By Anushka Gupta
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Before beginning this piece, it is imperative to qualify the audience it is suited for. This piece tries to understand a Term Sheet – an especially important document for those companies which are just starting out and being funded by Private Investments which are generally made by Private Equity Firms, Venture Capitalists and Angel Investors. These investments (Private Investments) are different from the ones received by companies which have stock that is open to the public (Public Companies) and are instead open only to Private Investors who fund the company directly. These investors also have very different rights from Public Investors as will be seen. It is easy to see why most startups fall under the category of Private Companies with Private Investments until they issue an Initial Public Offering (IPO).
Private Investments are facilitated
by a ‘Term Sheet’. This sheet plays
the role of outlining the terms as per which the investor makes the financial
investment in the company. It highlights the rights, obligations and
responsibilities of the Investors and
the Company following the transaction. These documents are often riddled
with terms and concepts, the meaning of which is often not clear to laypersons.
This article aims to break down these complexities for 3 terms sheets, each of
which deals with a different type of Private Investment that the investor can
opt for. The types which are being considered are as follows:
● Equity refers to the buying of shares (which are not being traded publicly) by the investor and funding the company directly (Click here to view Term Sheet)
● Compulsorily Convertible Preference Shares (CCPS) refers to a fixed-income security option where the investor is not immediately a shareholder but have the option to convert the security into Equity after a predetermined date and (Click here to view Term Sheet)
● Compulsorily
Convertible Debentures (CCD) is a hybrid security type as it is not purely a stock and
functions more like debt. Here too, the stock is converted into Equity after a
predetermined date, however here unlike the case of CCPS, this conversion is not an option (Click here to view Term Sheet)
While these definitions appear
vague, through the term sheets, one will be able to appreciate these
differences between the different equity instruments and the rights of the
investors in each. However, for the most part, all three documents are similar
in nature. Let us take a look at each of the components in the Term Sheet.
1.
TRANSACTION DETAILS
This part of the document lays down
some of the basic details of the transaction such as the business the company is involved in, the proposed transaction, the parties
to the transaction and the current value
of the company (the structure of which can be viewed at the end of the
document). It also mentions the optional clause for Advisory Equity (Clause
1.7) where the Equity is being exchanged for advisory and mentoring services.
All of these elements are common to all three documents.
The differences in the three sheets
in this part lie in Clauses 1.4 and 1.5. Clause 1.4 mentions the instrument that the investor is
considering (Equity, CCPS or CCD). In Clause 1.5, the CCPS Term Sheet mentions
a Dividend Percentage while the CCD
Term Sheet mentions an Interest
Percentage. The Equity term sheet mentions neither.
To understand why this is, let us
review how each of the instruments works in this aspect. There are two paths by
which any firm can gather funding- through
Equity or through Debt. In the
case of Equity, it makes sense for investors to have a consideration regarding
how the company is doing because the financial position of the company directly
affects the value of their own holding. In the case of debt, however, the
company must pay back the investor regardless of their financial position and
the amount remains the same (along with interest). In the instruments being
considered by us, Equity and CCPS are
Equity while CCD falls under the
latter.
Let us now consider the difference
between the two Equity options. In the case of CCPS, the holders do not
actually own a share in the company before the predetermined date. Instead, we
see that this option has a fixed
percentage as Dividend, which is pre-decided because the holder is not an
owner of the share itself, in which case, the amount of profits would be self-determined.
Additionally, since they are holding “preference
shares”, in adverse times, their dividend payment would be given a
priority. However, the CCPS holders still have reason to be invested in the
company affairs because their inflow is dependent on whether or not the company
is earning profits in the first place – unlike interest on debt, their dividends
do not form a charge on the company, and are therefore not paid when the
company suffers a loss. Clause 1.5 seen in the term sheet gives the fixed
Dividend Percentage of the CCPS holder.
On the other hand, Equity is a more “involved” option.
What this means to imply is that an Equity holder is a direct part-owner in the company because they own shares. Thus, the
value of their holding is dependent on the way the company is doing and the
Dividend payout is not a pre-decided one. There would be times where Equity
holders would not be receiving dividends at all because the dividends that the
company can afford to give will be given to preferred shareholders such as
CCPS. This works both ways, while a CCPS holder may be guaranteed dividends
even in bad times, they do not reap the benefits of the company doing very well
as much as an Equity holder and will continue to get a fixed percentage of
dividends. Thus, we see that there is no
fixed amount clause which can be found in its Term Sheet.
