Term Sheets

Introduction
Entrepreneurs and start-up founders are not the kind of people who would be extremely
adept with paperwork and are often clueless about the documentation required at the time
of seeking investment for their stunning business idea.

A term sheet happens to be the preliminary document that a start-up founder has to
encounter at the beginning of any investment transaction. This document is crucial to
attract investors. In simple terms, a term sheet is like a marriage proposal where the
company and the investor meet to negotiate the terms of their investment.

Why we use the term marriage proposal is because a term sheet is not binding on either of
the parties. It is a mere proposal signifying the intent to enter into a legal relationship which
would be eventually formalized at the time of executing the transactional documents like a
shareholders’ agreement, share purchase agreement or a share subscription agreement.

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. It is a document that marks the start of an investment transaction.

In simple terms, a term sheet is a non binding agreement outlining the basic terms and
conditions under which an investment will be made. The company valuation, investment
amount, percentage stake, voting rights, liquidation preference, anti-dilutive provisions and
investor commitments are some items that should be spelled out in the term sheet. It is
used for M&A and long term debt (i.e. Commercial real estate development)

A. What is a term sheet and why do you need it?

As mentioned above, a term sheet is the first document of understanding that is
entered into between the investor and the founders of the company. The terms in
the term sheet outline the “conditions” for an investment and sets the tone for
future negotiations and documents. The conditions would involve terms like the pre-
 valuation of the company, the price per share which is to be issued or purchased,
the post valuation, details regarding the control and the money which is to be
received at the time of the exit of the investor.

Term sheets are important because they act as a roadmap for lawyers to prepare
the transactional documents. Drafting of transactional documents is an extremely
cumbersome process. Once a transactional document is entered into, then there is
no going back. This is where terms sheets come in. They are a pre-transactional
document, the terms of which can be debated and negotiated upon. One term sheet
can be used as a basis for many transactional documents. Hence, saving time and
effort required for negotiating various documents individually. This is why it
becomes extremely important to have a term sheet that is comprehensive and
unambiguous.

B. Is it mandatory to prepare a term sheet before the

final investment agreement or a shareholders/share
subscription/share purchase agreement?
No, it is not mandatory to prepare a term sheet before the final investment
agreement. But most founders prefer having a term sheet because it gives a clear
picture of the major terms and conditions of an investment on which the investors
and the founders can agree upon thereby reducing the chances of a
misunderstanding and subsequent dispute.

A deal is not final until a definitive investment agreement or an investment

agreement is signed between the parties. Please find below the steps as to how the
process moves ahead:

The signing of the term sheet – The major terms of an investment agreed between
the investor and the company are laid out in the form of this document.

In addition, the Term Sheet also outlines the in-principle agreement of parties over
material terms and conditions, which acts as a basis for the preparation of definitive
legal agreements such as Share Purchase Agreement and Shareholder's Agreement
during later stages of a transaction. Usually, a term sheet leaves a lot of room for
negotiation, at the time when the definitive agreements are drafted, but it should
form the very beginning which gives a clear picture of the commercial proposal of
the investor – such as the price, stake to be purchased, parties involved, etc.
 Letter of intent (LoI) is issued to achieve the same end as a Term Sheet – laying down
the basic commercial proposal, recording common understanding of parties on
certain key issues and usually providing for an exclusive negotiation for advanced
level of deal striking. LoI is more often used in merger and acquisition transactions –
while the term ‘Term Sheet’ is used in VC and PE deals. Just like a Term Sheet, most
provisions of LoI are usually non-binding.

Note: This is different from a Letter of Intent (LOI) although both of

them serve the same purpose. The difference lies in the fact that an LOI
is a unilateral document, written in the form of an essay while a term
sheet is a bilateral document in the sense that most terms are
discussed, debated and negotiated upon and are usually in the form of
bullet points.

C. When does a term sheet need to be signed?

Term sheets are not time-specific but they are pre-financial documents. They are
precursors to any final agreement like an Shareholder Agreement, Share Purchase
Agreement or Share Subscription Agreement. They are the basis on which these
documents are executed. Hence, as far as the signing of the term sheets is
concerned, that will occur once both the parties agree to the terms of the term sheet
and before the financial agreements like SHA, SPA or SSA are executed.

D. Who usually prepares the term sheet?

A term sheet is usually prepared by the investors after the pitch of the entrepreneur
to such investors. That being said, there is no hard and fast rule with who can
prepare the term sheet first. Logically, the investors after listening to the pitch of the
entrepreneurs prepare the term sheet which then goes on for a number of rounds
of negotiations.

