Introduction
In the startup world, where innovation meets ambition and ideas transform into unicorns, the term sheet is your map to navigate the investment landscape. Whether you are a lawyer stepping into the thrilling world of startup practice, an early-stage startup gearing up for that game-changing investment round, or an investor on the hunt for the next big thing, understanding term sheets is your secret weapon. This article aims to demystify term sheets, offering a comprehensive guide that caters to all stakeholders involved from a commercial point of view while keeping the legal jargon to a minimum.
Imagine you are a startup founder, and your groundbreaking idea has finally caught the eye of an eager investor. Excitement is in the air, but before the confetti and champagne, there is a crucial document to tackle - the term sheet. It is like a blueprint for your investment, outlining the key terms and conditions shaping your company’s future. But do not worry. This is not some cryptic legal scroll. Think of it as the essential playlist for your startup’s greatest hits.
So, what exactly is a term sheet, and why is it so important? Simply put, a term sheet is a non-binding document laying the groundwork for a proposed investment. It is where the magic begins, setting the stage for the definitive agreements that will follow. Imagine it as the initial sketch of a masterpiece, capturing the essence of the deal without diving into every minute detail.
The term sheet is not just for founders and investors. It is a key player in the investment game, bringing together a trio of stakeholders: the startup founders, the visionaries, the investors, who bring the capital, and the legal counsel, who ensures everything is shipshape. Each party has its own set of priorities and concerns, and the term sheet is where these interests intersect and harmonize.
Let us dive into the ingredients that make up this pivotal document. The term sheet covers everything from valuation and equity stakes to board composition and exit strategies. It is a balancing act, ensuring the founders retain control and vision while investors secure their interests and legal counsel drafts precise and unambiguous terms. The art lies in creating a detailed yet digestible document, ensuring clarity without the clutter of legal mumbo jumbo.
In this article, we will explore the fascinating dynamics of term sheets, delving into their commercial implications for each stakeholder. We will break down the complexities into bite-sized, engaging insights that will make you a term sheet aficionado in no time. Whether you are a rookie in the startup arena or a seasoned pro, get ready to decode the blueprint of startup investment with us.
Note: I wrote this assuming that you, whether you are an investor, a startup founder, or a lawyer, are already somewhat familiar with the buzzwords and jargon flying around the startup world. But fear not! For those moments when the lingo gets a bit too thick, I have sprinkled in some handy descriptions in the end notes.
What is a Term Sheet?
A term sheet is essentially a non-binding agreement that outlines the basic terms and conditions under which an investment will be made. It serves as a blueprint for later drafting more detailed, legally binding agreements. The term sheet sets the stage for negotiations, guiding lawyers in creating definitive agreements to formalize the transaction.
Purpose of a Term Sheet
The primary purpose of a term sheet is to ensure that both parties—the investor and the target company—are on the same page regarding the main aspects of the investment. It helps to:
Clarify Intentions: Establish a mutual understanding of the investment terms.
Facilitate Negotiations: Provide a framework for discussing and refining the deal.
Save Time and Costs: Avoid extensive legal costs and time investments by identifying and addressing potential deal-breakers early.
Provide a Roadmap: Guide the preparation of the final, binding agreements.
Parties Involved
The main parties involved in a term sheet include:
The Investor: The entity or individual providing the capital.
The Target Company: The startup or business receiving the investment.
Legal Counsels: Lawyers representing both the investor and the target company.
Legal Nature of Term Sheets
Although no law in India defines the legal nature of a term sheet, it generally depends upon the terms and conditions laid down in the term sheet. But here is where it gets really interesting. Despite its importance, a term sheet is typically non-binding, meaning it is more of a handshake than a signed, sealed, and delivered contract. However, certain clauses can carry binding weight, adding a layer of intrigue to the negotiation process. This document can profoundly impact the definitive agreements that follow, shaping the trajectory of the startup’s journey.
Non-Binding Term Sheets
Non-binding term sheets are the most common in the investment world, particularly in markets like India. These documents serve as a framework for negotiation, outlining a proposed transaction’s essential terms and conditions without creating formal legal obligations. However, this does not mean they are entirely without consequence.
Key Characteristics
Purpose and Flexibility: Non-binding term sheets provide a basis for negotiations, allowing both parties to explore the feasibility of a deal without being legally tied to the terms.
Negotiation Tool: They serve as a starting point for discussions, helping identify and address potential deal-breakers early in the process.
Legal Binding Clauses: While the overall document is non-binding, specific clauses within it can be legally binding. These typically include confidentiality, exclusivity, no-shop clauses, and sometimes dispute resolution provisions.