The third option, CCD, functions more like Debt meaning that the holder of a CCD
(before the pre-decided date of conversion to Equity) has the liberty of being
comparatively disinterested in company affairs because their holding’s value is
not dependent on how the company is doing. Instead, their returns come from the
interest that is received by them upon the value invested, irrespective of
whether the company makes a profit or a loss, and this interest rate is the one that has been pre-decided by the Interest Clause (1.5) in the CCD Term
Sheet. However, since the Debenture is going to be converted into Shares at
some point, CCD holders are, more often than not, involved Investors as well.
Out of the three, this option is considered the most low-risk-low-returns
followed by CCPS followed by Equity.
2.
KEY CONSIDERATIONS
This part of the document deals
predominantly with the rights of investors and responsibilities of the
investors, promoters and owners in different situations the company might find
itself in, most of which are common to all three equity options. Let us
consider these one by one, starting with the clauses common to all.
- Board Composition Rights (Clause 2.1)
This clause highlights the
composition of company managers who would form the Board of the company and the number of people who would be on this
board. This is where Investors become a part of the proceedings of the company.
We see that regardless of the number of directors inducted into the board, 2
members among the investors find themselves mandatorily involved in company
affairs and management. They are (a) an Investment
Director (b) a Board Observer. The
other members are nominated by the Promoters.
The difference between the two roles
is that the Investment Director is part of the Board itself and has voting rights while the Board Observer
does not have a vote but attends all company meetings. This is an important
right because it makes sure that information is given to investors and that
their interests are protected. In order to avoid the situation that the number
of Directors in the Board is increased by the Promoters causing a dilution of
the Investor’s voice, additional members
may be nominated by the Investors proportional to any increase in the number of
members.
- Anti Dilution Rights (Clause 2.2 in CCD TS and 2.3 in
CCPS & Equity TS)
Dilution refers to the situation where the
value of the shareholding or the percentage of shareholding (or shareholder’s
rights) held by an investor goes down. To protect the percentage of
shareholding held by investors (to the extent that is viable), the Anti Dilution clause applies. This
clause states that if, at any point, the company sells any additional shares
(or instruments convertible to shares), then the Company would be obligated to
take the steps required to issue additional
shares to make the previous Investors’ holdings equivalent to their
previous value or percentage.
- Promoter’s Lock in Period (Clause 2.4 in Equity TS
& 2.5 in CCPS and CCD TS)
As per this right, the Promoters may
not transfer their ownership and responsibility in the company to any other
individual for a period of time (in the Sample Term Sheet, 3 years) and this
period is referred to as the Lock In
Period, This is to avoid the situation where the business is being
controlled by individuals not approved of by the investors. Thus, in the case
that the Promoter needs to Exit, it
is necessary that the person the ownership is being transferred to has gotten
the written approval from the
Investors.
- Right of First Offer, First Refusal and Tag Along
Rights (Clause 2.6 to 2.8 in Equity TS & 2.7 to 2.9 in CCPS TS)
In pursuance to the previous right,
if a Promoter wishes to sell their share in the company, then such shares have to first be offered to the Investors
at the same price as would have been offered to any other buyer. This right
once again gives the existing Investors control over who will hold the shares
in the company by giving them the option to buy the shares themselves before
anyone else, in proportion to their own shareholding.
As a corollary to the same, the
Selling Investors also have a similar obligation when they wish to sell all or
part of their shareholding in the company to a Third Party Buyer. It is stated that in such a situation, they
must first offer the shares to the Promoters
and if they (a) refuse to purchase the shares or (b) if they get an offer
from an existing investor at a price
higher than was being offered by all other offerrees, then the shares will be sold
to that Non-Selling Investor. In the event that neither part agrees to purchase
the shares, then the Selling Investor has the option of selling to the Third
Party Buyer as long as the offer being made is not lower than the price of the shares.
Here, the Investors have either the Right of First Offer (ROFO), which refers to the right to be offered the shares before the Selling Investor makes or
solicits an offer any Third Party Buyer, or the Right of First Refusal (ROFR), which means that, after a Selling
Investor wishing to exit makes an offer to or receives an offer from Third
Party Buyers, the Non-Selling Investors have the right to buy the shares on the same terms before the shares are
transferred to the Third-Party Buyer. An ROFR provision may be advantageous to
the Selling Investor when they have less information about the company and
therefore rely on the market to make a fair assessment of the value of their
shares, whereas an ROFO provision may be more appropriate for a better-informed
Selling Investor who has sufficient knowledge to negotiate the value of their
share.
