DECODING AN INVESTMENT TERM SHEET….
(Originally published on August 21, 2017 on LinkedIn)
The idea behind this post is provide basic knowledge about investment term-sheets without getting into associated legalese.
The first investment term sheet is nothing short of an achievement for a business venture and being so, it assumes great significance for a promoter and the investee company. An investment term sheet, which may be binding or non-binding, contains a summary of key terms proposed by an investor in relation to the proposed investment in the venture. Based upon the term sheet, the parties proceed with negotiating the investment transactions documents and finally with actual investment in the venture. Since, term sheet is first stage of formalization of association between an investor, the promoter(s) and the investee company, it is imperative that the term sheet is carefully understood and agreed upon by all the parties. Since, every venture has its own nuances and certain unique conditions, reliance on standard and generalized templates should be avoided and the parties concerned should always strive to settle for a tailor-made and customized documentation which address the specific needs of the parties.
Here I will attempt to decode and understand certain basic elements of a term sheet.
Instrument / Security – since the investor would be investing money into the investee company, the instrument or security to be issued against such investment should be identified and agreed upon. Depending upon the nature of investor, timing of the investment, amount of investment, source of investment (onshore / offshore), risk appetite, and business of the entity, there are variety of instruments available viz., equity shares, convertible (mandatorily / optionally) preference shares, convertible (mandatorily / optionally) debentures, convertible notes, redeemable preference shares etc.
Valuation / Issue Price – the valuation of the investee company should be carefully negotiated. The higher the valuation, lower the dilution and vice versa. The valuation of the investee company and issue price should also be considered from tax perspective so that there are no adverse tax implications on the investors and the investee company.
Liquidation Preference – this is a right which the investors normally seek to protect themselves from distress events like winding up or liquidation of the investee company. Normally investors prefer to have a liquidation preference of 1X of the investment amount. In a few cases, the event for trigger of liquidation preference rights are elaborately defined to include certain other events like mergers, takeovers etc.
Preemptive Rights & Anti-dilution Protection – Pre-emptive rights entitle the investors to maintain their stake in the investee company in case of any further issuance of securities. In such a case, the investors have a right to subscribe to additional securities in case of any new issuance on the same terms and at the same price at which the new investors may subscribe to securities to be issued by the investee company. Anti-dilution protection entitles an investor to an adjustment in its stake in case a company issues securities to any person at the price lower than the price paid by the investor. The investors normally like to see anti-dilution protection on a broad based weighted average basis. However, sometimes the investors may also seek a full ratchet protection.
Governance & Management – Depending upon the nature of the investor (friends & family, angel investor, venture capitalist etc.), the aspects of management and control of the investee company come into picture. The investor may ask for right to nominate a director on the board. In certain cases, the investor may not insist on a board seat but may be fine with having the right to nominate an observer (without any voting rights) on the board of the investee company. In addition to this, the investor may also like to have a list of matters (affirmative vote matters or veto matters) on which the investor’s consent would be mandatory before the investee company can act upon any of such matters. The investors may also seek right to certain periodical business and financial information from the investee company.
Transfer Restrictions – This is one of most debated aspect of term sheets. The investors may impose certain blanket or partial restrictions on the promoters from transferring the securities held by them in the investee company. The transfer restrictions may be in the form of lock-in, right of first refusal (ROFR), right of first offer (ROFO), tag-along rights etc.
Exit Options – This aspect is also very important from an investor’s perspective. An investor would like to see as to when and how the amount invested by the investor in the company would liquidate. Depending upon various factors like risk appetite of the investor, investment amount etc., the investor may include provisions like exit by way of an initial public offering (IPO), strategic sale, put option on promoters and the company, and drag-along right etc.
Since, the term sheet forms the foundation of an investment transaction, the provisions of a term-sheet should be carefully evaluated not only from a legal perspective but also from a business perspective. Once the provisions of the term sheet meet the business objectives and commercial rationale of the parties involved, one can expect a smooth investor-investee relationship going forward.