Binding Term Sheets
Though less common, binding term sheets create a formal commitment between the parties involved. Breaching the terms outlined in a binding term sheet can lead to legal consequences, making them a more serious step towards finalizing a deal.
Key Characteristics
Formal Commitment: Binding term sheets indicate a stronger commitment to the transaction, with both parties agreeing to adhere to the outlined terms.
Legal Consequences: Any breach of the terms can lead to legal action, making it crucial for both parties to be certain of their agreement before signing.
Precursor to Definitive Agreements: They typically precede detailed, legally binding agreements such as Share Purchase Agreements (‘SPA’) or Shareholders’ Agreements (‘SHA’).
At the end of the day, the legal nature of a term sheet (whether it is binding or not) depends on(i) the content of the term sheet and (ii) the intent of the parties entering into the term sheet.
For example, suppose a term sheet is binding in nature but does not contain a valuation mechanism to issue securities. In that case, it will be considered non-binding since the valuation mechanism will then be mutually agreed upon prior to the finalization of a definitive agreement.
Similarly, a non-binding term sheet may be considered binding depending on the content of the clauses and the intent of the parties.
The legal enforceability of term sheets was considered by the Delhi High Court recently in Zostel Hospitality (P) Ltd. v Oravel Stays (P) Ltd.,[i] wherein it was held that even in a case where the recitals of a term sheet specify that the term sheet is non-binding in nature if the clauses set out in the term sheet create certain obligations and the parties in the agreement take steps towards complying with such obligations, the term sheet can be construed as binding in nature.
Drafting a Term Sheet – Key Clauses and General Terms
In order to understand what is generally and legally prudent to include in a term sheet, let us take a specific scenario where a term sheet is to be drafted for investment through the issuance of equity shares by a startup company to its investor in a funding round. To get on this draft, it would be imperative to understand the following clauses:
1. Nature of the Term Sheet
This section explicitly states whether the term sheet is intended to be legally binding or not. Most term sheets are non-binding, except for certain clauses.
2. Parties Involved
This clause details the names and contact information of the investor and the target company.
3. Determining the Valuation of the Company
When determining the valuation of a company, whether to use pre-money or post-money valuation[ii] depends on various factors that play a crucial role in the decision-making process. It is an important aspect for both investors and startups to consider.
Stage of the company
One of the key considerations is the stage of the company. In the case of early-stage startups seeking financing, such as seed rounds or Series A investments[iii], pre-money valuation is commonly favoured. Pre-money valuation sets a baseline value for the company before the new investment, allowing investors to determine the percentage of ownership they will receive in exchange for their investment.
On the other hand, post-money valuation is often more appropriate for companies at later stages of financing, particularly those seeking larger investments like Series B[iv] and beyond; post-money valuation considers the company's value after the new investment has been made. This approach gives investors a clearer understanding of the company's overall value following the infusion of new capital.
Dynamics of negotiation
Additionally, the specific dynamics of the negotiation between the parties involved play a significant role in determining whether pre-money or post-money valuation is more suitable. Factors such as the level of competition for investment opportunities, investor demand, and the founders' bargaining power can influence the chosen valuation approach.
Moreover, the preferences of both investors and founders of the target company also come into play. While investors may lean towards post-money valuation for its clarity and transparency in assessing the impact of their investment, founders may have their reasons for favouring pre-money valuation to maintain control and ownership stakes in the company.
Thus, the choice between pre-money and post-money valuation is not a one-size-fits-all decision but rather a nuanced consideration that takes into account the company’s stage, the investment round, negotiation dynamics, and the preferences of the key stakeholders involved. By carefully weighing these factors, companies can determine the most appropriate valuation method that aligns with their goals and the interests of all parties involved.
4. Nature and Number of Shares Issued to the Investor
This clause of the term sheet usually turns out to be the final understanding between the parties – that finally conceptualizes the definitive agreement. While drafting this clause, it is pertinent to mention and consider the following:
Nature of the securities issued
Generally, investors seek preference shares against their investment in a target company. These shares come with certain special/preferential rights, which are negotiable and included in the term sheet.
Shareholding pattern – pre- and post-investment
Shareholding patterns can be based on (i) a stake on a Fully Diluted Basis or (ii) an Undiluted stake.
For instance, Mr. and Mr. B hold 100% equity in XYZ. However, the company had issued ESOPs[v] to its employees to the tune of 10%. On the exercise of such ESOPs, the equity of Mr. A and Mr. B will be diluted to 90%. Thus, in a cap table[vi] made on the date when the ESOPs have not been exercised, the undiluted stake of A and B will be shown at 50% each. The fully diluted basis stake (on converting ESOPs to shares) will be 45% each for A and B, and the employees who converted their ESOPs into equity will hold 10% on the cap table.
