How to Draft a Term Sheet for Business and Investment Deals?

Introduction

Business and the investment transactions involve the financial, ownership, intellectual property, and the commercial risks. A Term Sheet records the principal terms proposed before the definitive agreements are executed, including the investment, valuation, ownership, management, exit rights, confidentiality, as well as the conditions. Although generally preliminary, careless drafting may create legal uncertainty. Therefore, binding and non-binding provisions should be clearly distinguished.

Why a term sheet is important?

A Term Sheet provides a common framework for negotiating a complex transaction. It helps the parties by:

• Identifying the principal commercial terms at an early stage;

• Reducing misunderstandings between founders, investors, buyers, or business partners;

• Providing a roadmap for preparing definitive agreements;

• Identifying important issues requiring further negotiation;

• Recording the parties' commercial intentions;

• Reducing unnecessary negotiation of already-agreed principles; and

• Establishing confidentiality or exclusivity obligations where required.

A Term Sheet is an important tool for investors that helps them assess whether the investment proposal is commercially viable. For entrepreneurs and companies, it offers a chance to get an idea of their rights to ownership, dilution, control, and investment obligations before finalizing the contracts.

What is a term sheet?

The Term Sheet is the preliminary document that sets out principal terms and conditions proposed for the business or the investment transaction. It generally contains information regarding:

• Identity of the parties;

• Nature and purpose of transaction;

• Investment amount;

• Proposed valuation;

• Percentage of shares or ownership;

• Investment structure;

• Rights of investors and existing shareholders;

• Conditions precedent;

• Due diligence;

• Confidentiality;

• Exclusivity;

• Exit rights; and

• Timelines for completing the transaction.

A Term Sheet may be relatively short for a straightforward transaction or highly detailed where the transaction involves multiple investors, complex ownership structures, preference shares, convertible instruments, or extensive investor protections.

When is a term sheet used?

Term Sheets are commonly used in several types of business transactions.

1. Startup and Venture Capital Investment Founders and investors may use a Term Sheet before executing definitive investment documents. It can establish the valuation, investment amount, shareholding, liquidation preference, voting rights, as well as any other investor protections.

2. Private Equity Investment The Private equity transactions generally involve more of the detailed negotiations concerning the governance, management rights, exit mechanisms, reserved matters, as well as the transfer restrictions.

3. Joint Ventures The business partners may use Term Sheet to record proposed contribution, ownership, management structure, profit-sharing arrangement, intellectual property rights, as well as the responsibilities of each party.

4. Mergers and Acquisitions The Term Sheet may outline proposed purchase price, transaction structure, due diligence process, conditions, as well as the proposed timeline before parties execute the definitive acquisition documents.

5. Strategic Business Transactions Strategic partnerships, corporate investments, technology collaborations, and other commercial arrangements may also begin with a Term Sheet.

Essential elements of a term sheet

The properly drafted Term Sheet should clearly identify fundamental elements of proposed transaction.

1. Details of the Parties The document should identify all relevant parties, including:

• Company or target business;

• Founders or existing shareholders;

• Proposed investor;

• Acquiring entity; and

• Other strategic or financial participants.

Correct identification prevents uncertainty regarding who is expected to perform the proposed obligations.

2. Purpose of the Transaction The Term Sheet needs to explain as to why the transaction is being proposed. For example, the investment may be intended for business expansion; working capital; technology development; acquisition of assets; market expansion; or repayment of existing liabilities.

3. Investment Amount The proposed investment amount should be clearly stated. The Term Sheet should also specify whether the investment will be made through: equity shares; preference shares; convertible instruments; debt; or another agreed investment structure.

4. Valuation and Ownership Valuation is one of the most important provisions in an investment Term Sheet. The parties should specify whether the valuation is pre-money valuation; or post-money valuation. The proposed percentage of ownership should also be clearly identified to reduce future disputes concerning dilution and shareholding.

Business and investment terms to include

Depending upon the transaction, the following commercial provisions may be incorporated.

The parties should avoid using vague expressions where a commercial term can be stated precisely.

Binding and non-binding provisions

One of the most important aspects of Term Sheet drafting is distinguishing between binding and non-binding provisions. Generally, commercial terms such as valuation, investment amount, ownership, and proposed transaction structure may be stated as subject to execution of definitive agreements.

However, certain provisions may be expressly made legally binding. These may include:

• Confidentiality;

• Exclusivity or no-shop obligations;

• Expenses and transaction costs;

• Access to information;

• Governing law;

• Dispute resolution; and

• Certain procedural obligations.

The Term Sheet needs to expressly state as to which provisions are binding and which are not. The statement that entire Term Sheet is "non-binding" may create the ambiguity if at all the individual clauses are intended to be enforceable. Therefore, the drafting should clearly identify binding provisions.

Due diligence and conditions precedent

In most cases, investors will carry out this due diligence before proceeding with an investment. In addition, the Term Sheet should specify the scope of due diligence, which may include not only corporate documents, financial information, tax documents, contracts, but also patents, labour relations, any lawsuits in progress, compliance with the law, ownership of the property, as well as existing debts or loans.

