Know Various Aspects Related To The Term Sheet

Know Various Aspects Related To The Term Sheet

1. What is a Term Sheet?

A term sheet is a nonbinding agreement that shows the basic terms and conditions of an investment. The term sheet serves as a template and basis for more detailed, legally binding documents. Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is drawn up.

2. Term Sheet in the Indian Context 

A term sheet may likewise be referred as a letter of intent, an MOU i.e. memorandum of understanding. The first round of speculation from a financial investor is known as a term sheet. Every round of investment has its own terms & conditions and these terms define a business seeking outside capital funding. The label isn't imperative, and regarding their structure and drafting they set out the key business and legitimate terms in regard to a proposed transaction.

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3. Is the Term Sheet legally binding in India?

One of the fundamental aspects in every corporate transaction is ascertaining whether the term sheet is intended to be binding or non-binding. Below we discuss the various facets of binding nature of term sheets, from a drafting perspective as well as enforceability perspective.
a.    Drafting Perspective  
i)    Non-binding Term Sheet: While this is the most common position in term sheets, calling this document 'non-binding' term sheet is a misnomer as actually it is a partially binding term sheet. There indeed is express language to indicate that the term sheet would not be binding between parties, as there would be detailed definitive documents in the future. At the same time, typically an exception would be created for clauses like Exclusivity, Confidentiality, Term and Termination, Governing Law and Dispute Resolution, and the like, which would remain binding between the parties.
ii)    Binding Term Sheet: As is self-explanatory, a binding term sheet implies all clauses and provisions therein would be binding between the parties. From an enforceability perspective, it has more teeth. Therefore, any definitive documents in the future should clearly have provisions that override this document.
iii)    Unilaterally Binding Term Sheet: This is an interesting practice that we sometimes observe, where the term sheet is drafted as a hybrid of the above two models. In other words, for one party it would be non-binding (with the exception of clauses cited above), while for the other party all obligations and commitments would be binding. This is normally done to a party that is perceived to be one that could significantly try to alter principles agreed in the term sheet during negotiations of definitive documents, or for start-ups where at term sheet stage the investor/acquirer does not have sufficient visibility of the facts.

4. What does a Term Sheet include?

Company valuations, investment amounts, the percentage of stakes, and anti-dilutive provisions should be spelled out clearly.
Voting rights. Startups seeking funding are usually at the mercy of VCs who want to maximize their investment return. This can result in the investor asking for and obtaining a disproportionate influence on the company's direction.
Liquidation preference. The term sheet should state how the proceeds of a sale will be distributed between the entrepreneur and the investors.
Investor commitment. The term sheet should state how long the investor is required to remain vested.

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5. What is the purpose of a Term Sheet?

All term sheets contain information on the assets, initial purchase price including any contingencies that may affect the price, a timeframe for a response, and other salient information.
Term sheets are most often associated with startups. Entrepreneurs find this document crucial for investors, often venture capitalists (VC), who may offer capital to fund startups. 

6. Who prepares the Term Sheet?

A term sheet may be prepared by either party – the investor or the founder. Usually, if a venture capital firm is investing, the VC offers a term sheet.

7. Is a Term Sheet legally binding?

Generally, term sheets are non- binding in nature, but they can become legally binding if executed on a stamp paper. The provision for its nature being non-binding can be inserted in the term sheet itself. Parties should be careful while drafting these documents at the negotiation stage.

8. Why are the terms important if they are non-binding?

While terms in a term sheet may be non-binding, they still represent the conditions of an agreement that both parties have agreed in-principle, like a handshake deal. If the due-diligence progresses well, these are the terms according to which a binding stock purchase agreement will be prepared.

9. How do you negotiate a term sheet?

Following are the ways to negotiate a term sheet: 
Get more than one VC interested
Understand common market terms
Watch out for red flags
Understanding valuation and dilution is critical
Consult with experts for advice

10. Are term sheets enforceable?

Generally, term sheets are non- binding in nature, but they can become legally binding if executed on a stamp paper. The provision for its nature being non-binding can be inserted in the term sheet itself. Parties should be careful while drafting these documents at the negotiation stage.

11. What is a term sheet in M & A?

A term sheet is a mostly non-binding document signed by the target and the prospective buyer that describes the major terms of the proposed acquisition. While most term sheets are non-binding, they often contain binding provisions regarding non-solicitation, exclusivity and confidentiality.

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Decoding Term Sheets

Decoding Term Sheets

What Is The Meaning Of A Term Sheet?

A term sheet is a non-binding agreement outlining the essential investing requirements. It can be a starting point for creating more extensive, legally binding papers. An agreement or contract that complies with the term sheet's provisions will be drawn out once the parties concerned have reached an agreement on the details set out in the term sheet. In general, a term sheet should describe the most significant components of a contract without getting into small details or contingencies that would be handled by a formal contract.