Let us now consider a scenario where an investor, Mr. M, enters the scene and gets 25% equity for his investment. Mr. A and B will now hold 75% on an undiluted basis. However, the term sheet might have a clause stating – “even after conversion of the undiluted stakes, the investor shall hold 25% of the share capital on a fully diluted basis.” This would mean that the investor’s equity will not be diluted even on the exercise of ESOPs or the conversion events where all the outstanding convertible securities are converted into equity shares. In the given example, Mr. A and B’s equity will be diluted to 65% on a fully diluted basis, with the investor retaining his 25% and the ESOP holders getting their 10% on converting ESOPs to shares.
5. Investment Amount and Payment Terms
This clause, which must be transparent and clearly specify the amount of the proposed investment, is designed to provide reassurance and security to our legal advisors. The document also contains the mode of payment – whether the amount would be invested in one go or in tranches. In case the investment is decided to be made in tranches, each tranche, along with the trigger event, is clearly defined in the term sheet.
6. Appointment of Director(s) To the Board of the Company
It can generally be assumed that the right to appoint a director is directly proportional to the amount invested by the investor. Thus, based on the amount of investment, the investor may get the right to appoint a director to the board of the target company. Whether it would be an executive or non-executive director will also depend on the investor's influence on the target company based on the quantum of the investment or on any other factor that might come into play during negotiations.
Another role that may be established in the term sheet is that of an observer. An observer, nominated by the investor, has the privilege to attend board meetings and receive notices. However, they do not have voting rights, which distinguishes them from directors.
7. Promoters’ Lock-In
This is an important clause of the term sheet. When an investor takes a bet on the target company and decides to invest, he is also investing and placing his bets on the promoters to take the company to new heights. Thus, promoters are usually locked in for a considerable period, during which they cannot leave or dilute their stake in the company.
In this clause, what is generally negotiated is (i) the period of lock-in (during which the promoters cannot leave), and (ii) the nature of lock-in, i.e., a 100% lock-in where no dilution may be allowed, or a partial lock-in where promoters may sell a part of their holding in case of a sudden liquidity need. In such a case, the investor may want to agree clearly upon the triggers for a sudden liquidity need.
8. Fall-Away Rights
This clause is a fall-out of the lock-in clause and is highly negotiated in a term sheet.
The promoters are locking in and establishing their commitment. However, this commitment is given on the basis that the investor is also investing a certain agreed-upon amount in the company for a considerable period. So, the promoters may contend that they remain true to their commitment as long as the investor maintains a certain percentage of the company.
Thus, in future investment rounds, the previous investor's share is diluted, or, in general, if the investor sells their share below the agreed-upon percentage, the promoters ‘fall-away' rights are triggered. They may not be bound by the lock-in period that was otherwise agreed upon.
9. Transfer Restrictions on the Parties
This is another crucial aspect and is ideal to be agreed upon during the term sheet stage itself so that it does not crop up during the drafting of definitive agreements.
It pertains to conditions imposed on securities transfer. These restrictions dictate circumstances under which an owner of the securities can transfer securities to another party. This clause generally favours the investors’ interests, providing two broad methods for imposing transfer restrictions.
a. Right of First Offer (‘ROFO’): Granting a party the first opportunity to make an offer to purchase securities before they are offered to others. For instance, Mr. A and Mr. B are shareholders of the company. Mr. A has the right to the first offer. Then, Mr. B has to offer the shares he intends to sell first to Mr. A before going to any third party. If Mr. A makes an offer to Mr. B, then Mr. B can choose to sell his shares even to a third party, with a mandatory condition that he cannot sell the shares to a third party at a price lower than Mr. A's.
b. Right of First Refusal (‘ROFR’): It is a right to match the terms of a third-party offer before a security can be sold to a third party. Continuing the same example, when Mr. B finds a third party, Mr. A will have the right to match the price offered by the third party. If Mr. A matches the offer price, Mr. B will have to sell shares to A instead of the third party.
10. Anti-Dilution Provision
Imagine you have just placed a sizable bet on a promising startup, believing in its potential to skyrocket in value. But wait—what if, down the road, new investors come in at a lower valuation, diluting your hard-earned stake? Enter the anti-dilution clause, your trusty shield against the perils of down rounds and equity erosion.
The anti-dilution clause is like a superhero in your term sheet, swooping in to protect your ownership percentage when the company raises additional funds at a lower valuation. Let us break down how this works and why it is crucial for both investors and startups.
