A term sheet is an important document which helps to clarify key terms of an agreement that two parties wish to enter, more specifically to investors and business owners. It is a broad understanding that comes prior to the legal contracts and due diligence that follows. In this article, we shall discuss the most important elements of a term sheet with a real life case from Bada Business Professor Sanjay Kathuria. Get the insight of the primary components as well as their roles in the investment process.

An Introduction

A term sheet is one of the primary agreements that can also be termed as a foundational agreement such like “Roka” ceremony in a marriage, is where both parties agree on the essential features of the relationship prior to the marriage. It comes before the very detail due diligence that needs to be done and the agreements that shall be signed.

Let’s pick a term sheet example with a startup, Harness Technology. This tech-based startup is funded by Unicon Investment Corporation for the amount of Rs. 10 lakh and has two promoters that go by the names of Param and Disha. The startup operates under the term of the tech industry and the term sheet is necessary to facilitate the transaction between the investors and the promoters.

Key Components of the Term Sheet

1. Type of Business and Its Equity Structure

The first part of the term sheet includes the description type of industry being operated in. For instance, in this case, it is technology and also includes the name of the promoters, Param and Disha. The capital structure is very important because it specifies the total amount of equity shares, the face value of the shares, the total number of preference shares and the shareholding pattern. Take for instance, if this company has 10 lakh shares at face value of Rs. 10 each, then the total value of the shares would be Rs. 1 crore. Param and Disha could have a percentage ownership of 25% which means they would hold 2.5 lakh shares.

2. Content

The term “instrument” pertains to different kinds of investments which for the most part are made by purchasing equities. A term sheet usually contains the face amount of the share value, for example, Rs. 10, and a premium over that amount, to entice prospective investors. For instance, rather than issuing the shares at Rs. 10, the company can issue the shares at Rs. 210. This enables the company to collect more capital.

3. Valuation.

The valuation is one of the more important constituents to the term sheet. This incorporates both the pre-money and post money valuation of the company. For example, if the company is valued at Rs. 10 crore and the investor is putting in Rs. 2 crore, then the post money valuation will be Rs. 12 crore. This assists in determining the value of the equity stake for the investor and in this circumstance 16.27% for a Rs. 2 crore investment.

4. Proposed Transaction

The term sheet needs to outline which documents need to be signed, the conditions within the agreement, its scope, and the deadline to complete the transaction. It also needs to clarify the timing of the shareholder agreement and share subscription agreement and the amount of change to the shareholding pattern post investment.

5. Board Composition

It is common for investors to want representation in the company’s board. The term sheet must cover the distribution of board seats amongst the parties, striking a balance between promoters and investors decision-making ability and control. It’s important to put limits regarding the number of board members for the promoters as they will most likely determine the strategic direction of the company.

6. Pre-emptive Rights

Pre-emptive rights gives an opportunity to investors to buy more shares before they are offered to outsiders. This guarantees that investors are protected from losing their ownership interest from future share allotments.

7. Anti-Dilution Protection

This clause defends investors from their shares being diluted. For instance, where a company gives out new shares at a price lower than the original investment, the anti-dilution measures force the company to either lower the investor’s new shareholding or increase the investor’s original shareholding to maintain the value of the investment.

8. Lock-In of Share Holder

A lock-in period is often decided for promotors to safeguard the investors’ interests. This is best described as putting a restriction on the sale of shares within a timeframe of 2-3 years. At the end of the lock-in period, promoters may sell their shares but on a staged basis as per term-sheet agreement.

9. Graduated Vesting of Pro Romoter

This explains how the promoter will gradually vest shares over time and examples set, say for a pro-moter with 2 lakh shares and a 3-year lock-in, may sell 20% of his shares after the lock-in period, and the remaining in subsequent years.

10. ESOPS (Employee Stock Option Plan)

It’s a great tool to offer employers a chance to really engage and motivate employees while giving them a samll stake in the company. It is imperative that the term details the shares given to employees and directots, their vesting time and qualification for allotment.

11. Right of Approving Voting Decisions

Affirmative voting that enables him to mandatory seek attendance and approval is good, however these terms tend to get extremely narrowed. Clauses need to be self-explanatory. What the investor must vote on before decisions such as funding the business or directional change may then be implemented.

12. Liquidation Preference

Liquidation preference makes it so that investors receive back their investment before any other party, other shareholders included, gets to take their share. Usually, the investor tends to have the most preference, followed by secured creditors and other stakeholders.

13. Information Rights

It’s normal for investors to want to track the progress of the company they are investing in. Information rights likely comprise of regular updates, for example, quarterly reports, audited financial statements, and other relevant disclosable information.

14. Exit Mechanism

The exit mechanism is one of the most important clauses in terms of an investor’s exit from the investment. This could be an Initial Public Offering (IPO) or a company share buyback. While it is usually included in the term sheet, the strategy and the exit rights of first refusal should be specified as well.

15. Free transferability

Investors usually prefer to reserve their right of global selling of the shares, with the exception of competitors. This clause helps the investor to divest from the investment when the company is failing to perform.

16. Non-Selling Investors Promoters Right of First Offer (ROFO)

When investors wish to sell portions of their shares, the shares are first offered to other current shareholders before being opened for purchase by third parties.

17. Right of First Refusal

In the case where an investor receives an offer for the purchase of their shares, other investors must be informed and provided an option to match the offer prior to the shares being sold to external parties.

18. Tag-Along and Drag-Along Rights

Tag-along rights permit minority shareholders the option to sell their shares alongside a majority shareholder. On the other hand, drag-along rights enable a majority shareholder to compel the minority shareholder to part with their shares if they decide to sell their own.

19. Documentation

The timeframe for signing definitive agreements like the Shareholder Agreement and Share Subscription Agreement should be outlined in the term sheet. These agreements set the conditions of the deal in place.

20. Conditions Precedent

Legal and financial due diligence, checking employment agreements, and all relevant permissions being granted are some of the steps that must be completed prior to closing the deal.

21. Standstill Provisions

Standstill Provisions govern what occurs in the event of disagreements with respect to the investors or promoters of the company. This provision explains how a difference of opinion will be settled.

22. Representation and Warranties

The term sheet will have provisions from the promoters who will guarantee that all the information pertaining to the company and its legal standing in the constituent documents are true.

23. Statutory Approvals

The term sheet should outline what statutory approvals may be required to facilitate the investment deal.

24. Events of Default

The term sheet should describe actions such as non-payment or non-performance that might lead to a default on the part of the investor or the promoter.

25. General Clauses

These clauses pertain to costs for extraction of other services such as legal as well as for due diligence and state the allocation of responsibility for the costs involved.

26. Confidentiality Agreement

A portion of the term sheet should state that sensitive information regard this investment must be protected with a confidentiality clause.

27. Exclusivity

The promoter shall be bound to the investor until such a time that the deal is transacted. During this period, no other potential investors may be sought by the promoter.

28. Termination

The term sheet should describe how the deal can be terminated, including all penalties or other conditions that might relate to termination.

29. Amendment

Alterations to the term sheet should be made with the agreement of both parties.

Conclusion–

A term sheet serves both as a reference document and as an expectation document for both the investor and the promoter. This becomes helpful in preventing the possible conflicts of interest. For an investor, a term sheet is crucial for establishing and maintaining a healthy rapport with the associated business.