Any private equity investment transaction in a venture may have multiple stages to it. Right from pitching to closing a particular transaction, each stage is backed by its own nuances and processes. When any venture receives an investment commitment from a potential investor, the same is outlined in a term sheet, which becomes the genesis of the particular transaction.
A term sheet is a non-binding document capturing the key terms and conditions pertaining to a particular transaction. A term sheet is comparable to a soft commitment by way of a commercial handshake, and is in a nature of a memorandum of understanding outlining such investment transaction, thereby forming skeletal to such a transaction.
The role of a term sheet is primarily two fold. One of which is to set out an understanding between the venture and the investor in relation to a particular transaction, and second, any term sheet also provides for a process to undertake such transaction. Thereby, execution of a term sheet does not by itself mean that the proposed investment is consummated, rather it formulates a roadmap for undertaking such a proposed investment.
In all investment transactions, pursuant to the execution of a term sheet, the concerned parties enter into definitive agreements to elaborate the understanding provided in the term sheet and to make it legally enforceable. However, the complete transaction and the relationship between the venture, its stakeholders and the investor is heavily relied upon and derived from the provisions of the term sheet. Thereby, although a term sheet is merely a preliminary non-binding document, it is highly recommended that the investee entity and its stakeholders examine the proposed term sheet (from the investors) in line with their strategy and expectations, and ensure that the term sheet elucidates their concerns and any other outstanding points which may require negotiations in the future.
Key Constituents:
There are multiple provisions constituting an early stage investment term sheet. Such provisions can broadly be classified as follows:
A. Functional details pertaining to the transaction: Every early stage term sheet outlines certain fundamental information concerning the proposed investment. Such information includes (a) the names and details of the concerned parties i.e., the investee entity, the investors and the founders of the investee entity; (b) the valuation of the investee entity, either pre-money or post-money; (c) the nature of financial instruments which is proposed to be issued and allotted to the investor; (d) the investment amount and the shareholding percentage of the investor; (e) pre-money and post-money capitalization tables of the investee entity; and (f) usage of funds being invested.
B. Management rights: Venture investors generally seek certain management rights in the investee company to have a definite level of control over the operations and to ensure adequate checks and balances in relation to the operations of the investee. Such management rights include: (a) board composition of the investee; (b) right of the investor to appoint director in the investee company (b) right of the investor to appoint observer in the investee company; (c) information and inspection rights; (d) voting rights; and (e) affirmative voting rights
C. Economic rights associated with the financial instrument: An early stage term sheet encapsulates a list of rights which are directly affiliated with the financial instrument proposed to be issued by the investee entity. Such rights may include (a) dividend rights/interest; (b) liquidation preference; (c) voting rights; (d) conversion of the instrument; and (e) redemption of the instrument.
D. Transfer restrictions: An investor may impose certain restrictions on the issuance of new shares by the investee entity or transfer of shares by the other shareholders of the investee entity, specifically the founders. The rationale behind such restrictions is multi-fold, including (a) to protect the investors from diluting their interest in the investee entity; (b) to discourage the founders from transferring their interests before providing an exit to the investor; and (c) to protect the investors to lose control over the investee entity. In an early stage term sheet, such transfer restrictions may be imposed by way of (a) pre-emptive rights; (b) right of first refusal; (c) right of first offer; (d) tag along rights; and (e) founder’s lock-in period
E. Anti-dilution: More often than note, every investor seeks an anti-dilution right to protect their shareholding interest in the investee entity. Anti-dilution rights can be broadly classified into “full ratchet” and “weighted average”. Under a full ratchet anti-dilution, the investor’s shareholding is protected from being diluted up to hundred percent, and under weighted average method, the investor’s shareholding is protected on a proportionate basis in accordance with a formula provided.
However, the framework of an anti-dilution right is contingent to the nature of instrument that is issued. To illustrate, (a) for equity shares issued to the investor, the anti-dilution protection may be by a way of issuance of fresh shares at a discounted price upon any future down round; and (b) for convertible shares issued to the investors, the conversion ratio may be adjusted in accordance with “full ratchet” or “weighted average” formula agreed upon.
F. Exit rights: Exit rights in an early-stage term sheet refer to the provisions that outline how investors can realize a return on their investment. These exit rights are crucial for the investor in determining their ability to cash out their investment and potentially make a profits. Generally, exit rights are backed by certain timeframe (“Exit Period”) within which the investee entity is required to provide an exit to the investor through one of the following means: (a) by way of an initial public offering; (b) by way of a strategic sale; or (c) by way of a buy back.
Further, the investor is also provided with certain remedies in the event a rightful exit is not facilitated within the Exit Period. Such remedies may include (a) drag along rights, whereby the investor may require the other shareholders of the investee entity to sell their shares to the potential third-party buyer, introduced by the investor; and (b) a right to sell the shareholding to any competitor of the investee.
G. Other key clauses: Apart from the fundamental information and the abovementioned rights, an early stage term sheet is generally constituted of the following key clauses:
a. Conditions to the proposed transaction including conditions precedent, due diligence requirement and creation of an employee stock option pool.
b. No shop clause: Under a no-shop/exclusivity clause, the investee entity is prohibited from approaching any other investor during a certain pre-determined time from the date of the term sheet.
c. Binding clauses: Although a term sheet is non-binding in nature, there are certain provisions of a term sheet which are made legally enforceable. Such binding provisions may include governing law of the term sheet, confidentiality requirement and no-shop clause.
d. Expenses: For the consummation of any investment transaction, there are certain costs and expenses incurred in relation to due diligence, legal/accounting reviews, preparation and review of definitive agreements, and undertaking the closing. This clause is provided in the term sheet to clarify which of the parties i.e., the investor or the investee, will bear such costs, and the limitations/cap on such costs.
Although a term sheet is a letter of intent provided by the investor, it is one of the most fundamental documents in an early stage investment. A term sheet should be well balanced and adequately detailed to ensure that the key terms of the investment are rightly addressed and there is minimum scope of negotiation and delay while undertaking the transaction.
As a founder, it is imperative to analyze a term sheet from multiple view-points. It’s an opportunity for the founders to ensure that their interests and expectations are properly addressed and that the terms are fair and reasonable. Additionally, a founder shall also ensure that the term sheet is aligned with the long term and short term strategies and intended arrangements outlined by the founder.