In pursuance to these above rights,
in the situation that the Promoter has
sold their shares to a Third Party Buyer,
it is upon them to make sure those are purchased on the same terms as other shareholders and that ownership shall be given
only subsequent to purchase. This is called the Tag-Along Right. Purchase by
any existing investor will not be
subjected to this right.
- Affirmative Voting Rights (2.9 in CCD TS, 2.10 in Equity
TS & 2.11 in CCPS TS)
This right plays the role of
magnifying the importance of Investors in company decisions. As will be
apparent from the previous clause on Board Composition, there are fewer Investor Directors than the other
Company appointed Directors. Thus, in order to protect Investor Interests, in
some matters, the Company would not be allowed to proceed without a “yes” vote from the side of the Investor Director.
Other than the Investor Director,
all Investors also have a right to vote in meetings which involve shareholders
with the weightage of their vote being in proportion
to their shareholding. However, they will not have a veto right as is in
the case of Investment Director in the case above.
- Liquidation Preference Rights (2.10 in CCD TS, 2.11 in
Equity TS & 2.12 in CCPS TS)
A
liquidation event
refers to a situation where the ownership of liquid assets is being transferred
or dissolved. This may refer to an acquisition,
a merger or close down of the company. In these situations (especially
considering the cases where the Company is in adverse loss), the company gives preference to certain shareholders
over regular public equity holders.
The same has been identified in this clause. Although the clause has been
worded similarly in each of the three term sheets, as was discussed previously,
among the three the preference order is first towards Debentures, then to CCPS or
Preferred Shares and finally to Equity Holders.
But, all three have greater rights than all other kinds of shareholders because
of this clause.
- Information Rights (2.11 in CCD TS, 2.12 in Equity TS
& 2.13 in CCPS TS)
Another right which gives way to
Investors into company affairs, this right obligates the Company to provide to
the Investors with documents which would inform them about how the company is
doing, allowing them to make subsequent
investing decisions based on the same. The Documents mentioned are (a)
Financial Statements of every quarter (b) Financial Statements of every year
(c) Operating Business Plan every year and (d) any other information that is as
per the requirement of the Investors.
- Transferability Rights (2.14 in Equity and CCD TS &
2.15 in CCPS TS)
Subject to the clauses mentioned
regarding ROFR and ROFO, and some
other clauses which will be discussed ahead, the shares held by the Investors
are freely transferable to any other
individual, meaning that at no point is the Investor bound to hold the shares (at least not explicitly). The only
situation in which the shares are not transferable at all are if the shares are
being sold to a Competitor of the
company.
Other than these various rights
given to the Investors, there are some other important concepts that are
detailed as part of Key Considerations. One of these is the details for Conversion of CCPS and CCD into shares
as can be referred to in Clause 2.3 of CCD and 2.4 of CCPS. This conversion may
take place on the predetermined date
or on the occurrence of a liquidation
event.
Conversion of CCPS
Conversion
of CCD
Note that
there is an extra clause of conversion in the case Company raises Qualified Financing (which refers in
simpler terms to a sufficient threshold amount) and is in a position to repay
the debt
Other than this, the process of Vesting of shares is explained. It is
seen how and when shares could be considered fully in the hands of the
Investors. This process of vesting over a period of time acts as a kind of Investor Lock In for a short amount of
time till all the shares have been properly vested to them.
Process of Vesting of Shares
One good way to term the shares
before and after vesting would be that before vesting, the holder owns the
share but cannot sell it because they are not in possession of it. After
vesting, they are both in ownership
and in possession of the share and
may do what they will with it, subject to the other clauses.
In addition, this part mentions ESOP which is better understood as the Employee Stock Option Plan. This stock
option helps to incentivise employees and is often used as a performance
reward. The percentage of stock reserved to be given to Employees has been
included in the agreement with the added assurance that these ESOP shares will not dilute the shares of the
Investor.
Last but not the least, this part
explains the Exit Mechanism that is
provided to Investors when they wish to sell their shares in the company. The
same is subject to the clauses of ROFR, ROFO and Vesting before a 5 year
period.
