Mastering Term Sheets in India

What Is a Term Sheet?

A term sheet is essentially a non-binding agreement that outlines the key terms and conditions of a proposed investment or business deal. It serves as a blueprint for the negotiations between the parties involved, typically covering aspects such as valuation, investment amount, shareholding structure, rights and obligations of the parties, and other significant deal parameters.

The term sheet is instrumental in aligning the expectations of the parties before the drafting of definitive legal agreements, thereby streamlining the negotiation process. Term sheets are widely utilized across various sectors, especially in the startup ecosystem, where they facilitate the early-stage funding by venture capitalists and angel investors.

Despite their non-binding nature, term sheets provide a clear framework for the proposed transaction. This framework enables both investors and companies to understand and agree upon the fundamental aspects of the deal.

Binding vs. Non-Binding Clauses: Legal Implications

Generally, the substantive terms related to the investment, such as valuation, capital contribution, and share distribution, are non-binding. This means they are subject to further negotiation and will only become legally enforceable upon the execution of definitive agreements, such as Share Purchase Agreements (SPA) or Shareholders Agreements (SHA).

However, certain provisions within a term sheet are customarily binding on the parties. These typically include:

• Confidentiality: Clauses that obligate the parties to maintain the confidentiality of the information shared during the negotiations.
• Exclusivity: Provisions that restrict the company from engaging in similar negotiations with other potential investors for a specified period, ensuring that the investor has a unique opportunity to close the deal.
• Governing Law and Jurisdiction: Clauses that determine the applicable law and the jurisdiction for resolving any disputes arising from the term sheet.

The enforceability of these binding clauses is grounded in the Indian Contract Act, 1872, which mandates the presence of essential elements like offer, acceptance, consideration, and the intention to create legal relations for a contract to be valid. Despite the term sheet’s overall non-binding nature, parties must carefully draft and review these clauses to avoid unintended legal obligations.

Key Elements of a Term Sheet

Investment Structure and Valuation: Setting the Stage for Negotiations

The term sheet outlines the proposed transaction’s key financial terms, including the investment amount and the target company’s valuation. These elements are crucial as they determine the equity, preferred stock, or ownership percentage the investor will receive in return for their investment. Valuation negotiations are significant, especially in the context of foreign investments, where the fair market value of the investee company must be ascertained.

The investment structure, often detailed in the term sheet, includes specifics like the rights of the investors and promoters, the manner of transfer or issue of securities, and the payment of consideration thereof. The negotiations typically involve determining the specific investment instrument (equity, convertible debt, preference shares, etc.) and the terms associated with it.

Types of Securities: Equity, Debentures, and Preferences

The type of security offered is a critical component of a term sheet, impacting capitalization, valuation, and the rights associated with the investment. The term sheet usually specifies whether the investment will be made through equity, convertible debentures, preference shares, or other financial instruments. Each type of security comes with its own set of rights and obligations, influencing the overall structure of the transaction.

Governance and Control: Board Composition and Voting Rights

Governance and control are pivotal in term sheets, focusing on the board of directors’ composition and voting rights. Investors often negotiate for the right to appoint a non-executive director or to reconstitute the board to ensure their interests are represented in the company’s management. The constitution of the board and the appointment rights of investors versus promoters are key negotiation points, ensuring that the investor’s voice is heard in significant company decisions.

Protective Provisions: Anti-Dilution, Liquidation Preferences, and Exit Mechanisms

Protective provisions like anti-dilution clauses, liquidation preferences, and exit mechanisms safeguard investor interests. Anti-dilution rights protect investors in the event of a ‘down-round’, ensuring their investment does not diminish in value. Liquidation preferences define the order of payment in a liquidation event, ensuring investors receive a preferential payout.

Exit rights, crucial for investors, outline the mechanisms through which they can divest their stake, including IPOs, strategic sales, and buy-backs. These provisions are often linked to events that allow investors to capitalize on their investment or minimize losses, such as liquidation events where investors receive a multiple of their investment before other shareholders.

Term Sheets Across Different Transactions: PE/VC and M&A Insights

PE/VC Term Sheets: Fueling Startups and Growth-Stage Companies

In Private Equity (PE) and Venture Capital (VC) investments in India, term sheets serve as the blueprint for structuring transactions with startups and growth-stage companies. These documents lay the foundation for subsequent definitive agreements, such as shareholders’ agreements, share purchase agreements, and others, by outlining the principal terms agreed upon by the investors and the investee company.