Why Anti-Dilution Matters?
In the dynamic world of startups, the journey from initial investment to eventual exit is rarely a straight line. Market conditions fluctuate, and sometimes, startups need to raise funds at valuations lower than previous rounds.[vii] Without anti-dilution protection, your equity slice could shrink, leaving you with a smaller piece of the pie just when things get interesting.
The Mechanics of Anti-Dilution
Anti-dilution provisions come in two main flavours: (i) Full Ratchet and (ii) Weighted Average. Think of them as your armour options, each offering a different level of protection.
Full Ratchet Anti-Dilution: Full Ratchet is like having an impenetrable force field. It ensures that your original investment price is adjusted to match the new, lower price in its entirety. For instance, you bought shares at $10 each, and the company issued new shares at $5. With Full Ratchet, your shares are repriced to $5, meaning you get more shares to maintain your ownership percentage.
Weighted Average Anti-Dilution: Weighted Average is a bit more nuanced, like a fine-tuned suit of armour. It adjusts your share price based on the average price of all shares issued, taking into account the number of new shares and the lower price. For instance, suppose you bought shares at $10 each, and the company issues new shares at $5. Instead of fully adjusting to $5, the Weighted Average might adjust your price to somewhere around $7, depending on the specifics of the calculation. This provision strikes a balance between protecting your investment and being fair to the company and new investors.
Commercial Implications
For investors, anti-dilution clauses are a safety net. They ensure that your stake in the company remains robust, even if the startup needs to raise funds at a lower valuation. It is about preserving your upside potential and minimizing risk.
For startups, offering anti-dilution protection can make your investment proposition more attractive. It shows you are committed to protecting your investors’ interests, fostering trust and long-term collaboration. However, it is also a double-edged sword, as overly generous anti-dilution terms can deter future investors who may feel their stakes could be unfairly diluted.
Crafting the Perfect Clause
When drafting an anti-dilution clause, clarity is key. Specify whether it is a Full Ratchet or Weighted Average and detail the exact mechanics of the adjustment. Ensure both parties understand the implications to avoid disputes down the line.
In the high-stakes arena of startup investments, anti-dilution clauses are essential tools in your investment arsenal. They protect your stake as investors, safeguard your returns, and ensure you remain a key player in the company’s journey to success. By understanding and negotiating robust anti-dilution provisions, you can invest with confidence, knowing your interests are well-guarded against the ebbs and flows of the market.
11. Anti-Competition Clause
An investor would also want to ensure that the promoters fully focus on the target company's growth and do not utilize their intellect and technical know-how to root other companies. Thus, it is ideal for the investor to ensure that a term sheet includes(i) the employment terms of the promoters, (ii) the anti-competition clause, and (iii) the non-solicitation clause.
In the vibrant world of startups, where innovation and competition are the names of the game, investors want to ensure that the brains behind their investments are wholly committed to the cause. Imagine you have just invested a hefty sum into a startup that promises to revolutionize its industry. The last thing you want is for the visionary founders to be sidetracked, pouring their genius into side projects or rival companies. This is where the anti-competition clause comes into play.
The anti-competition clause is like a loyalty pledge, ensuring that the promoters’ intellectual and technical prowess is dedicated solely to the growth and success of the target company. It is a safeguard that keeps the talent laser-focused on the mission at hand. Here is how it works and why it is crucial from a legal and commercial standpoint.
Employment Terms of Promoters
First off, let us talk about the employment terms of the promoters. This section of the term sheet should clearly outline the expectations and commitments of the founders. It ensures that their primary employment and efforts are devoted to the startup. It is the foundation upon which the anti-competition clause is built. By setting clear employment terms, investors can be assured that the promoters are contractually obligated to prioritize the company’s growth more than anything else.
Anti-Competition Clause
The heart of the matter is the anti-competition clause itself. This clause explicitly prohibits the promoters from engaging in any business activities that compete directly or indirectly with the target company. It is like drawing a line in the sand, making it clear that their creative and strategic energies must be channelled exclusively towards the startup’s success.
But what exactly does this generally entail? Here is a breakdown:
Direct Competition: Promoters cannot start, join, or support any venture that competes with the target company’s business. For instance, if the startup is a tech firm developing cutting-edge AI software, the promoters cannot simultaneously work on another AI project, even if it is in its infancy or a side hustle.
Indirect Competition: This extends to any activities that could indirectly benefit a competitor. It means no sharing of trade secrets, no moonlighting as a consultant for a rival, and certainly no plotting to set up a competing enterprise.
Duration and Scope: The clause typically defines a specific duration during which these restrictions apply, often extending beyond the period of direct involvement with the company. It also specifies the geographical scope to ensure that promoters do not simply take their talents to another region.