● The first exit option which is
common in all three instruments is that of
IPO or Initial Public Offering (available after 5 years and subject to
availability). This refers to the Investor selling their shares at the Market
Price and releasing it into the Publicly traded pool of shares subject to
agreement by all other parties involved.
● The second option provided which is
also common to all three Term Sheets is that of Strategic Selling of the share. This may refer to selling to a
third party investor with the consideration that their offer is higher than
that of other offerrees.
● The third option which is common to
all three Term Sheets is a Drag Along
Option which refers to the second option’s situation except with the
addition of Promoter also selling some part of their share in order to
facilitate the offer being made to the Third
Party buyer.
3.
DOCUMENTATION AND INCIDENTAL MATTERS
This part of the document does not
deal with the financial processes involved and is thus entirely common for all three Term Sheets. It
discusses predominantly the logistical
responsibilities of the Company before and after the closing of the deal
with the Investor.
The very first clause of this part
warrants the issuing of a Definitive
Documentation which when signed, would complete the deal between the
Investor and the Company. This document, also referred to as the Share Subscription and Shareholders
Agreement (SSSHA), is the official offer that when signed, creates a
binding agreement. This document mentions all the terms that have been included
in the Term Sheet which are capable of being made clear. Examples would include
– who is a Competitor to the Company, the Vesting process of the Company,
Detailed provisions for Exit, etc.
Other than the drawing up of the SSSHA, certain conditions need to be
fulfilled before the closing of the deal which would facilitate the Investor’s
understanding of the current standing of the company and make sure logistical
arrangements are made. In addition, it makes sure that the standing of the
company remains the same as the Investor
had agreed to.
Conditions precedent to Closing of the Deal
To further ensure that no major changes take place in the
functioning or in the status of the Company during the period between the
execution of the Term Sheet and the execution of the Definitive Documentation,
the following conditions are laid down which are referred to as the Standstill Conditions. The purpose of
the same is to avoid a situation where an Investor had made the deal on the
previous position of the company and when the deal is executed, is met with
entirely different conditions. However, since such a situation wouldn’t occur
if the Investor had been consulted, the Company may do any of the listed things
with the consent of the Investor.
Standstill Provisions apply in the period
between the Term Sheet has been considered and the Definitive Documentation has
been signed
Finally, this part of the Term Sheet
places the onus upon the Company to make sure that the documentation is in compliance
with the existing law with respect to Companies. In the case of India, this is
the Companies Act of 2013. All other
Statutory Approvals which are
required are also to be obtained by the Company
and not the Investor.
4.
GENERAL
This part talks about general
conditions to be followed regarding the document regardless of whether or not
the Term Sheet finds effect by conversion into an SSSHA. This includes the
Basic Expenses involved with respect to the transaction such as Stamp Duty
charges, charges of any Statutory allowances, etc. These are to be borne by the
Company. Only the charges of the processes initiated by the Investor have to be
borne by the Investor.
It also disbars the parties to the
transaction from discussing the matters under negotiation with any other Third
Party individual (regardless of whether the contract is made). Confidentiality about matters of the
company is required from both parties with exceptions subject to the applicable
law as well as based on consent from
the other party. It is also required that for the 60 days following the execution of the Term Sheet, the Investing
Party shall not discuss, encourage or discourage negotiations with any other
potential investor in the Company and the matters of the deal must be kept exclusive.
Finally, it is clarified that the Term Sheet is not binding upon the parties (except for the fourth part of the
document) and that it may be amended before Termination which would occur automatically following 90 days of its execution and may be
replaced by the Definitive Documentation. It is also clarified that the Term
Sheet would be governed by the laws of India regarding the transaction, here,
the Company Law of India. For the matter of disposal of any disparities that occur
between the parties with respect to a legal aspect, the parties also have the
option of approaching a commonly agreed upon Court which would hold jurisdiction on the matter. As per the
documents referred to, in the case of CCPS, the same may also be done through Arbitration while in the case of CCD
and Equity, the Jurisdiction lies with the Indian Court System.
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Anushka Gupta is a 2nd year law student at National Law University, Delhi. Her interests lie in Psychology, Economics, Philosophy and any other subject that uncovers a hidden side of the world. On most days, you’d find her listening to a podcast or playing the Ukulele. While eager to explore all fields in law, her inclinations are towards Jurisprudence, Corporate Law and Criminal Law at the moment.
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