The nature of the term sheet, whether binding or non-binding, significantly influences the flexibility of the negotiation process and the enforceability of the terms agreed upon.

For PE/VC transactions, a non-binding term sheet is commonly preferred, offering parties the leeway to adjust terms until the execution of definitive documents. However, certain clauses like confidentiality, exclusivity, and dispute resolution are typically made binding.

Key negotiation points in PE/VC term sheets often encompass valuation, investment structure, board rights, and exit mechanisms, with a special focus on pre-emptive rights to maintain ownership percentages post subsequent financing rounds.

M&A Term Sheets: Strategic Alliances and Acquisitions

Mergers and Acquisitions (M&A) transactions utilize term sheets to outline the framework for strategic alliances and acquisitions, detailing the key terms and conditions that will govern the transaction. The term sheet in an M&A context may include information on the offered price, mode of payment, and details regarding the assets and liabilities involved. Like in PE/VC deals, the term sheet in M&A transactions often leads to the drafting of definitive documents, making it a critical step in the negotiation process.

In both PE/VC and M&A transactions, the term sheet plays a pivotal role in setting the stage for successful negotiations by clearly outlining the terms of the deal, thereby reducing potential disputes, and identifying deal-breakers early in the process. It is crucial for parties involved to carefully negotiate and draft term sheets, taking into consideration the unique requirements of each transaction and ensuring that the term sheet serves as a solid foundation for the definitive agreements that follow.

The binding nature of term sheets can vary based on the intent of the parties and the specific terms of the agreement, with courts occasionally ruling on the enforceability of these documents on a case-by-case basis. It is essential for parties to be clear about which aspects of the term sheet are intended to be binding to avoid legal uncertainties and ensure a smooth transition to the final agreements.

Term Sheet: Essential Clauses

When crafting a term sheet several key clauses are crucial to include:

1. Valuation and Capitalization: This involves determining the company’s worth and the equity or ownership percentage the investor will receive. It is particularly important for foreign investments to ascertain the fair market value of the investee company.
2. Board of Directors: The composition of the board and the rights associated with board appointments are significant. Investors often negotiate for the right to appoint a non-executive director or to reconstitute the board.
3. Investment Amount and Structure: Outlines the total investment amount and the structure, including the rights of investors and promoters, and the transfer or issue of securities.
4. Pre-Emptive Rights: These rights allow investors to maintain their ownership percentage in the company after subsequent financing rounds by offering them the first right to purchase additional shares.
5. Lock-in Period: This clause ensures that the founders remain invested in the business by restricting them from transferring their shares for a specified period.
6. Transfer Restrictions: These provisions restrict the transfer of securities and may include rights of first refusal, right of first offer, put and call options, etc.
7. Indemnity: Covers representations and warranties for compliances, regulatory soundness, and business-related matters, with a right to the investor for indemnification in case of breach.
8. Exit Rights: Includes various mechanisms like IPOs, strategic sales, and buy-backs, offering protection and capitalization opportunities for the investor.
9. Liquidation Preference: Determines the order of payment on a liquidation event, ensuring investors receive a preferential payout.
10. Anti–dilution Rights: Protects the investment from being diluted in value, especially in ‘down-round’ scenarios.
11. Initial Public Offer (IPO): Terms regarding providing an exit to the exit right holders and beneficiaries from the investee company by way of an IPO.
12. Non–Competition: Restricts founders from engaging in competing businesses, ensuring focus on the company.

Negotiation Tactics: Balancing Investor and Company Interests

In negotiating term sheets, it is crucial to balance the interests of both investors and the company. Key aspects of negotiation include:

1. Valuation Negotiation: Involves complex considerations and various methodologies to ascertain a fair and beneficial investment amount. 
2. Rights and Obligations: A balance must be struck in terms of rights and obligations, ensuring both parties are protected and have a clear understanding of their roles and expectations. 
3. Risk Mitigation: The negotiation process should also focus on identifying and mitigating potential risks, ensuring that the transaction is secure and beneficial for both parties. 
4. Flexibility and Clarity: While maintaining flexibility, the term sheet should be clear and unambiguous to prevent future disputes and misunderstandings. 
5. Legal Compliance: Ensuring that the term sheet and its clauses are in compliance with the Indian Contract Act, 1872, and other relevant regulations. 

