Investment Term Sheet: Nature and Standard Concepts Part I

In this newsletter we examine the nature of investment term sheet and the standard concepts in an investment term sheet.

I. Nature of the Investment Term Sheet

The investment term sheet is a non-binding document that contains the essential terms and conditions under which the investment will be made by a VC/PE investor into a target company. Neither the investor nor the investee company is bound by what is outlined in the term sheet barring certain provisions such as confidentiality, exclusivity clause, governing law, dispute resolution and jurisdiction.

The investment terms are subject to the fulfilment of certain condition precedents such as completion of legal, tax, financial and business due diligence, creation of an Employee Stock Options (“ESOPs”) pool, there being no material adverse change in the business of the target company etc.

Once the condition precedents are fulfilled, the definitive documents i.e., the Share Subscription and Shareholders Agreement are executed. The definitive documents are subject to the approval by the Board of the company.

The exclusivity clause of the investment term sheet prevents the company from seeking investment proposals from other investors. This gives the investor leverage, as it prevents the company from shopping around for better terms. From the company’s perspective, it is advisable to have the time period for the exclusivity limited to a period of 2 or 3 months.

II. Investment Term Sheet -Standard Concepts

One of the standard concepts indicated in the term sheet is the type of shares offered to the investors.

Types of shares

In India investors normally subscribe to the following types of:

  • Compulsorily convertible preference shares: The Compulsorily Convertible Preference Shares (“CCPS”) provide its holders with a preferential right to payment of dividend and a preferential right to re-payment of capital in the event of a liquidation event with limited voting rights to that which affects the rights attached to its preference share. Section 47 of the Companies Act, 2013 provides an exception that that if a dividend is not paid to the preference shareholder for a period of 2 years or more the preference shareholder would be entitled to vote on every resolution placed before the company in general meeting.The term sheet provides for the terms of the conversion of CCPS. Conversion is an investor protection mechanism which allows the preference share to be converted into equity shares.  when the milestones are not met the conversion ratio will be higher i.e., the CCPS will convert into a higher number of equity shares. When the milestones are met the CCPS will convert into a lower number of equity shares.
  • Equity shares: This class of shares carries with it a voting right on every resolution placed before the company.
  • Combination of Equity shares and CCPS: Investment terms may also include a combination of equity shares and CCPS, which is the preferred mode of investment in India. Consequently, the equity shares will give the investor voting rights while the CCPS will give the investor a preferential right to payment on the occurrence of a liquidation event,

Conclusion: The term sheet is the first step to negotiating the final investment and preparing the definitive documents.  The company needs to make sure to understand the essential terms and conditions in a term sheet and the standard concepts which are acceptable and non-negotiable. It is important to keep in mind that while it is common for investors to request for the ESOPs pool to be created prior to the investment, it is advisable, from the company’s perspective, that the ESOPs pool is created after the investment, so that the shares of the investors are diluted as well in such creation.

The author is Mini Raman