Non-Solicitation Clause
Hand-in-hand with the anti-competition clause is the non-solicitation clause. This part ensures that promoters do not lure away key employees, clients, or business partners to their new ventures. It is about maintaining the integrity and strength of the team and the business relationships that are critical to the startup’s success.
Employee Non-Solicitation: Prevents promoters from poaching talent from the startup to join any new or competing ventures. It helps retain the core team that is driving the company forward.
Client and Partner Non-Solicitation: Ensures that promoters do not entice clients or partners away from the startup, which could undermine the business’s stability and growth.
From a commercial perspective, these clauses are vital. They provide investors with the peace of mind that the founders are all-in, not just today but for the foreseeable future. It mitigates the risk of intellectual property and business strategy being diverted to competitors, which could severely impact the startup’s potential for success.
From a legal standpoint, clearly articulated anti-competition and non-solicitation clauses in the term sheet can prevent costly disputes down the line. They set clear expectations and boundaries, making it easier to enforce the commitments made by the promoters.
12. Affirmative Voting Rights / Reserved Matter Rights
This is arguably the most important clause from an investor’s point of view. It outlines specific decisions or actions requiring approval from the person holding the affirmative rights on the matters reserved under this clause.
Affirmative Voting Rights are the ultimate safeguard for investors, ensuring they have a say in significant decisions that could impact their investment. This clause outlines specific decisions or actions that require the investor’s approval before proceeding. It is like having a VIP pass that grants exclusive access to the most critical boardroom discussions.
These rights are crucial because they provide investors with a level of control over the company’s strategic direction. Without them, investors would be left in the dark, unable to influence key decisions that could affect the company’s value and, by extension, their returns.
The Mechanics of Affirmative Voting Rights
The list of reserved matters under this clause is often a hotbed of negotiation, as it directly impacts the company’s operations and management. These matters typically include:
Issuance of New Shares: Any decision to issue new shares or securities that could dilute the investor’s ownership must be approved.
Debt Financing: Taking on new debt above a certain threshold requires a nod from the investor.
Mergers and Acquisitions: Any mergers, acquisitions, or sales of substantial assets need investor approval.
Change in Business Model: Shifts in the core business strategy or model cannot proceed without consent.
Major Expenditures: Large capital expenditures beyond a specified limit must be greenlit.
Hiring or Firing of Key Personnel: Decisions related to the hiring or termination of senior executives are reserved matters.
Amendments to Organizational Documents: Changes to the company’s charter or bylaws need investor backing.
These reserved matters are meticulously scrutinized and negotiated as they significantly influence the company’s future trajectory. The goal is to strike a balance where the investor’s interests are protected without stifling the startup’s ability to operate efficiently.
Commercial Implications
For investors, Affirmative Voting Rights is a shield against unforeseen risks. They provide a mechanism to oversee and, if necessary, veto decisions that could adversely affect their investment. It is about having a seat at the table when the big calls are made.
For startups, while these rights offer a layer of security to investors, they also come with the responsibility of maintaining a collaborative relationship. It is essential to craft these clauses in a way that provides reassurance to investors without creating bottlenecks in decision-making processes.
Crafting the Clause
When drafting an Affirmative Voting Rights clause, precision and clarity are paramount. The reserved matters should be explicitly listed, leaving no room for ambiguity. Both parties need to understand the scope of these rights and the circumstances under which they can be exercised.
It is also wise to establish a threshold for what constitutes a major decision requiring approval. For instance, not every minor expenditure or operational change should trigger this clause. Setting clear limits ensures that the board retains its agility while the investors’ significant concerns are addressed.
To sum up, Affirmative Voting Rights or Reserved Matter Rights are the bedrock of investor protection in startup investments. They ensure investors retain influence over key decisions, safeguarding their interests and fostering a collaborative environment. By carefully crafting and negotiating this clause, startups and investors can build a partnership based on trust, transparency, and mutual respect.
13. Exit Rights
Any company entering into an agreement with an investor by issuance of shares will indubitably lay out a well-defined exit mechanism for the investor. In general, a term sheet would include the following exits provided to the investor:
Initial Public Offer: When the company hits the stage of the public offering, i.e., the shares of the company are listed on a recognized stock exchange, all shareholders, including the investors, get the right to sell the shares publicly and reap profits from their investment. While this is a common exit mechanism, it may involve an initial lock-in period based on mutual understanding and certain statutory prohibitions.
Trade sale: The right of an investor to sell his shares may also be triggered when the company intends to sell a part of it to another business, often in the same industry.