It simply lays the framework for ensuring that the parties engaged in a business transaction agree on the most critical parts, reducing the risk of misunderstanding and unnecessary litigation. It also guarantees that significant legal fees for drafting a formal agreement or contract are not incurred prematurely.

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Typical Clauses Included In a Term Sheet

  1. Is the Term Sheet Legally Binding?: No, save in the case of legal liability for confidentiality, exclusivity, and costs. The goal is to specify the terms and see if the agreement has enough legs to close between the parties.
  2. Assessing the Worth of Your Company: Calculate the value of your firm realistically using comparable companies as a baseline. A high value may look good on paper, but it will also raise the bar for future fundraising if you want to acquire another round.
  3. Due Diligence: It's critical for the founder to conduct full due diligence on everybody they'll be doing business with. One of the major concerns raised by venture capital and private equity firms is that the entrepreneur does not conduct their due diligence on their long-term partner. Be specific about how your investors will assist your company in ways other than finance.
  4. Financial Instrument: Stocks, which include preferred and ordinary stocks, are the most popular equity. Convertible debt notes are becoming more popular.
  5. Partner Participation Rights: There are three categories of partner participation rights, each with a different level of economic upside potential for investors.
    • Non-Participating — The choice that is most owner-friendly. The investor must select between a straight preference for liquidation or a pro-rata share of all proceeds.
    • Capped Participation – Similar to the Full (see below), but the total return from liquidation and participation rights is limited to a certain multiple.
    • Full Participation - This is the most investor-friendly option. The investor gets their liquidation preference first, followed by a pro-rata share of any residual funds. Determine the voting rights of each of the three different sorts of investors.
    • Determine the voting rights of each of the three different sorts of investors.
  6. Pro-rata Rights: Pro-rata rights give initial investors the choice (but not the obligation) to invest in subsequent rounds to keep their ownership, which would otherwise be eroded.
  7. Liquidation Preference: Liquidation preferences define the payout hierarchy in the case of a corporate liquidation, such as a sale or merger. Liquidation preferences allow investors to specify the initial payout amount and breadth that they will receive.
  8. Anti-dilution Provisions: This right protects an investor from equity dilution caused by future stock issues if the stock is sold for less than the original investment price. This also changes relative ownership percentages to prevent new stock investors' stakes from being lowered.
  9. Protective Provisions: Protective Provisions give investors veto power that they would otherwise be unable to wield on the board of directors since their percentage share does not equal a majority vote. Examples are forcible discussions, such as a company sale, stock issuing to costs, or hiring sign-offs.
  10. Drag Along Rights: This provision permits investors to persuade other stock classes to comply to their voting requests in the event of a liquidation event such as a sale, merger, or dissolution.
  11. Right of First Refusal/Right of Co-Sale: Notifies all investors about stocks available for acquisition by other investors and requires board approval of all stock transfers to prevent stock transfers that are done in secret.
  12. Guarantees: If the founder is needed to be a guarantee, specify how and when the guarantor will be removed from the note.
  13. Vesting Schedule: Vesting is the method through which a company's shares/equity are earned over time (typically four years or fewer.) When a founder with vested stock leaves unexpectedly, the cap table is left with dead-equity. This event may have significant ramifications for the remaining founders and funders.
  14. Liquidation Preference: Liquidation preferences allow investors to specify the initial payout amount they will receive.
  15. Confidentiality and non-competition protect investors from conflicts of interest that develop when they try to leverage their portfolio by sharing information or investing in competitor enterprises. The duration of this insurance spans from two to twenty years (as seen in oil and gas deals.) In addition, the founder wants the investor to be entirely focused on guaranteeing the success of their company.
  16. Mediation/Arbitration/Governing Law and Jurisdiction: Disputes arise that necessitate the intervention of a third party. If this action is required, ensure it is handled in the most convenient jurisdiction for you.

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How Can VCs Protect Their Interests In A Term Sheet?

Four provisions must be included in the term sheet to protect the interests of VCs:

  1. Voting Rights: Preferred stock frequently includes Board seats and voting rights. Venture investors have a greater say in the company's operations, management, and direction due to this.
  2. Dividends: Dividends are features that distinguish preferred stock from common stock. Dividends boost the overall return for preferred investors while lowering the total return for common stockholders. Dividends are sometimes expressed as a percentage of the preferred stock's initial issuance price.
  3. Participation and Liquidation Preferences: Participation and liquidity preferences ensure that the investment is compensated before a liquidity event occurs (when a company is sold, goes public or declares bankruptcy). These considerations are critical if the company is liquidated for less than the amount invested.
  4. Anti-Dilution: In the event of a down round, a firm issues equity at a lower valuation than in earlier rounds, the anti-dilution provision protects investors.

The majority of term sheet protections are paid for by common shareholders, who include founders and workers, so it's critical that they're reasonable and equitable. If a VC is overly shielded, it can stifle a company's growth and success by reducing its ability to attract talent and attract new investors in the future.