In this article we take a look at what exactly is a term sheet and what is in a term sheet for private equity.
With the burgeoning start-up culture in India, many investment-related terms are becoming part of common vocabulary. One such word that we often hear in the same breath as the word ‘investment’ is ‘term sheet’. Learn more about What Is Term Sheet In Private Equity.
But What Exactly Is a Term Sheet?
Literally speaking, a term sheet is exactly what its name sounds like. A list of terms and conditions is put down on a sheet. It can be with regard to any arrangement or transaction that involves two or more parties to come to a common agreement. Depending on the nature of the transaction, the term sheet can be a list of terms and conditions that one party needs to be fulfilled in order to deliver their end of the agreement. Or it can be the result of a discussion between all parties involved. When it comes to private equity investment, the term sheet is a list of terms and conditions that need to be met for an investor to invest in a private limited company and for the company to sell the equity to the investor in return for the investment.
A term sheet, however, is only the preliminary agreement in an investment transaction. It is a precursor to the actual final agreement, the shareholders’ agreement. A term sheet is a non-binding agreement with the broad terms and conditions under which a party is willing to commit to a shareholders’ agreement. It is meant to get the discussion going.In fact, a party can come up with a term sheet without even engaging another party, to begin with. Any company looking for investment can put down what kind of investment it is looking for and what it is willing to offer in return for the investment. Similarly, an investor can, too, have a general term sheet of his or her own where he puts down the kind of money he is willing to invest and what exactly he or she is looking for in a company before investing. Once either of the two parties finds another party that they feel is close enough to what they are looking for, the two parties can begin discussions and make the necessary adjustments to the term sheet, if necessary. Once the fine points of the term sheet are finalised, it is signed by the consenting parties.
Contents Of A Term Sheet
There are no standard rules as to what a private equity term sheet can and cannot contain. But there are certain elements of a term sheet that make it a term sheet. These are the defining elements of the document and hence are always present in almost all equity-related term sheets in one form or another. Let us take a look at these.
Investment details – All details agreed upon with regard to the investment should be detailed in the term sheet. This includes the agreed valuation of the company, the amount of money being invested and the amount of stake being given in return for the investment.
Voting rights – Anyone who holds equity in a private limited company has the right to vote in the internal affairs of the company. And if nothing is mentioned in specific anywhere, then it is presumed that the value of the vote is commensurate to the value of the equity held. So it is extremely important to clearly define the voting rights in the term sheet if the rights have to be distributed in a specific way. The company can state the matters on which the investors can and cannot vote. At the same time, the investor can point out the areas of operation which affect his or her investment and hence has the right to vote in those matters. When both parties reach a middle ground, the terms are put down on the term sheet.
The obligation of each party – This part will state in specific terms what each party is expected to bring to the table, how they are expected to carry out their obligations, and what the deliverable will be in measurable terms. This is important to be able to see if the arrangement is actually yielding results or not. If it is not, then the agreement can be dissolved, and the parties can move on. And if it is working, then the parties can move to a more detailed, binding agreement.
Liquidation – In this part, you need to mention how the proceeds are to be divided in the event that the company is liquidated or sold to a prospective buyer. This can be on the basis of certain markers or certain checks. For an investor, time is the biggest factor. He or she will want enough time for his or her investment to grow along with the valuation of the company. So the investor can state that if the company is sold before x number of years, then he or she should be compensated for the diminished growth of his return on investment. At the same time, the company can put in a clause saying that if the company is sold at an ‘x’ valuation achieved due to its performance, then the company and its founders get a bonus on liquidation. The milestones can be anything that both parties agree on as long as it is measurable.
Dividends – This section should clarify under what circumstances shareholders are entitled to dividends from the profits. This can be based on the amount of profit or can be based on time-period, or even a combination of both. For instance, a company can say that x% of annual profits will be put into a ‘dividend fund’, which can be an FD or a mutual fund, and upon maturity of the fund, the shareholders will receive dividends.
Some Important Terminology In A Term Sheet
Pre-money / Post-money valuation – This refers to the valuation of the company before and after the investment. Sometimes an investor brings a certain amount of goodwill with him or her when they are investing in a company which can boost the valuation of the company in the market. So the investor will want in writing the valuation of the company before he or she comes on board and the valuation of the company after he or she comes on board.
Drag along / Tag along – These clauses are used in the context of liquidation of equity. Any equity holder has the right to engage in negotiations with any eligible party with regard to the sale of their equity in the company. So when the equity holders have an agreement amongst them, they mention drag-along / tag-along rights. Drag-along rights are usually held by the majority stakeholder, which is usually the founders of the company. It is to ensure that when a majority equity holder is selling their stake and the buyer wants to buy the stake of the minority stakeholder as well, the majority stakeholder has the right to ‘drag along’ the minority stakeholder in the sale. Tag-along rights are usually held by the minority stakeholder, which is usually the investor. When a majority stakeholder is selling their stake, the minority shareholder can ‘tag along’ and sell their stake at the same valuation as the majority stakeholder.
Pro-rata rights – This clause is to understand how the results of any future occurrence will be shared by the two parties. It is usually based on the shareholding pattern. So when the company is going for another round of investment, at what rate will both parties be required to dilute their equity? At what rate will the proceeds of any sale of the company be divided between the parties can also be detailed here.
Conclusion
When it comes to an arrangement of private equity, each party is looking out to get the best for themselves. And not always can the situation be a win-win for both parties. So it is very important to make sure that each and every clause is understood from several perspectives. It is always better to consult someone who has ample experience with drafting or vetting term sheets across various situations. If you are looking for a consultation with regards to an investment or need help with drafting a term sheet, get in touch with Vakilsearch, and we will assist you with the best professional help for your requirements.
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