Tag along rights: This provision, commonly granted to minority shareholders, allows the persons holding the right to ‘tag along’ with a selling shareholder at the same valuation and same offer when the selling shareholder intends to sell their shares to a third party. The timing and proportion in which such right holders can exercise the right and the pricing and payment terms for such a ‘tag along’ are pertinent aspects to be factored in.
Drag along rights: This is another right commonly granted to the majority shareholders. Suppose a prospective buyer offers to buy the entire company at a good valuation. In that case, the investor may trigger this right and ‘drag along’ all the shareholders of the company, eventually leading to the sale of the company.
Buyback of shares by the company: A company may intend to buy back its shares from its shareholders for financial consolidation and financial attractiveness in the market. This offers a viable exit route to the investors. However, a company cannot selectively buy back its shares due to statutory prohibitions. An offer would have to be made to all the shareholders, after which the buy-back will happen on a pro-rata basis if more shareholders express their interest in selling the shares to the company than the actual percentage fixed by the company to this effect.
14. Liquidation Preference
This clause outlines the priority order in which the investors are entitled to receive proceeds in the event of the company’s liquidation, sale, or winding up. It specifies how much money the investors are guaranteed to receive before other stakeholders, such as founders and common shareholders. What is mostly negotiated in this clause is the liquidation preference rate.
As discussed above, since most investors are issued preferential shares, it grants certain special rights, including the liquidation preference, making them more valuable than the common shares. In the event of liquidity, the preferential shares have priority over the common shares in receiving the proceeds of liquidity. In general, the following are the types of preferences negotiated between the investors and the target company, out of which one is finally mutually agreed upon:
Straight preferred: In this, the investors have the right to get back their investment with a multiple amount of the original investment. For example, it may be mutually agreed in the Term Sheet that in a liquidity event, the investor will have the first right to get 2x of their investment before distribution of the proceeds to the common shareholders.
Participating preferred (double-dip): This right is extremely tilted towards investors’ benefit. Firstly, the investors get multiples of their original investments. Thereafter, when the proceeds are to be distributed to the common shareholders, they get the right to participate along with the common shareholders and receive their share from the common stock proceeds. For instance, an investor with an investment of Rs. 20 lakhs holds 10% of the stake of the target company and has the right to receive 2x multiple. The company will be sold at Rs. 2 crores in a liquidation event. In this case, the investor will first get Rs. 40 lakhs, and thereafter, he will receive 20% of the remaining proceeds, i.e., Rs. 32 lakhs, participating in the pool with the common shareholders.
Partially participating preferred: This is a suitable compromise between the investor and the target company. This kind of preference gives the same rights to the investors as the preference for participating. However, in this case, their aggregate return is capped. Once they receive the capped amount, they cannot share the remaining proceeds with the other common shareholders.
15. Exclusivity Rights
This clause grants exclusivity rights to the investor to negotiate and finalize the terms of investment with the target company within a specified period of time. The startup/target is barred from negotiating with any other potential investor during this period.
This clause provides the investor with a window of time to conduct its due diligence and negotiate and finalize the terms without the risk of competing terms or distractions from any other investor.
An exclusivity clause typically entails(i) the duration of the exclusivity period, (ii) any exceptions or carve-outs in the same, and (iii) consequences of breach. Thus, this clause is usually binding in nature.
16. Dispute Resolution
The exhilarating ride of startup investments is not always smooth sailing. Sometimes, disagreements arise; when they do, the Dispute Resolution clause steps in as the referee. This clause is the go-to mechanism for resolving conflicts and deciding where and how disputes will be settled. Let us dive into the nuts and bolts of this crucial clause and understand why it is a linchpin in the term sheet.
Dispute Resolution clauses are generally binding in nature, meaning they carry legal weight and set the stage for how disagreements will be handled. This clause is not just about resolving conflicts; it is about choosing the battleground. The forum of jurisdiction is decided here, which could either be a court or an arbitral tribunal. Arbitration is a popular choice due to (i) confidentiality and efficiency, (ii) speedier resolution compared to court proceedings, and (iii) a more amicable form of resolution, especially in the fast-paced startup world.
When parties opt for arbitration, they agree to refer disputes to an arbitral tribunal. However, deciding on the seat or venue of arbitration can be a bit tricky, especially when foreign investors are involved.
Imagine a scenario where an Indian startup and a foreign investor, say from the USA or Singapore, have a dispute. The foreign investor might prefer arbitration in their home country, where they feel the legal system is more familiar and favourable. On the other hand, the Indian startup would likely prefer arbitration in India to avoid the logistical challenges and costs of fighting a legal battle abroad.