Legal Considerations and Compliance

Regulatory Framework: FEMA and RBI Guidelines for Foreign Investments

The Foreign Exchange Management Act (FEMA), governed by the Reserve Bank of India (RBI), lays down the regulatory framework for foreign investments in India. Key considerations under FEMA for term sheets involving foreign investments include:

• Foreign Direct Investment (FDI): Defined as investment through equity instruments by a person resident outside India in an unlisted Indian company, or in 10% or more of the post-issue paid-up equity capital on a fully diluted basis of a listed Indian company. If an investment falls below 10%, it continues to be treated as FDI provided it was above 10% at the time of investment.
• Foreign Portfolio Investment (FPI): Investment by a person resident outside India in equity instruments where such investment is less than 10% of the post-issue paid-up equity capital on a fully diluted basis of a listed Indian company.
• Sector-specific Conditions: FDI linked performance conditions are stipulated for companies receiving foreign investment, which are critical when drafting term sheets to ensure compliance with sector-specific caps and conditions. 

Dispute Resolution

Choosing an appropriate dispute resolution mechanism in the term sheet is vital for addressing potential disputes efficiently. Options include:

1. Arbitration: Preferred for its confidentiality and the ability to choose arbitrators with specific expertise. The term sheet should specify the arbitration rules, seat of arbitration, and the governing law.
2. Mediation: Can be considered before arbitration or litigation to resolve disputes amicably, which is less adversarial and can preserve business relationships.
3. Litigation: May be chosen for its transparency and the possibility of appeal, but it can be more time-consuming and costly compared to other mechanisms.

The choice of dispute resolution method should consider factors such as the nature of the transaction, the relationship between the parties, and the complexity of potential disputes. It’s crucial to clearly articulate the chosen mechanism in the term sheet to avoid ambiguity and ensure both parties are aware of the process for resolving disputes.

Term Sheet Case Laws

• Comprehensive Reading of Term Sheets: The Supreme Court emphasized reading term sheets read as a whole and not in piecemeal to grasp the parties’ intentions, as illustrated in DDA Vs. Durga Chand Kaushish – 1973 2 SCC 825
• Withdrawal from Non-Fulfilled Term Sheets: In cases where the sell side fails to meet term sheet conditions, the acquirer has the right to withdraw, demonstrated in Rajasthan Cooperative Dairy Federation Ltd. Vs. Maha Laxmi Mingrate Marketing Services Pvt. Ltd. and Others- 1996 10 SCC 405
• Conduct Indicating Binding Agreement: Even without a signed binding agreement, parties’ conduct can signify a consensus ad idem, making a non-binding agreement enforceable, as seen in Rickmers Verwaltung GMBH Vs. Indian Oil Corporation Limited- 1999 1 SCC 1
• Letters of Intent and Binding Intentions: A recent ruling clarified that a Letter of Intent (LoI) typically signifies a future contractual intent without creating a binding relationship, except when explicitly stated, highlighted in South Eastern Coalfields Ltd. Vs. S. Kumar’s Associates AKM (JV),2021 SCC Online SC 486

Key Takeaways

Understanding the complexities of term sheets in India’s vibrant startup and investment sector is a critical skill for both entrepreneurs and investors. A term sheet serves as the foundational document in negotiations, setting the stage for potential business deals by outlining the crucial terms and conditions such as investment amounts, company valuation, and the distribution of shares.

Though primarily non-binding, certain elements within the term sheet—like confidentiality agreements, exclusivity clauses, and jurisdiction specifications—are legally enforceable under the Indian Contract Act, 1872. These documents are pivotal in detailing the financial and governance structures of the deal, including the specifics of the investment, types of securities involved (equity, preference shares, or debentures), and the strategic governance mechanisms like board composition and voting rights.

They also feature protective provisions to safeguard investments, such as anti-dilution rights and exit strategies. Essential in both Private Equity/Venture Capital engagements and Mergers & Acquisitions, term sheets function as the blueprint for more detailed definitive agreements, emphasizing the importance of clear negotiation on valuation, investor rights, and exit mechanisms.

With the Foreign Exchange Management Act (FEMA) and Reserve Bank of India (RBI) guidelines in play, legal compliance becomes paramount, alongside choosing an effective dispute resolution mechanism—be it arbitration, mediation, or litigation. The strategic crafting and negotiation of term sheets are indispensable for securing successful transactions, ensuring all parties’ interests are aligned and potential disputes minimized in India’s dynamic investment ecosystem.