India is said to be the third largest ecosystem of the world, and no wonder, it is home to more than 39,000 active startups. According to a 2018 report, startups in India have raised billions of dollars in funding and have been performing exceptionally well, bringing a lot of foreign as well as domestic investor interest. However, from an entrepreneur’s point of view, there’s a lot of risk in opening its startup and its uniqueness to an unknown investor while they seek funding support. In such a situation, an entrepreneur’s survival kit is the Term Sheet.
What is a Term Sheet?
A term sheet is a legal document that contains terms and conditions for potential investment and presented to entrepreneurs after they have made a successful pitch to an investor. It broadly covers 3 areas: Funding, Corporate Governance, and Liquidation, all of which are equally important.
It forms the basis for negotiations between the parties on final terms and conditions, after which the final contract is made up and signed. Term sheets are so important that they are often equated to be a prenuptial agreement. Thus, start-ups must be able to decode a term sheet thoroughly to be able to negotiate effectively and get a good deal.
What does a Term Sheet contain?
Term Sheet generally contains the details of who the investor is; name and identities of the investors and founders; the pre-money valuation of the company; investment amount; whether the investors are going to get a board seat, and then a whole lot of special rights such as veto rights and affirmative rights.
Key Terms of a Term Sheet
There are certain key contents of a term sheet that must be present in the document. However, these terms are general and it is still advised to consult a good startup lawyer to get the term sheet drafted or decoded in India.
- The minute details of the company, current directors as well as shareholders
- Any rights concerning the investors or for particular founders
- Details regarding the invested funds
- If any investor has certain rights or rights reserved to take a major decision in the company
- If any restrictions are on the activities of the founders
- Summary of all rights related to the transfer of a share, or issues, or in case the company is sold must be included.
Important Clauses of a Term Sheet in India
- Closing date: The term sheet must have no ambiguity regarding what the next step would be after the negotiations have been agreed amicably by both parties.
- Investment amount and equity: In very clear terms, preferably, the term sheet should emphasize the final negotiated amount offered by the investor to the founders and for how much equity.
- Price per new share: What price is being paid by the investor on per share of equity being bought? This is usually derived from the capitalization of the company, which is attached to a term sheet. “Capitalization” is commonly referred to as market cap and is computed by multiplying the number of shares with the price per share.
- Pre-investment valuation compared to post-investment valuation: This is done particularly to provide a comparison between the valuations, given the size of the equity reserve, and the expected multiplier impact of the capital raise.
- Founder(s): For all future legal and business purposes no matter how many co-founders exist it is to be made clear as to who is in charge or if, multiple, are together in-charge. The investors usually add such a clause that bars the exit of the founder(s) soon after receiving the investment.
- Involvement of the Board of Directors: Entrepreneurs generally limit the seats for investors in the Board of Directors. It becomes very necessary to include the details of the involvement of investors on the board of directors of the company.
- Class of shares: Main investors would always demand preference shares, which entitles them to a minimum return generally as these shares are given priority over other equity shares in case the venture needs to be shut down and liquidated.
- Tranches: It means the different stages in which the investor wants to deliver the cash to the start-up. The period of the same must be pre-specified in the term sheet as it reduces both the founders and investor’s risk.
- Validity clause: This is most important for the investors so that it gives a reasonable yet limited time to the founders to pursue the term sheet without wasting time or the term sheet validity would lapse.
It is complicated for an entrepreneur to file a term sheet because the founders are habitual in dealing with sophisticated investors. While entrepreneurs can find all this daunting, at the end of the day they will find the term sheet not just protects the rights of the investors but equally protects their own rights as well.
Entrepreneurs generally deal with investors who invest based on clear mandates and principles. Most importantly, the investor has a duty to manage other people’s money– which is why they have to be more careful about how they deploy their money. So, investors come up with certain safeguards to protect themselves, and those principles get summed up in a term sheet and eventually in the rest of the documents.
However, entrepreneurs must appreciate that high-quality legal documentation is an absolute necessity to ensure that they protect their rights and control over the business that they are working so passionately to grow. One-sided financing documents can cause operational hardship and even financial leakages to founders even where they have built successful companies.
Why a Lawyer is Required to Decode a Term Sheet
One’s approach when it comes to picking a legal advisor for something that is as important as a start-up must be clear and straight forward. Most times, founders feel they can draft their own term sheet as there are open source templates available online. However, it’s not about the template but about getting the expertise of a lawyer who has dealt with the matters between investors and entrepreneurs for a long time. Simply said, founders need somebody on the legal side advising and mentoring them.
Every business has different requirements and needs customized term sheet suitable to its investment model. LetsComply’s legal experts can help you in drafting your own customized term sheet. To know more, call us at +91-9717070500 or send an email at email@example.com.