Investment may be made conditional upon successful completion of due diligence. Other conditions precedent may include:

• Approval of the board or shareholders;

• Regulatory approvals;

• Execution of definitive agreements;

• Completion of corporate filings;

• Receipt of necessary consents; and

• Absence of material adverse changes.

Clearly identifying these conditions helps prevent disputes about whether the transaction is ready for completion.

Investor rights and founder obligations

A Term Sheet should balance investor protection with the founders' ability to continue operating the business.

Investor Rights Depending on the transaction, investors may seek:

• Board representation;

• Information and inspection rights;

• Voting rights;

• Veto rights over reserved matters;

• Pre-emptive rights;

• Anti-dilution protection;

• Liquidation preference;

• Tag-along rights; and

• Defined exit rights.

Founder Obligations

• Founders may be required to agree to:

• Continued involvement in the business;

• Confidentiality obligations;

• Intellectual property assignment;

• Non-solicitation obligations where legally appropriate;

• Restrictions on transfer of shares;

• Vesting or lock-in arrangements; and

• Compliance with applicable company policies.

Common mistakes while drafting a term sheet

Several mistakes can create problems during the later stages of a transaction.

1. Failing to Define Binding Provisions The Term Sheet should clearly distinguish enforceable provisions from commercial proposals.

2. Using Ambiguous Valuation Language Failure to distinguish between pre-money and post-money valuation can significantly affect ownership calculations.

3. Ignoring Dilution Founders should understand how future fundraising rounds may affect their ownership percentage.

4. Overlooking Exit Rights Investors and the founders should consider as to how and when the investor may realise its investment.

5. Not Addressing the Due Diligence A Term Sheet should clarify whether completion depends upon satisfactory due diligence.

6. Relying on Verbal Understandings Important commercial terms should be recorded in writing rather than left to oral discussions.

7. Making the Term Sheet Excessively Detailed A Term Sheet should provide sufficient clarity without unnecessarily attempting to replace the definitive transaction documents.

Legal framework governing term sheets in India

The effects of a Term Sheet in India are determined by many factors including its text, parties’ intentions, the transaction nature, and the provisions that must be followed.

In India, the Indian Contract Act of 1872 is used for determining fundamental contractual principles such as offer, acceptance, consideration, approval, enforceability, and obligations under contracts.

Companies must comply with the Companies Act of 2013 together with the required rules concerning issuance and transfer of securities, corporate approvals, shareholding process, directors and other corporate procedures.

Investment actions require adherence to applicable securities regulations, foreign investment laws, taxation, exchange control regulations, and others depending on the activity sector.

If a foreign investment is involved, it is also required to consider exchange laws and regulations.

Thus, a Term Sheet cannot be considered a separate commercial document without accounting for the final contracts and requirements.

Practical Tips for Drafting a Term Sheet

Before signing the Term Sheet, the parties should carefully consider the following:

• Clearly identify each and every party to the transaction.

• State proposed investment amount and the structure.

• Clearly distinguish the pre-money and the post-money valuation.

• Specify the proposed ownership percentage.

• Identify important investor and founder rights.

• Clearly mark the binding and non-binding provisions.

• Include all the confidentiality obligations wherever it is appropriate.

• Specify duration and scope of the exclusivity, if applicable.

• Identify important conditions precedent.

• Provide a clear due diligence framework.

• Address board and voting rights.

• Consider dilution and future fundraising.

• Address transfer and exit mechanisms.

• Specify the proposed timeline for definitive agreements and closing.

• Ensure that Term Sheet does not conflict with the applicable law.

• Obtain the professional legal advice before signing where transaction is substantial or is complex.

A carefully drafted Term Sheet can mainly save the significant time and expense by identifying all of the potential disagreements before the parties invest the substantial resources in preparing definitive agreements.

Conclusion

A Term Sheet defines the significant commercial and legal terms related to an intended business deal or investment. It describes concepts related to valuation, investment, ownership, rights and obligations, due diligence, confidentiality, exclusivity, and exit provisions precisely. Parties have to make a distinction between binding terms and non-binding clauses and follow legal requirements. Engaging a qualified lawyer can help resolve any issues and protect the interests of both parties.

How Lead India can help you?

1. Provide the legal guidance for the drafting and reviewing the business and investment Term Sheets.

2. Assist the founders and the investors in negotiating the valuation, ownership, governance, and the investment terms.

3. Review the binding and non-binding provisions to reduce the contractual uncertainty.

4. Assist with drafting the confidentiality, exclusivity, exit, as well as the investor-protection provisions.

5. Review the proposed investment structures and the related definitive agreements.

6. Assist in identifying the potential legal and contractual risks before signing Term Sheet.

7. Provide legal support for business negotiations, investment transactions, and related commercial disputes.

One can talk to lawyer from Lead India for any kind of legal support. In India, free legal advice online can be obtained at Lead India. Along with receiving free legal advice online, one can also ask questions to the experts online free through Lead India.