This article has been written by Surya Sriram, pursuing Diploma in General Corporate Practice: Transactions, Governance and Disputes from LawSikho. It has been edited by Zigishu Singh (Associate, LawSikho) and Arundhati Das (Associate, LawSikho).
Are you involved in any transaction of investment or raising capital? Are you involved in fundraising for your new start-up? In the book ‘The Art of Startup Fundraising’ the author says, “term sheets can be really scary for new startup founders”. The reason behind this is described as the “fear of the unknown, or of making a mistake that the founders may regret later”. Hence, through this article, an attempt is made to give a holistic view on term sheets which enables the founders or whoever concerned to overcome that “fear of unknown” or of the fear of “making a mistake”.
“Term sheets”, “memorandum of understanding”, “letter of intent”, are some of the documents with a similar nature, with certain minute differences, which usually outline a deal or a transaction. This is considered as the first step after the process of negotiation of a deal or a transaction, where parties formulate a term sheet before entering into formal agreement. The actions or obligations of the parties in the further process of a transaction are usually dependent on what has been outlined in a term sheet. Hence, the parties should be aware of various aspects in relation to term sheets to understand how it affects the transaction or interests of the parties’ firm or the company.
Understanding the Term Sheets
As explained above, a term sheet is a document which highlights and outlines the intentions and expectations of the parties of a transaction where they enter into an “agreement to agree”. A term sheet is a ‘precursor’ to the actual or formal agreement which the parties will enter in the further process of the transaction.
The importance of a term sheet can be understood from the fact that it sets out key commercial and legal terms of a proposed transaction. As we know that consensus ad idem is an essential element to enter into a contract, a term sheet facilitates the parties to reach consensus by identifying the major issues and ‘deal breakers’ before committing the time and money of the parties in the extensive process of entering into the contract and carrying out the due diligence.
If we talk about types of term sheets, it is wholly dependent on the type of transaction that has been carried out by the parties. The objective of a transaction dictates the term sheet and the variations in the types of clauses to be included. For example, A Private Equity or a Venture Capital transaction entered with an objective to gain financial returns. This would include clauses like; Valuation, Conversion Rights, Proposed Amount of Investment, Affirmative Rights, etc.
Binding and Non-Binding Term Sheets
A Binding term sheet implies that the parties are bound to follow the obligations contained therein, and it can be enforceable in a court of law. Many entrepreneurs have a misconception that the term sheets are non-binding, and they have the flexibility to renegotiate the transaction. Considering a term sheet as non-binding is a ‘misnomer’ because it is partially binding in most of the cases. The partially binding nature is usually indicated in the ‘preamble’ of a term sheet where it states, “this term sheet is non-binding except for Clause XYZ which shall be legally binding on the parties”. Though the term sheet might not mention the nature, it can be obtained from the facts of the scenario and the clauses of the term sheet. For instance, clauses like ‘Confidentiality’, ‘Exclusivity’, ‘Governing Law and Jurisdiction’, etc. indicate the partially binding nature of a term sheet, which may vary from case to case.
On the other hand, though a term sheet is non-binding except for certain clauses agreed, it often becomes difficult to renegotiate the terms of the term sheet as it may reflect the unreliable nature of the party which insists for such renegotiation. Further it becomes more difficult if one of the parties had begun working on such terms internally, which might result in a waste of efforts if renegotiation takes place. Therefore, there is an informal enforceability of a term sheet created in this way, which makes it binding.
Zostel Hospitality Pvt. Ltd. (Zostel) v. Oravel Stays Pvt. Ltd. (Oyo) is a unique case which illustrates the fact that even though the non-binding nature of the term sheet is explicitly mentioned, it may become binding subsequently, based on the judicial evaluation of the circumstances of a case.
Brief Facts: In this case the parties executed a term sheet for the purpose of acquisition of assets including Intellectual property rights, software, key employees, etc. The claimants (Zostel) claim that they acted upon the term sheet and fulfilled all the obligations contained therein . They contend to be aggrieved by the acts and omissions of the respondent (Oyo), and breach of terms and conditions of the term sheet, due to which the acquisition process couldn’t be concluded. Hence, one of the main issues raised is as follows:
Issue: Whether the term sheet is non-binding as stated in it or whether it is a binding, valid and enforceable agreement in terms of the acts of the parties as alleged by the claimants?
Held: The Arbitration Tribunal held that the term sheet was binding in their opinion as the claimants took various steps to fulfill the obligations outlined in the annexure of the term sheet.
Analysis: The tribunal observed that the respondent has entertained or shown interest in communication regarding fulfilment of certain obligations. Hence, the term sheet cannot be considered non-binding and meaningless as argued by the respondent. This highlights that one needs to be mindful of one’s conduct in pursuant to the execution of non-binding term sheet, so as to complete the transaction, which can make the term sheet binding.
