Most entrepreneurs and start-up founders are not the kind of people who would be particularly adept with paperwork and are often clueless about the documentation required when seeking investment for their stunning business idea. One such document is the “Term Sheet”.
The Term Sheet is a preliminary document that a start-up founder encounters at the beginning of any investment transaction. In simple terms, a Term Sheet is like a marriage proposal where the company and the investor meet to negotiate the basic terms and conditions of their investment.
Most times, a Term Sheet is non-binding. It signifies the intention of the parties to enter into a legal relationship which would eventually be formalized when executing legally binding documents such as a Shareholders’ Agreement or a Share Subscription Agreement. It is a document that marks the start of an investment transaction. Let’s understand the basic questions regarding Term Sheets.
Why do you need a Term Sheet?
Being the first document of understanding between the founders of the company and the investors, the Term Sheet gains importance considering the following:
- It outlines the “conditions” of investment and sets the framework for future negotiations. These conditions would involve terms like valuation of the company, details of investment, control provisions, exit route for investors, and rights of investors, among others.
- It acts as a roadmap to prepare final investment agreements.
- It covers vital aspects of the deal without describing every small uncertainty covered by a binding agreement.
- It saves time and effort to negotiate numerous transactional documents individually.
- It minimizes the likelihood of a future misunderstanding or dispute.
Is it mandatory to prepare a Term Sheet before the final investment agreement?
Preparing a Term Sheet before the final investment agreement is not mandatory. However, most founders prefer having a Term Sheet because it gives a clear picture of the significant terms and conditions of an investment on which the investors and the founders can agree, thereby reducing the chances of a misunderstanding and subsequent dispute.
Who usually prepares a Term Sheet?
Investors generally prepare a Term Sheet after the entrepreneur’s pitch to such investors, which then goes on for several rounds of negotiations. That said, there is no hard and fast rule regarding who can prepare the Term Sheet first.
When does a Term Sheet need to be signed?
Term Sheet s are not time-specific, but they are pre-transactional documents. They are precursors to any final investment agreement. They are the foundation on which the final transaction documents are executed. Thus, as far as the signing of the Term Sheet s is concerned, that will occur once both parties agree to the terms of the Term Sheet and before the final investment agreements are executed.
What are the essential clauses in a Term Sheet?
The Term Sheet consists of certain important clauses, which are also included in the final investment agreements in the same manner, as the parties have already discussed, negotiated and agreed upon most of them. It is for this reason that these clauses should be minutely observed. The following are some of the important clauses which should be well understood by parties to the Term Sheet:
- The Investment Amount: This clause is highly essential because the purpose of seeking investment from the company’s perspective is to raise capital.
- Pre-money Valuation: The primary aim of investors is first to see the value of the company pre-investment and then assess the value post-investment to ultimately decide whether they will invest or not.
- Anti-dilution Clause: This clause is inserted for the protection of investors as they generally have an apprehension that their own shareholding in the company may get diluted when the company goes ahead and issues new shares.
- Liquidation Preference: This clause sets out who gets paid first and how much they get in the event of winding up, IPO, or any strategic exit by the investor. By inserting liquidation preferences in a Term Sheet, investors protect themselves against downside risks by ensuring they get their money back before other stakeholders.
- Board Rights: Many Term Sheets include a clause where a director will be nominated by the investor (with voting rights in board meetings). Alternatively, the investor can also choose to have a board observer (with no voting rights).
- Restricted Matters: This clause mandates the Promoter/Director to obtain prior consent of investors before proceeding with major events that may have significant impact on the business of the Company or its shareholding such as merger, amalgamation, takeover, restructuring of capital, change of business nature etc.
- Tag-along and Drag-along rights: While the tag-along clause seek to protect the minority shareholders by enabling them to “tag-along” with the majority shareholders, drag-along protects majority shareholders by preventing the minority from being a bottleneck in case a third party seeks to purchase shares of/acquire the company.
- Investor’s Right of First Refusal: As per this clause, if the founders intend to exit the company due to some event, then investors will have the right to purchase the stake of the founders.
- Information Rights: These rights enable investors to get information from start-ups regularly. This may include financial statements, budget plans, MIS, key metrics and performance indicators.
- No-shop clause: This provides the investor with an exclusivity period in which promoters of the company cannot deal with another set of investors while negotiations with one set of investors are already going on.
- Transfer restrictions: This clause imposes restrictions on transfer of shares by the Founder or their exit from the Company, without the consent of the Investors.
Once final investment agreements are entered into, there is no going back. This is where the role of Term Sheet come in. They are pre-transactional documents that the parties can debate and negotiate. A single Term Sheet can be the foundation for several transactional documents. This saves time and effort in negotiating several documents individually. Hence, it is very crucial to have a Term Sheet that is comprehensive and unambiguous.
In case you’re looking for assistance in preparation of Term sheet, drafting of agreements and corporate secretarial compliance support for issuance and allotment of any shares/securities, then please get in touch with us.
The content of this document has been developed based on relevant information and are purely for private circulation. Though the authors have made utmost efforts to provide authentic information, however, the authors expressly disclaim all and any liability to any person who has read this document, or otherwise, in respect of anything, and consequences of anything done or omitted to be done by any such person in reliance upon the contents of this document.