E. Are term sheets lengthy?

Term sheets are supposed to give the major points to both the investor and the
investee to agree upon and based on these, go further with the transactional
documents. They are made in the bullet point format and hence, term sheets are
not lengthy documents, usually, ranging from 5-8 pages.
F. Is the term sheet binding? If yes, on whom?
It is famously said that a “signed term sheet” is more of a gentleman's handshake
than a legally binding document. It is because while most of the clauses of the term
sheets are not binding and the parties have the privilege of going back and changing
a few things in the transactional documents previously agreed upon, some clauses
are binding because that arrangement is convenient. That being said, the most
common clauses that parties usually keep as binding are described below:

● Exclusivity period or no-shop clause- This clause helps the investor. If made
binding, it mandates that the promoters of the company can’t go and talk to
multiple investors while the deal is being negotiated upon. This helps the
investor because then the investor can deal without the fear that his offer will
be compared to other offers.

● Confidentiality - This clause is usually made binding. It is beneficial to both

the investor and the company. It makes negotiating the deal without the fear
of secrets getting divulged, easier. This clause, if made binding, is especially
helpful to the company as the company can show the investors their books
without the fear that company secrets may be leaked.

● Fees and expenses - More often than not, the clause regarding fees and
expenses is made binding. This is done to avoid future disputes regarding who
will bear the expenses of the transaction. Further, costs like legal, accounting,
logistics, and investment banking fees can be divided to lessen the possibility
of any dispute or hassle.

● Conduct of the business - This clause is often made binding to increase the
efficiency of the business being undertaken. It will be of no help to anyone if
one of the parties does not respond or take interest in the deal after engaging
the other party.

● Termination - This clause talks about the termination of the term sheet after a
specified time period.
G. What are the essential clauses in the term sheet I need
to pay attention to?
A term sheet is an important document. As already discussed, it forms the basis on
which the transactional documents are formed. Further, while it is not binding, it
cannot be revoked until and unless it is breached by any of the parties. Going back
on the term sheet, once it is signed is difficult if not impossible as it increases the
chances of investors getting upset (You don’t want that!) Additionally, the term sheet
contains some important clauses which are also put into the transactional
documents as it is since 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 the clauses which should be well understood by parties:

S. No Clause Relevance

1. Investment The amount that is being invested in the company. This

amount clause is important because the purpose of seeking
investment from the company’s perspective is to raise
capital.

2. Pre-money Companies are valued by the investors, business gurus

valuation and experts to see how a company is doing. The primary
aim of any investor who values a company is to see how
much it is worth right now and how much it will be worth
after the investment.

Investors see the value of a company pre-investment.

Then they assess the value of the company post an
investment infusion in the company. This is how they
make a choice as to whether they will invest or not.

3. Conversion A conversion right is the right to convert preference

Right shares or debt into equity shares. These can be optional
or mandatory. Investors at early stages either invest
through convertible notes (a loan which is then
converted into equity) or convertible debentures
(debentures which are later converted into equity). This is
quite a favorable option for early investors whose
 ultimate objective is usually to gain equity control in the
company.

4. Option Pools An options pool is a set of stock set apart by the

company to give it to the employees who stay with the
company for a long time. This is used by the companies
to attract employees with expertise. For example, let’s
say there is a start-up that needs talented employees. It
will attract them by having an options pool that will be
given to them if the employees help the company to do
well to go public, they are compensated with stock.

5. Liquidation The liquidation preference clause (LP clause) sets out

preference who gets paid first and how much they get in the event of
an IPO, winding up or the investor wants to strategically
exit the company.

In case of shareholders, the investors would want to get

paid first. Hence, these clauses are often referred to as
'downside protection' clauses and are meant to protect
the investors from the adverse consequences of
downside events (like a sale of the company at a
valuation lower than investors' entry valuation) to
the investor. Usually the investor would affix a 1x return
on investment coupled with the percentage held by it in
the company: For example: a LP clause may be
structured like this:

1 investor coming aboard the Company and investing Rs.

10 crores - the pre investment valuation of the Company
is Rs. 30 crores - therefore the post money valuation of
the company is Rs. 40 crores - the investor now holds
(10/40) 25% of the Company in the form of equity shares.

In a Rs. 100 crore Company sale, this is what the Investor

would make:

(i) 1x of investment amount (i.e. Rs. 10 crores) + 25%

participation in what is left (Rs. 22.5 crores);
 Thus, the investor will be walking away with 32.5 Crores
despite an initial investment of INR 10 Crores.