Thus, negotiating the seat of arbitration is where things get interesting. It is a delicate dance, balancing convenience, legal familiarity, and strategic advantage. Here is how this negotiation typically unfolds:
Foreign Investors’ Preference: Foreign investors often push for arbitration in internationally recognized venues like Singapore, London, or New York. These locations are known for their robust legal frameworks and neutrality.
Local Companies’ Preference: Indian startups, understandably, prefer to keep things close to home. They might advocate for arbitration in cities like Mumbai or Delhi, where they are more comfortable navigating the legal landscape.
Finding Common Ground: Sometimes, the compromise is to choose a neutral venue that is acceptable to both parties. Places like Hong Kong or Dubai often serve as a middle ground, offering a blend of neutrality and strong legal systems.
Drafting the Clause
When drafting the Dispute Resolution clause, clarity and precision are key. The clause should explicitly state:
Preferred Method: Whether disputes will be resolved through arbitration or litigation.
Seat of Arbitration: The city or country where the arbitration will take place.
Governing Rules: The rules under which the arbitration will be conducted, such as those of the International Chamber of Commerce (‘ICC’) or the United Nations Commission on International Trade Law (‘UNCITRAL’).
Language of Proceedings: The language in which the arbitration will be conducted ensures all parties are comfortable and clear on this aspect.
In the high-stakes world of startup investments, disputes are almost inevitable. The Dispute Resolution clause is your blueprint for handling these conflicts efficiently and fairly. By carefully negotiating and drafting this clause, parties can ensure they have a clear, agreed-upon path to resolve disputes without derailing the startup’s journey.
So, as you craft your term sheet, give the Dispute Resolution clause the attention it deserves. It is your plan B, your safety net, ensuring that when disagreements arise, there is a clear, effective way to handle them. With a well-drafted Dispute Resolution clause, you can confidently navigate the choppy waters of conflict, keeping your startup venture on course towards success.
Key Considerations for Stakeholders in Term Sheets
Navigating the world of term sheets requires a keen understanding of their implications from multiple perspectives. Whether you are a startup founder, an investor, or a legal counsel, each party has unique priorities and concerns. Here is a detailed analysis to ensure everyone is on the same page.
For Startups
Clarity on Terms
As a startup, ensuring that every term in the term sheet is clearly defined and understood is crucial. Ambiguities can lead to misunderstandings and disputes down the line. For instance, if the term sheet mentions ‘preference shares,’ ensure you know what rights and privileges come with those shares. Each term must be articulated with precise language to avoid any possible confusion. Furthermore, it is essential to avoid legal jargon that can obscure the meaning of important terms. A well-crafted term sheet should be concise and to the point, focusing on the key terms and conditions that will ultimately guide the transaction.
Future Implications
Terms like anti-dilution provisions and liquidation preferences can significantly impact future financing rounds. Anti-dilution provisions protect investors if the company raises funds at a lower valuation in the future, but they can also dilute the founders’ equity. Liquidation preferences determine the order in which investors get paid in the event of a liquidation. While these terms protect investors, they can affect the company's attractiveness to future investors.
For instance, imagine you have agreed to a 2x liquidation preference with your current investors. If your company is sold for $10 million, your investors will receive twice their initial investment before any remaining proceeds are distributed. This could leave less for the founders and other shareholders, potentially complicating future fundraising efforts.
Control and Governance
Be mindful of clauses that affect control over the company, such as board seats and affirmative voting rights. Investors often seek these rights to have a say in major company decisions. While giving investors some level of comfort is important, retaining control is equally crucial for founders.
Board Seats: Consider how many board seats investors will occupy versus the founders. Maintaining a balanced board is key to ensuring your vision for the company is not overshadowed.
Affirmative Voting Rights: These rights allow investors to veto certain decisions. Ensure these reserved matters are clearly defined and not too restrictive, allowing you to manage the company effectively.
For Investors
Protecting Investment: Your primary goal as an investor is to protect your investment. Clauses like anti-dilution provisions and liquidation preferences are essential tools.
Anti-Dilution Provisions: Ensure these are robust to maintain ownership percentage in future down rounds. Weighted average anti-dilution protection is a common choice, balancing the interests of both investors and founders.
Liquidation Preferences: Clarify the terms of your liquidation preference. A 1x non-participating preference is standard, but participating preferences offer greater security by allowing investors to share the remaining proceeds after receiving their initial investment back.
Exit Strategy
Having a clear exit strategy is vital. Ensure that exit rights are well-defined to facilitate a smooth exit when needed. Include terms such as drag-along rights, which compel minority shareholders to sell their shares if a majority agrees to a sale. This ensures a streamlined exit process and maximizes returns.
