This article is written by Shreemonti Das pursuing a Diploma in Advanced Contract Drafting, Negotiation, and Dispute resolution from Lawsikho. This article has been edited by Ojuswi (Associate Lawsikho).
This article has been published by Sneha Mahawar.
Table of Contents
Introduction
A contract is a legally binding agreement between two or more parties who get together for consideration and also comprises all the rights and obligations that the parties have to perform during the life of the contract. For the contract to be smooth and hassle-free without any confusion, many rounds of pre-contractual negotiation take place between parties before the final contract. A lot of discussions take place before the terms of the contract are finalized. And the parties put forward their intentions, objects, rights, obligations, the risk involved, and so forth. Although the pre-contractual instruments are not legally binding but could be made so at the instance of the parties. Pre-contractual instruments include a Memorandum of Understanding (MOU), a Non-Disclosure Agreement (NDA), and a Term Sheet. The article shall be discussing the meaning, purpose, and usage of a term sheet. It also includes the terms that should be included while drafting the term sheet.
What is a term sheet
A term sheet is a legal document that outlines the proposed terms and conditions to be adhered to by parties in a business agreement. A Term Sheet is a potential document as it acts as a guideline for lawyers to prepare the transactional document smoothly. Once a Term-Sheet is prepared, it could be used as a basis for many future transactions also.
Term Sheets are pre-financial documents and they are not time-specific. They are the previous stage of investment agreements like Shareholder Agreement, Share Purchase Agreement and so on. Most likely these Term Sheets turn into investment agreements and become legal. The Term Sheets are signed once both the parties agree to the terms mentioned in the Term Sheet and before the execution of the above-mentioned agreements.
Transactions where term sheets are used
Private equity( PE) and Venture capital (VC) transactions
PE and VC are significant financial documents where Term Sheets are used. When capital is invested in a company that is not listed is Private equity. And Venture Capital is when investment is done in start-ups or young entrepreneurs who have the potential for growth in the long term.
Merger & Acquisitions(M&A) transaction:
In these merger and acquisitions transactions or financial transactions, Term Sheet is used. Here the assets and the companies are consolidated through various financial transactions. These include mergers, acquisitions, consolidations, and tender offers.
Signing of term sheet
Term Sheet is more like a gentleman’s handshake rather than a legally binding agreement.
As the terms of the Term Sheet are non-binding as the parties have the option of going back into the document and altering the clauses mutually which was agreed upon previously.
Generally, some clauses in a Term Sheet are binding which include Confidentiality, Exclusivity, Dispute Resolution, Condition Precedent, Fees and Expenses and so on.
Amendment in term sheet
As a Term Sheet is considered a significant pre-contractual instrument and like any other legal document, a Term Sheet also has an option for amendment.
Term Sheet includes an amendment clause using which a Term Sheet can be amended.
The limitation in amending a Term Sheet is that the terms in the Term Sheet could be amended mutually before signing the final agreement.
Purpose of a term sheet
A term sheet is a detailed document prepared as a pre-contractual instrument for financial transactions. The parties to the Term Sheet (investors and company founders) can discuss and negotiate the terms mutually without the restriction of the document being rigid and binding. And it must be assured that the terms in a Term Sheet must be spelt out in detail so as to avoid any future confusion and dispute between the parties.
Points to be included in term sheets
Valuation
Company’s both pre-money valuation and post-money valuation must be included. That is, what is the valuation of the Company when the investor is investing in the Company. Example- For the purpose of the Proposed Transaction the pre-money valuation of the is INR 4 crore.
Proposed transaction
Proposed transaction is a very significant term to be included in a Term Sheet. It clearly states how the investor is proposing or intending to invest in the start-up. It mentions a closing date by which the investor would make the investment and if the investment would be made at one go or in portions The clause is written as below:
The investor proposes to make an investment of INR 10,00,0000 (the “Investment Amount”) into the Company in the manner set out hereunder. The parties will work towards achieving completion of the Proposed Transaction, i.e. remittance of the Investment Amount and issue of corresponding Subscription Shares(“Closing”) within the timeframe specified in the SHA.
Pre-emptive and pro-rata rights
Pro-rata rights are the rights of the investors in the Company which decide if the investors would be able to invest in the subsequent rounds of funding proportional to their ownership. Investors with pro-rata rights are eligible to invest in the subsequent round in an amount that allows them to maintain their ownership percentage.
Pre-emptive rights are rights that allow specific shareholders of a Company to buy extra shares before it is offered to anyone else by the Company.
