Want to invest? or want to sell or buy business? or want to raise capital? In order to begin with such transaction, one has to execute an initial agreement i.e., ‘Term Sheet’. It is important to understand the concept of the term sheet with the perspective of an Investor or a Seller or a Buyer. While dealing into such transactions one must give due consideration to the factors as: Whether the terms sheet is binding or non-binding? What are affirmative rights? How to negotiate the term sheet? Which important aspects of the transaction are to be incorporated under the term sheet? However, all terms sheets contain basics terms of the transaction, it also contains other special terms with respect to the need of such transaction as every term sheet have its own eccentricity. This article brings out the detail analysis of the term sheet from initiating a transaction to executing definitive agreements.
What is Term Sheet?
A term sheet is a written document executed after the pitch meeting or a preliminary commercial meeting of minds with respect to the proposed transaction. The objective of the term sheet or memorandum of understanding (MoU) or letter of Intent (LOI) is same as the parties to a transaction exchanges their intentions through this written document encompassing various important terms and conditions of the transaction. However, the terms of the term sheet vary from transaction to transaction. Generally, term sheet can be defined as a non-binding agreement, as it serves a template for executing definitive agreements between the parties. However, in order to determine the nature of the term sheet ‘whether binding or not binding’ one has to look at the facts and circumstances of the case in hand. A term sheet is a document that sets out the key financial and other important terms of the proposed transaction, which are subject to negotiations and certain conditions precedents resulting into formation of final legal documentation such as Business Transfer Agreement, Joint Venture Agreement, Subscription Agreement, Shareholders Agreement, and many more. Therefore, a term sheet is server as a base to all definitive agreements.
Purpose of Term Sheet
The purpose of the term sheet is to identify the issues with respect to the proposed transaction before committing time and money to due diligence and to ascertain rights and liabilities with respect to the transaction before entering into definitive agreements. Well negotiated term sheet also tends to reduce future disputes and also identifies “deal-breakers”. Moreover, the term sheet also determines the growth expectations, valuation and mitigation of risks involved in a deal. The term sheet serves as a blue print to the documents to be drafted when:
- Selling or purchasing a business; or
- Selling or purchasing shares; or
- Rounds of capital raising.
Binding and Non-binding – The Term Sheet
Recently, in the dispute between the Oyo and Zo Rooms, the Supreme Court appointed Arbitrator awarded that the ‘Term Sheet was a binding document’. However, in order to determine the nature of the term sheet ‘whether binding or not’, it is important to understand that ‘what was the intention of the parties at the time of signing the term sheet and what actions have been in place after such signing’, in other words it will depend upon the facts and circumstances of the case in hand.
In addition to this its is also essential to understand that the facts of each case are interpreted as per the Contract Act 1872, in order to decide the binding and non-binding of the term sheet. Binding and non-binding of the term sheet also depends upon the object of such documents as generally the term sheet are preliminary documents / agreements aligned with an intention of parties to enter into a contract at a future date. Such agreements can be considered as “Agreements to Agree”, which are not enforceable under Indian Law as well as in English Laws. However, these agreements are also subject to certain exceptions which depends upon the facts of each case. It depends upon the parties to a proposed transaction to determine what clauses of the term sheet are enforceable and what not. Generally, clauses like Confidentiality, Exclusivity, Fees and Expenses, Conduct of Business, Condition Precedents, Dispute Resolution provisions etc., are treated as a binding in nature. Moreover, the problem of binding and non-binding arises with the term sheet when it appears like a definitive agreement which are subjected to interpretations of courts.
Term Sheet Under Different Transactions
Following are the different transactions under which Term Sheet is executed:
- Term Sheet – PE/VC Transaction
The PE and VC transactions are undertaken in order to gain financial returns. VC Transactions are entered into the early stage of the company or start-up while PE Transactions are entered at a later point of time in the business cycle of the company. However, both generally required same terms to be included in the term sheet. Generally, PE/VC term sheet includes terms such as valuation, amount of investment, anti-dilutive provisions, affirmative rights, liquidation, conversion rights, etc.
- Term Sheet – M&A Transaction
The M&A Transaction are undertaken with an objective of strategic benefits and corporate restructuring. Term Sheet used as in M&A transaction will contain information’s about the offered price, mode of payment, assets and liabilities, business details and other standard terms.
What to include in Term Sheet?