Governance
Secure adequate control and oversight through board seats and affirmative voting rights. This involvement helps safeguard your investment and influence key decisions.
Board Seats: Aim to have representation on the board to monitor the company's direction and performance.
Affirmative Voting Rights: These rights allow you to veto decisions that could negatively impact your investment, such as changing the business model or incurring significant debt.
For Legal Counsel
Detailed Drafting
As legal counsel, your role is to ensure all terms are drafted with precision to avoid ambiguities. A well-drafted term sheet minimizes the risk of disputes and misunderstandings. Clearly define terms like 'affirmative voting rights' to prevent differing interpretations. This term often triggers significant actions, such as the investor’s right to withdraw from the deal if the company’s circumstances worsen.
In drafting a term sheet, it is pertinent to keep several key aspects in mind. Clearly defined terms and precise language are essential. Focus on the key terms that will guide the transaction, and be concise, avoiding unnecessary legal jargon. Using non-binding language is preferable, providing flexibility for both parties as they navigate the details of the deal. Including contingencies to address potential issues that may arise during subsequent negotiations and due diligence ensures that all parties are prepared for various scenarios and can handle them effectively.
Negotiation
Help clients understand the implications of each clause and negotiate terms that align with their interests. Your expertise is crucial in striking a balance that protects your client while maintaining deal attractiveness.
For Startups: Negotiate terms that provide flexibility and minimize undue restrictions.
For Investors: Advocate for protective measures without stifling the company’s growth potential.
Compliance
Ensure that all terms comply with relevant laws and regulations. This includes corporate law, securities regulations, tax implications, and industry-specific requirements. If your client is an international investor, ensure compliance with foreign investment regulations and anti-money laundering laws.
Including contingencies to address scenarios that may arise during subsequent negotiations and due diligence is also important. These contingencies should outline how such scenarios will be handled, provide a roadmap for resolution, and ensure smoother negotiations.
Conclusion
Navigating the startup investment landscape without a firm grasp on term sheets is like trying to sail uncharted waters without a map. Term sheets are more than just formalities; they are the very blueprints of your investment journey. They set the stage for negotiations and establish the groundwork for legally binding agreements that can make or break your venture’s future. Stakeholders can craft investment deals that protect their interests and foster successful collaborations by paying close attention to every term and its implications. The term sheet sets the tone for the entire investment relationship, serving as a vital checkpoint where all parties align their expectations and commitments.
For startups, this means gaining clarity on terms and understanding how provisions like anti-dilution and liquidation preferences will shape future financing rounds. It is about maintaining control while giving investors the reassurance they need. For investors, the focus is safeguarding their investment through robust anti-dilution clauses, clear exit strategies, and adequate governance rights. And for legal counsel, the challenge lies in drafting precise, compliant, and unambiguous terms that facilitate smooth negotiations and solidify the deal.
The devil, as they say, is in the details. A meticulously crafted term sheet can pave the way for a thriving and mutually beneficial partnership. It is where the potential pitfalls are addressed, and the roadmap to success is clearly defined. With this detailed guide, you are now equipped to tackle the term sheet process with confidence and foresight. Whether you are drafting, negotiating, or finalizing a term sheet, the insights provided here will help you steer through this crucial phase of the investment journey.
End Notes
[i] 2022 SCC OnLine Del 455.
[ii] Pre-money valuation is the estimated value of the company before it has received the investment. Whereas post money valuation is the company’s value after the new capital injection.
[iii] Seed round, in a crude sense, is the financing round that raises the initial capital to start the business. In this round, the investment is typically made by Angel investors or friends and families of the founders. At this stage, the company has completed its R&D round and is ready to launch the product in the market. On the other hand, series A is typically a name given to the company’s first significant round of investment. This is generally backed by early-stage venture capital firms.
[iv] Once the company has launched its product and has subsequently raised its first significant funding, the company may also plan for expansion and diversification in the future. At this stage, the company would tend to raise further capital by getting into later-stage funding rounds such as Series B (succeeding Series A). The investors for these funding rounds are typically Venture Capital and Private Equity firms aiming to invest in companies that are past the prototype stage – having established their business and now looking for expansion.
[v] Employee Stock Ownership Plans (ESOPs) give ownership interest/stake to the employees of the company.
[vi] Capitalization Table (commonly known as Cap Table) is the spreadsheet that shows who has ownership in the company.
[vii] This is known as a down round in the startup parlance.
Authored by Sanyam Aggarwal, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinion. To engage further with the author, please email sanyam.aggarwal@metalegal.in