. They take the clauses in the term sheet as final and binding. Consequently, when they receive a shareholding agreement with substantially different clauses, they are literally spooked. We have seen ripe investment deals go caput due to such misunderstandings.

Term sheets and shareholding agreements are two different sets of documents. In this article, we have tried to visit the finer points that differentiate both the documents, and the reasons why variations occur.

What is a term sheet?

A term sheet is a non-binding agreement that sets forth the basic terms and conditions under which an investment will be made. It serves as a template to develop more detailed legal documents and is the basic tool for negotiation. It is more like an offer to invest under specific conditions.

What is a shareholding agreement?

A shareholding agreement is the final document. It is definitive and legally binding. It is a written agreement among company's shareholders, describing how the company should be operated. It also outlines the shareholders' rights and obligations.

If we simply go through the definitions, it is pretty much evident that these documents are fundamentally different. In most cases, the clauses in the term sheet are ratified in the shareholding agreement. However, there might be cases wherein there are stark differences. There are two major reasons for this:

  • The “horrific” due diligence process- the investor viewpoint

The investors’ Due Diligence process starts right after the signing of the term sheet. It is like the litmus test for the claims you made while negotiating with the investors. If some material discrepancy is unearthed in this process, wherein the facts of your case beg to differ from your negotiation claims, then be ready to expect some mammoth changes in your final document.

I keep saying this, but the fact is that currently, the Indian startup scenario is ruled by tech startups or guys from a non-finance background. Most of the times, they are not aware of the legal compliances that their company needs to undertake.

There are also situations where they are in perfect compliance with the basic annual compliances, but thoroughly non-compliant with internal control norms and procedures. Some grievous areas of non-compliance that might lead investors to rethink your term sheet clauses are listed below:

  • Secretarial practices are not in place
  • Statutory Registers, Minutes and Resolutions are not recorded correctly and in a timely manner
  • Ownership of Intellectual Property does not reside with the company
  • State-specific licenses and permits have not been obtained
  • No clarity on internal agreements and contracts between shareholders or directors
  • Government filings done with additional fees and penalties
  • Annual tax and RoC filings not done at all

There can be various other reasons as well. However, these, being the most common ones, need to be taken care of on priority.

  • The Negotiation Leverage- The Startup Viewpoint

Obtaining funding from third parties, especially from venture capitalists, is a bargaining exercise. Most of the time, startups are not in a position to exercise leverage over seasoned VCs. Another practical aspect to this is that most investors visualize the term sheet as a trailer of a movie. It is “just another” document for them. The ultimate document is the shareholding agreement, and they are more concerned about the same.

Now, a significant amount of cost and time is already incurred by startups by the time the shareholding agreement arrives. Thus, they can be lured into accepting conditions they otherwise wouldn’t have agreed to. Though this is not a very common scenario, it is not unheard of. Further, most of the time, the psyche of a startup also puts it at a back footing.

A possible solution to this is doing a thorough background check of investors, so that the concerned startup chooses the right investor. Even more important than that is deciding the timing of your investment. There is always a right time to get funded.

These problems usually arise when a startup goes for premature funding exercise, automatically giving the investor an edge. For example: a start-up with a defined prototype and an executable operational blue print is likely to have a competitive advantage over a start-up with nothing but an idea. The same VC for the same business line might just invest much more for a lesser stake in the former one, as compared to the latter one. Hence, it becomes very important to judge the timing of your investment pitch.

To Conclude

In conclusion, we can say that a shareholding agreement is the foundation stone upon which the startup-investor relationship is laid, the material for which is provided by the term sheet. Startups need to focus equally well while signing the shareholding agreement as they do while signing the term sheet.

You may get in touch with the author on his website Taxmantra.com and get more information.

(image credit: Shutter Stock)

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