GENERAL CORPORATE,

INVESTMENT, M&A &

FINANCING
All You Need To Know About Term Sheets
General Corporate, Investment, M&A & Financing
All You Need To Know About Term Sheets

Learning Objectives:
● Understanding the importance and the legal validity of a term sheet.
● The important terms and clauses to be taken care of in a term sheet.
● Determining the right kind of investment and security.
● To understand the aftermath of signing a term sheet.

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. 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.

Basically, a term sheet is a legal document that sets out the parameters to be adhered to by
parties in a business agreement. It is a document that marks the start of an investment
transaction.

Now, let us start answering questions that arise out of the discussion regarding a term
sheet. This will be very useful especially for founders of a company, lawyers working for
companies or law firms, law students who wish to work on M&A transactions or students in
general who want to understand what term sheets are, its implications and why one needs
a term sheet.

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

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All You Need To Know About Term Sheets

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.

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.

Shareholders agreement (SHA) - An SHA is an agreement usually entered into

between an investor, a company and its founders. It is the document where all the
rights, duties and obligations are found with respect to the existing and potential
shareholders inter-se as well as the company. It strikes a balance between the
competing interests of the founders and the investors by protecting their interests,
investment of the investor and laying down a middle path on which both of them
can agree upon. An SHA usually contains, among other things, anti-dilution rights,
drag-along, tag-along rights, type of security that the investor is investing upon and
exit rights, etc.

Share purchase agreement (SPA) - An SPA is an agreement executed between the

investor and the founders or between previous and next investor for the sale of the

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All You Need To Know About Term Sheets

existing shares held by the founders or previous investors to the new investor.

Share subscription agreement (SSA) - An SSA is a document executed when the

company wants to issue new shares to the investors. This is different from an SPA
where the existing shares of the founders are sold.

It needs to be further mentioned that an SSA or an SPA is more often than not
executed with the SHA as one document. This is because logically, it does not matter
whether the company is issuing new shares, in the case of SSA, or the existing
shareholders are selling their own shares, in the case of an SPA, there will always be
a need for an SHA which defines the rights, duties, and obligations of the
shareholders towards the company.

After these documents have been executed, a company needs to fulfil the conditions
precedent for these documents to fully come into force. Upon the satisfaction of the
last condition precedent applicable in respect of the closing of the transaction, the
promoters of the company provide the investors with a certificate, called a
“Conditions Precedent Satisfaction Certificate” stating that all the conditions
precedent have been satisfied and duly completed.

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 SHA, SPA or SSA. 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.

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All You Need To Know About Term Sheets

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.

● Amendment - This clause talks about how there is scope to bring about
changes in the term sheet.

● Governing Law and Arbitration - The law of which country will be applied if
any dispute arises regarding the amendment and implementation of the term
sheet.

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All You Need To Know About Term Sheets

Quick Tip: If the term sheet has both binding and non-binding
clauses, it is always better to bifurcate the term sheet into two. This
helps the parties to know which clauses are binding and which are not
in one glance.

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.

Valuations are usually done by either the Asset Based

Model, Market Based Model or Comparable Company
Technique, Discounted Cash Flow Model and the most
relevant for our discussion is Investor Valuation Model.
These models will be discussed in future sessions and
chapters.

Investors see the value of a company pre-investment.

Then they assess the value of the company post an

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All You Need To Know About Term Sheets

investment infusion in the company. This is how they

make a choice as to whether they will invest or not.

For example, If an investor thinks about investing, $100

for 20% of the business. Then in effect, the investor is
saying that, after the transaction, he will own 20% of the
company. Here, he is assuming that his 20% of the
company is worth $100. This, in effect, means that the
value of 100% of the company will be $500 ($100 times
5). Hence, the post-money valuation in this example of
the business would be 500$. The pre-money valuation,
on the other hand, would be 500$ minus the amount
invested, that is, 100$, which is equal to 400$.

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 they get the company to an IPO, or to
making it public. Option pools are part of pre-money
valuation and are mostly taken out of the stock of the
founders. Hence, this assessment will be valuable for
investors in order for them to understand how their
stakes will get affected.

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.

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All You Need To Know About Term Sheets

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 means that a majority shareholder will
rights be able to ‘drag’ a minority shareholder ‘along’ in case the
majority shareholder wants to sell but the minority
shareholder does not. This, however, can only be done
when the price, rate and terms of the offer that the
majority shareholder gets are the same as one that the
minority shareholder gets. This clause is beneficial to the
buyer because it helps him get the most control of a
company with a deal. 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. When warrants
are issued, their price is typically higher than a common

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stock’s value but they prove beneficial in cases when the

predetermined price is higher than the actual value of
the stock. A Warrant clause in a term-sheet focuses on
the terms of the issue of such warrants. This clause is
usually put with a warrant-purchase agreement clause,
with the latter focusing on what the agreement will
contain.

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 anti-dilution is usually achieved by having an
adjustment formula through which the investor’s original
shareholding is arrived at.

10. Pre-emptive These rights give the investors the right to buy shares in
rights 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. This
right is similar to the anti-dilution right in purpose but
the means to achieve that is significantly different.

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.

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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. Apart from these, the investor can also
have put options as well as buy-back rights at the time of
exit. 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. Most
people confuse this with drag-along rights discussed
above. 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

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shareholders. In tag-along rights, it is the opposite. Here,

the minority shareholders obligate the majority to tag
them along.

17. Redemption Companies issue debentures for a limited period of time.

rights Once the maturity period ends, the companies have to
return the principal amount to the investor. The right of
redemption in a company means the right to get your
money back once the maturity period of debenture ends.
This was in the context of debt-based security,
debentures. For equity -based security, that is, stocks,
however, these rights mean differently. In stocks,
redemption is the right of the shareholders to obligate
the company to buy-back the stocks of the shareholders.
These rights can be optional or mandatory in the case of
stocks and the investors can have either of them
depending on the intent of the investor and what he
wants out of the investment.

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.

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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.

J. How to determine the right kind of security-

CCPS/CCD OR EQUITY and why investors prefer
CCPS more than other instruments while negotiating
the same in a term sheet.
Investors have a lot of options when it comes to deciding what kind of security they
want to invest in. Broadly, the securities can be divided into equity-based,
debt-based and a mix of both, hybrid securities. Each of these possess their own
distinct features, their advantages, and disadvantages. The investor chooses which
one of these instruments he wants to invest in based on what he wants out of such
investment. Please refer to the chapter of “Types of securities” to understand each
type of security in detail.

Recap:
In this chapter, you learned what a term sheet is, why parties should have a term sheet,
and what significance it has for future transactional documents to be executed. You also
learned about:

● Major clauses in a term sheet.

● Which clauses need to be binding and which should not. And more importantly,
whether there needs to be any clause that is binding or not.
● What are the options for investors who want to invest in the capital of a company
and what are the parameters they should keep in mind while choosing a security.
● We saw whether a signature on a term sheet is time bound, whether it can be
amended, whether they are lengthy or short and who prepares the term sheet.
● Finally, we also examined what investors do to make sure that a company they are
dealing with does not deal with multiple investors at the same time.

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