GAIL (India) Limited v M/s Sravanthi Energy Private Limited is also one of the unique cases where the term sheet entered into between the parties was termed as contingent contract. The appellate tribunal, while deciding on the issue of restrictive trade practices on the part of GAIL (India), analyzed the question that whether the term sheet is binding and Gas Transmission Agreements (GTA) being part of the same transaction never came into effect as the Conditions Precedent stipulated in the GTA were never satisfied. The tribunal held that the “term sheet was a contingent contract subject to condition precedent and was not enforceable”. The reason behind this decision is that the term sheet signed between the parties was subject to condition precedent, and the term sheet got frustrated and never got converted to the intended agreement (Gas Supply Agreement), thus it became contingent due to non-fulfilment of the condition precedent therein. This provides a caveat to all those parties entering into a term sheet to carefully decide the conditions precedents for the purpose of enforcing it.
Drafting v. enforceability
The main considerations that need to be kept in mind while drafting a term sheet is to decide the nature of obligations that the parties want to create. This can be elaborated in three major types of the nature of obligations that is binding, non-binding, and unilaterally binding of the term sheets. We have discussed binding and non-binding term sheets above which thus indicating that nature is dependent on the clauses we include under it. Unilaterally binding term sheets are not so common compared to a hybrid model of both binding and non-binding. It creates obligations on a party which may try to alter the terms or on a party, usually startups, where the investor does not have the visibility of facts. Overall, the following are some potential clauses of a term sheet:
|Type of Security Offered:||It is important to determine the type of security, whether equity, debt, derivatives, or hybrid securities, to be offered to the other party in a deal.|
|Capital Structure:||This clause contains the paid-up capital, share capital which include face value of equity, preference shares, etc. It also mentions the shareholding pattern of the company as on the effective date of the term sheet.|
|Valuation:||This clause mentions the valuation of the company prior to the investment or financing, for the purpose of the proposed transaction.|
|Investment Amount:||This clause sets out the proposed amount to be invested into the company where post investment shareholding structure is also laid down.|
|Conversion Rights:||This clause gives the shareholders the ability to convert preferred shares to equity where the investor would get certain key rights.|
|Anti-Dilution Protection||This right protects the investor from dilution of equity from future issues of stock if the stock is sold at a lower price than the initially invested price.|
|Board Composition||This clause mentions the composition of board members immediately after closing the deal where the investor may be given the right to nominate directors.|
|Transfer Restrictions||This clause provides any condition or restriction on the ability of the shareholder to sell or transfer such securities, protecting the interests of the investors.|
|Conditions Precedent||This clause mentions the list of conditions or obligations that need to be performed by the obligated party prior to a certain date, as agreed, to give effect to the term sheet.|
|Pre-emptive Rights||This clause provides a right to the investors to participate in the future fund raise, where the first option is given to buy before public offering or whatsoever the case may be.|
|Confidentiality:||This clause obligates the parties to maintain confidentiality with respect to the term sheet, its terms, negotiations, and such other details.|
|Liquidation||This clause entails the payout preference to determine the hierarchy of the payout in the event of sale or merger of the company.|
|Governing Law and Jurisdiction:||This clause would determine the jurisdiction governing the term sheet as it may be entered between companies governed under the laws of two different jurisdictions.|
As emphasized earlier, the enforceability is dependent on the judicial evaluation of the facts and circumstances.m if there is a dispute regarding the enforceability aspect, between the parties. It is clear from the Oyo-Zostel dispute that the court or an Arbitrator may not solely depend on the clause stating whether the nature of the term sheet is binding or not. It needs to be ascertained whether other clauses, facts, and the obligations are fulfilled in pursuant of the transaction. Hence, it is possible that the non-binding term sheet may be construed as binding by the authorities.
Main Points of Difference
|Drafting Perspective||Enforceability Perspective|
|Main consideration under it is to keep in mind the intended nature of the term sheet which is binding or non-binding.||The nature of the term sheet which is binding or not is determined by judicial evaluation of the scenario.|
|Obligations outlined in the term sheet and performed for the purpose of completing the transaction.||Obligations performed in pursuant of completing the transaction may be construed as binding nature of the term sheet.|
It is of prime importance for entrepreneurs, especially founders of new startups to know the importance and the aspects relating to a term sheet. A term sheet is a document representing the intentions of the parties in relation to a transaction or a deal, which acts as a precursor to the contract that would be entered into by the parties in furtherance of a transaction. Formulating a term sheet is one of the important aspects of a transaction as it allows the parties to frame key legal principles which would allow them to form a definitive and mutually agreeable contract. Usually, the nature of a term sheet is non-binding except for certain exempted aspects by the parties. But it is a misnomer to consider a term sheet as a non-binding document as sometimes there are partially binding aspects of it. The whole binding, non-binding conundrum may be different than what is expressed by the parties based on the judicial evaluation of the scenario by a court or an arbitrator. The case studies of the Oyo-Zostel dispute and GAIL(India) case illustrated the fate of this conundrum to some extent. Hence, it is important to consider a term sheet from the perspective of drafting and enforceability so as to sustain the interests of the company or the firm of the parties.
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