Securing Investment From Term Sheet to Shareholding Agreement
Securing Investment From Term Sheet, contrary to what many young entrepreneurs might believe, is not a binding agreement between the parties but is only the blueprint of the actual deal to be given a final shape by the shareholding agreement. It is the shareholding agreement formally signed between the parties that is a binding contract.
Between the Term Sheet and the Shareholding Agreement, the deal between the parties might go several changes, and some of those changes might be radical. Often the entrepreneurs launching a startup take the Term Sheet to be the final understanding, and are disappointed when the Shareholding Agreement is placed in their hands. And quite understandably, some of them also have this acute feeling of being cheated, which sometimes makes them look at their investors as the game-spoilers, which is quite certainly a bad way to begin.
Therefore, Term Sheets must be seen for what they are. They are written representations of the basic understanding between the investors and the entrepreneurs which are later concreted into Shareholding Agreements after much thought has been given to them by the investors. This significant rethink after the Term Sheet might make the investors change the terms of the deal towards making the deal more suitable for them to milk maximum returns on their investment.
The Shareholding Agreement, as mentioned above, is a document very different from the Term Sheet. Unlike the Term Sheet, it is legally binding, and while in most cases, it ratifies the terms mentioned on the Term Sheet, it does in some cases radically change the terms of the agreement. And it is the Shareholding Agreement according to which the enterprise operates fuelled by the financial commitment of the investors and the vision of the entrepreneurs. The divergence between the Term Sheet and the Shareholding Agreement can be principally on account of two factors: due diligence and practical leverage.
DUE DILIGENCE Securing Investment From Term Sheet
To put it simply, the process of due diligence is nothing but an investigation carried out by a business or a person into all aspects of the business the company, firm or person concerned is going to invest in or have a substantial stake in before entering into a contract giving effect to the arrangement. You, as an entrepreneur, can make all the tall claims you want, but you can rest assured that none of those claims is going to be taken on face value. Every single claim that you make would be verified and counter-checked during the process called ‘due diligence’, and it is the end result of this process of verification and counter-checking that determines the terms of the final deal on the Shareholding Agreement.
One of the factors that can influence the final deal is shoddy state of requisite legal compliances on part of the startup. In India, most of the startups are founded by those who have no idea about how companies are supposed to operate within the legal framework provided for the purpose. So, they fail to undertake the required legal compliances, which leaves them in a state where the investors can count the non-compliances against the venture, and which is when the investors can also revisit the Term Sheet to tweak it against the entrepreneur.
Sometimes the entrepreneurs manage basic annual compliances but fail to follow the internal control norms like maintaining proper records of internal processes, maintaining minutes of meetings and keeping a record of the board resolutions, securing required intellectual property rights, obtaining necessary permits and permissions, ensuring tax-related or ROC-related compliances etc. Any of these factors can make the investors change the terms of the Shareholder Agreement. Insider Tradings
It is important to understand that the investors, particularly the Venture Capitalists, are in the business of striking the most profitable bargain possible, and most often startups fail to exercise any leverage against the seasoned investors primarily because they are in a great hurry to start the venture and do not have the patience to negotiate very hard. However, in certain situations, you might not be in a position to get a better bargain simply because you don’t have many takers anyway, and the investors, after having conducted due diligence, might have got to know that.
Wiser entrepreneurs make sure that they bargain from a position of strength, and sometimes it’s better to stay low and wait for the right time to seek funding than to rush in for it at the earliest. The more you have in addition to the business idea, the better leverage it brings for you because if you already have your business running at a small scale, the investors would naturally have more confidence in your ability to run it at a larger scale compared to someone who just has a great idea but has nothing to show in terms of commitment and practical experience of running a business.
It is also a good idea to do a thorough check on the investors you choose to approach for funding so that you have a fair understanding of the way they operate and the kind of ventures they are comfortable investing in. Furthermore, it goes a long way in enabling one to understand which investor would be more supportive of one’s enterprise and why.
Suffice it to say that if you have done your homework, your Shareholding Agreement is very likely to be identical to the Term Sheet it is founded upon.