6. Drag- along Drag along rights is a provision or clause in an agreement

rights that enables a majority shareholder to force a minority
shareholder to participate in the sale of a company. The
majority owner doing the dragging must give the
minority shareholders the same price, terms &
conditions as any other seller. On the other hand, it helps
the majority shareholder sell without caring about the
objection of the minority shareholder. This clause also
helps the minority shareholder in most cases because
they get the same share price as majority shareholders.

7. Warrants Warrants are security that allows the holder to buy a

company stock at a predetermined price. A Warrant
clause in a term-sheet focuses on the terms of the issue
of such warrants.

8. Dividends The dividend is a periodic payment done by the company

to its shareholders from its net profits. It is the capital left
with the company after the deduction of capital needed
to be used for the future and ongoing businesses. In a
term sheet, this clause assumes the highest importance
because investors would want to invest in the companies’
equity only when they know that they are going to
receive dividends out of it. Hence, investors can insist on
whether they want the dividend to be paid in a particular
manner, like quarterly, half-yearly, etc. or whether they
want it to be paid in cash, or in the form of shares, etc.

9. Anti- Dilution Investors always have an apprehension that their own

clause shareholding in the company may get diluted in case the
company goes ahead and issues new shares. For these
purposes, the investors insist on an ‘Anti-dilution clause’.
This will allow the investors the right to maintain their
 ownership percentages in the event that new shares are
issued.

10. Pre-emptive Governing the issuance of shares, including the right of

rights existing shareholders to acquire additional shares before
external parties. These rights give the investors the right
to buy shares in the company proportionate to the
dilution of their shareholding that has happened in case
of a new issue of shares to prevent their shareholding
from dilution.

11. Investor’s right In case founders intend to exit the company due to some
of first refusal event, then investors should have the right to first
purchase the stake of founders. The founders cannot exit
before the lock-in period if there is a clause to that effect
in the term sheet. This clause protects the interest of
investors and is very important.

12. Duration of In this clause, the investor will ensure that he will keep
the stake his investment in the company and he will not revoke it
up to a certain number of years.

13. No- shop It is put to provide the investors an exclusivity period in

clause which the promoters of a company can’t deal with
another set of investors while dealing with negotiations
with one set of investors are going on.

14. Control An investor can have many aims while he invests in a

company. Some only want profit out of a company while
others also care about how much control they have over
the management of the company. One way to achieve
this is obviously to have more voting rights. The other
way is to have the power to appoint directors on the
board of directors. The investors can sometimes insist
upon having some representation on the board of
directors. This hence, becomes a key term in any term-
sheet.
15. Exit- rights Different investors have different expectations out of an
investment. Some may just want to have quick capital
gains while some may want to retain control for a long
time. It is for these different aims that investors have
different exit rights in any investment. This clause in a
term sheet lists out, in brief, the different exit rights that
an investor wishes to have in the investment. The tag
along, drag-along rights, already discussed form part of
the exit rights. He or she can also have exit rights that get
triggered at the happening of an event for example
breach of a representation or a warranties clause.

16. Tag- along This clause is put in the interests of minority

rights shareholders. It enables the minority shareholders to ‘tag
along’ the majority shareholders in case the majority of
shareholders are selling their stake in the company.
These are pre-negotiated rights that a minority
shareholders includes in their initial issuance of a
company stock, these rights allow minority shareholders
to sell their shares if a majority shareholder is
negotiating a sale for their stake. The main distinction is
who is obliging whom. So in drag along rights, the
majority shareholders drag obligate the minority to sell
its share with the majority shareholders. In tag-along
rights, it is the opposite. Here, the minority shareholders
obligate the majority to tag them along.

17. Redemption The legal or contractual provisions that grant investors or

rights shareholders the ability to demand the return of their
investment or repurchase of their shares under certain
circumstances.

18. Confidentiality This clause is beneficial to both the investor and the
company. It makes negotiating the deal without the fear
of secrets getting divulged, easier, and hence, facilitates
the agreement.
H. Can I amend the term sheet later?
An amendment is a necessary part of any legal document. The term sheets are no
exception to that rule. Hence, most term sheets come with an amendment clause
that states how a term sheet will be amended. Terms set out in a term sheet may
be modified at any time prior to signing the final funding agreement however,
once a term sheet is signed, it is not considered appropriate to go back. This is
because sometimes, the parties start drafting financial documents on the basis
of this term sheet and going back again only results in wasting of time and
resources.

I. Can I sign term sheets with multiple investors but

enter into an investment agreement with only one of
them?
Generally, the practice of signing term sheets with multiple investors but entering
into an investment agreement with only one of them is considered wrong on ethical
grounds. Investors, however, can put a ‘no-shop clause’ or an exclusivity period in a
term sheet that precludes the promoters from approaching other investors during
the period of the negotiation.