Following are some important terms to be included in the term sheet:
1. Type of Security Offered
2. Capitalization and Valuation
3. Board of Directors
4. Conversion Rights
5. Anti-Dilution Provisions
6. Liquidation/Exit Preference
7. Purchase Price
8. Investment Amount
9. Voting rights
10. Confidentiality
11. No-shop
12. Transfer Restrictions
13. Indemnity
14. Break Fees
15. Conditions Precedent
Affirmative Rights
Before proceeding to “How to Negotiate a Term Sheet”, it is important to know “what are affirmative rights”. Generally, these rights are seen under the transactions where some amount of shareholding or control of a company is transferred to the other party in the transaction resulting into transfer of ownership through investment or acquisition in a targeted company. In simple words these are the rights or consents which are required before approving and implementing any matter on the table. These rights are required to deal in the contractually agreed matter because of the importance of such reserved matters. These matters cannot be implemented unless affirmative rights or consents are not attached to such matter. Generally, it has seen that these rights are heavily negotiated between the investor and the investee. However, there is no specific provisions and no complete clarity about the treatment, regarding such matters in any legislation such as Companies Act, 2013, Securities Exchange Board of India Regulations, Foreign Direct Investment Policies, etc. Some common matters required affirmative right as follows:
1. Change in capital structure of a company.
2. Change in the charter document of the company.
3. Appointment and Removal of Key-Managerial Personnel.
4. Dilution of shares.
5. Transferability of shares.
Negotiating a Term sheet
With the interest to undergo with the proposed transaction, the parties to the transaction often tends to negotiate the term sheet in order to execute definitive agreements. Therefore, in order to remove ambiguity and to ascertain the rights and obligations of the parties, this often leads to prolonged discussions among the parties in order to effectively closed the transaction. The objection of entering into the negotiation round is to provide the mechanisms that keeps the other party from taking unfair advantage of the other party. Following are some important terms need to be negotiated in various transactions undertaken through PE or VC or M&A or by any other means of investment:
1. Valuation
The one of the most important term of the term sheet is the valuation of the transaction. In the case of PE/VC, the valuation is distinguished as a Pre-Money and Post-Money and in the case of M&A generally the valuation of the targeted entity is based on its financial statements. However, it is important to negotiate the investment amount in such a way that it benefits the investor and the investee.
2. Board of Directors
Generally, this term is negotiated in the transactions which some amount of the shareholding and control is transferred to the investor. In this, the investor demands the right to appoint the director in the Board of Directors. The parties to a transaction generally negotiate on the rights relating to removal, reappoint, and fresh appointments of directors.
3. Exit Rights
Generally, in any transactions involving investments in early stage of the targeted company Exists rights are highly negotiated between the investor and investee. Initial Public Offering, Buy-back, Put/Call Options are some common mechanisms to exit a company.
4. Pre-Emptive Rights
The pre-emptive right mechanism is widely used in the transactions when the investors is given right to participate in future fund raise. Such rights create a mechanism with the anti-dilution and valuation protection rights. The promoters and investors negotiate in order to retain this right in order to prevent dilution of their stakes on further fund raising through series or Initial Public Offer.
5. Restrictions on Transfer of Shares
Transfer rights are associated with the shares of the targeted company as shares are freely transferable, thus investors and investee negotiated the transfer rights and restricts one another from freely transferable of shares. Drag-along, Tag-along, Right of First Refusal, Right of First Offer are some terms used in the term sheet in order to restrict the right to transfer of shares freely. Promoter and Investors often negotiated restriction on the transfer of shares to a competitor.
6. Indemnity
Indemnity is given through representations and warranties as promoters provide the investors with certain indemnity in order to invest in or acquire the company. It also includes various covenants to be fulfilled after the closing date. The investors and promoters often negotiate as to what will be representations and warranties and covenants of the proposed transaction.
Conclusion
A term sheet is a pre-contractual document mostly non-binding in nature which is signed by the target and the prospective buyer that describes the major terms of the proposed transaction. However, term sheet often contains binding provisions regarding non-solicitation, exclusivity, confidentiality etc. A term sheet can also be called a head of agreement or memorandum of understanding and is drawn up prior to executing definitive agreements. As discussed above, clauses of a term sheet are highly negotiated between the parties to a transaction. A term sheet is short, usually in table or dot-point form for clarity. It covers the most important elements of the transaction. Generally, PE/VC term sheet are smaller compared to M&A term sheets. The term sheet comes into the picture after the investor has decided to get into an agreement with target company. A term sheet is the first essential step of the transaction. It has all the essential & critical points of the definitive agreements.
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