Anti-dilution protection
Investors in a startup usually demand preferred shares in exchange for investments. It is a term that protects the interests of early investors of the Company. Preferred shares protect the rights of the investors. Anti-dilution protection clause safeguards the interests of the investors if in the future the shares of the Company are sold at a lower price to successive investors. It is done by adjusting the ratio at which the preferred shares convert into common shares. Thus the anti-dilution clause protects the value of the shares of the previous investors from being diluted.
Promoters’ lock-in or investor’s lock-in
The Promoter shall not be entitled to transfer the shares held by them in the Company, directly or indirectly for a period of ‘x’ years from the date of closing (lock-in period). The Promoters may however transfer their shares to a third party during the lock-in period subject to the prior written approval of the investors and right of the first refusal or tag-along right.
Promoters’ rights
The investors will have no right to terminate the employment of the Promoter for a period of ‘x’ years.
Right of first refusal
The right to the first refusal gives an investor the right to buy shares from the company before any third party is offered. In other words, subject to the Promoter’s lock-in period, in the event, that any of the Promoters or any other shareholders intend to sell all or part of their shareholding in the Company to a third party (“selling shareholder”), then such selling shareholder(s) shall first offer their shares, to the Investors (Non Selling Shareholders’) at the same price as they have offered to the third party. The Non-Selling shareholders, at their sole discretion, shall have the right to purchase shares in proportion to their inter-se shareholding in the Company.
Tag-along right and drag along right
Both the rights are for minority shareholders but are opposite to each other. In the case of tag-along rights, the minority shareholders in the company are provided with negotiating rights in
the event of a sale. On the other hand, in the case of drag along right the minority shareholders are forced to accept whatever decision has been negotiated by the majority shareholders.
How is the term sheet different from LOI
Most of the time, the words “Term Sheet” and “Letter of Intent” are confused and used as synonyms but they have the following differences:
| LOI | Term Sheet |
| LOI includes all business transactions like lease deed, purchase, business and so on. | A Term Sheet includes only investment proposals |
LOI are unilateral or proposals | Term Sheets are bilateral discussions |
| Here the primary intentions of parties are captured | Here the major points which are to be included in the financial transactions are negotiated |
Terms to be included while drafting
Heading
Term Sheet For Investment( insert the name of the company)
The proposed investment
- Company
- Promoters
- Investor
- The aggregate amount of investor’s investment
- Shares to be issued and pre-money valuation
- Price per share
- Closing/Disbursement(s)
- Use of proceeds
- Company Capitalization
Terms of investor shares
- Dividends
- Liquidation Preference
- Voting rights
- Optional conversion
- Automatic conversion
- Anti-dilution adjustment
- Transfer restrictions on Investor Shares
- IPO
- Exit rights
- Tag-Along
- Issuance of new securities
- Right of First Refusal
- Management Lock-in, ESOP and Promoter Vesting
- Board of Directors
- Board observer rights
- Information and inspection rights
Other terms
- Share Subscription Agreement and Shareholders’ Agreement
- Conditions Precedent to Closing
- Fees and expenses
- Non-Competition, Non-Solicitation and Employment Agreements
- Employee Share Option Plan
- Key Person Insurance
- Auditor
- Governing Law
- Arbitration
Conclusion
Term Sheets are considered one of the most significant pre-contractual instruments. It is generally non-binding in nature except for the clauses which are specifically stated that they are binding. Usually, the clauses like exclusivity and confidentiality clauses are considered to be binding. and especially outlines the basic terms and conditions for an investment agreement. Generally, the language and terms of the clauses communicate if the Term Sheet is intended to be binding. The Term Sheets are often used as a document where the terms are negotiated between the investors and founders as a precursor to the investment agreement. They are in most cases associated with startups. Terms like Term Sheet, Letter of Intent, and Memorandum of Understanding are often used interchangeably as they are similar documents and serve similar goals and most of the time contain similar information. But the three documents are not the same and are a little different from each other. The main purpose of a Term Sheet is it lays the groundwork and ensures that the parties involved in the investment transaction and in most of the terms are on the same page. And it is considered a good Term Sheet that is able to bring the investor’s and founder’s interests aligned and thus helps in the long run for everyone associated with the transaction.
Reference
- https://www.wiley.law/newsletter-4160
- https://thebusinessprofessor.com/en_US/business-personal-finance-valuation/capitalization-definition
- https://www.investopedia.com/terms/e/esop.asp#:~:text=An%20employee%20stock%20ownership%20plan%20(ESOP)%20is%20an%20employee%20benefit,benefits
- https://taxguru.in/finance/all-term-sheets.html
- https://www.contractscounsel.com/t/us/terms-sheet
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