Term Sheets in M&A Transactions and PE/VC Investments in India

A term sheet is a legal document that outlines the terms of an investment between investor(s) and the investee company and acts as a guideline for the parties to understand the structure of a transaction and the terms and conditions encompassing the same. In a private equity/venture capital investment or a merger and acquisition transaction, a term sheet is usually signed between the investor(s), the promoter(s) and the investee company.

An important aspect of a term sheet is that it lays down the foundation for the preparation of definitive agreements such as shareholders’ agreement, share purchase agreement, share subscription agreement, business transfer agreement or an asset purchase agreement, as the case may be (referred to as “Definitive Documents”). A term sheet is signed once the parties agree to the terms of an investment, before the execution of the Definitive Documents.

Nature of Term Sheet:

One of the fundamental aspects in an investment transaction is to ascertain whether a term sheet is intended to be binding or non-binding on the parties.

Non-binding Term Sheet: 

The most common practice while carrying out investments is executing non-binding term sheets. Parties incorporate express language to indicate that a term sheet would not be binding between them, as it provides the parties with the flexibility to modify the terms captured under the term sheet until the execution of Definitive Documents. At the same time, an exception may be created, for clauses like confidentiality, exclusivity, term and termination, governing law and dispute resolution, which can be binding on the parties.

In the case of Gas Authority of India Limited vs. Sravanthi^[1], the parties concerned signed a term sheet for supply of natural gas but failed to later convert the term sheet into a more detailed gas sale agreement. The Electricity Appellate Tribunal had to determine whether the term sheet was binding and could form the basis of restrictive trade practices on part of Gas Authority of India Limited (GAIL). While the court of first instance found that the term sheet was binding, the Appellate Tribunal disagreed with this finding, because the term sheet provided that none of the rights or obligations set out therein shall become effective until the date known as conditions precedent ‘Satisfaction Date’. In the Tribunal’s understanding, since the obligations stemming from the term sheet were subject to the performance of the conditions precedent, and those conditions precedent were not performed, the term sheet was not binding. This was held despite the term sheet explicitly providing that it was binding.

Binding Term Sheet:

A binding term sheet implies that all the clauses and provisions therein would be binding between the parties. From an enforceability perspective, it has more teeth. Therefore, any Definitive Documents in the future should have provisions that clearly and explicitly override this document.

In M/s. Best on Health Limited and others v. M/s. Bestech India Private Limited[2], it was held that the contention of the respondents that the term sheet is not a binding contract is incorrect. Various courts including the Supreme Court have observed in a catena of judgments that a term sheet is a binding contract.

In Trimex International FZE Ltd. vs Vedanta Aluminium[3], the Supreme Court has held that mere fact that a formal contract is yet to be prepared and initiated by parties, would not affect their acceptance of contract or its implementation, even if formal contract has never been initiated.

So, it can be concluded that the binding nature of a term sheet depends on a case-to-case basis whether the intent of the parties is to construe the term sheet to be binding or non-binding. In practice however, entering into a non-binding term sheet provides the parties with the flexibility to amend, revise and revisit the provisions at the time of formulating the Definitive Documents.

Key Clauses in a Term Sheet and their Negotiations

Following are some material and key clauses generally agreed to between the investor(s), promoters and the investee company regarding the terms and conditions of a transaction:

• Valuation: The valuation of a company is a crucial point of negotiation to negotiate the company's worth and determine the percentage of equity or ownership that the investor will receive in exchange for their investment. Furthermore, it also plays a crucial role from the legal standpoint in the case of investment by way of issuance or in case of foreign investments where it becomes imperative to ascertain the fair market value of the investee company.
• Investment Amount and Structure: The term sheet generally outlines the total investment amount and the investment structure which includes but is not limited to specific rights of the investors and promoters, manner of transfer or issue of securities and payment of consideration thereof. The negotiations involve determining the specific investment instrument (for example equity, convertible debt, preference shares, etc.) and the terms associated with it.
• Pre-Emptive Rights: Pre-emptive rights are also known as pro-rata rights. This right is generally sought by the investors to enable them to maintain their ownership percentage in the company after the subsequent financing rounds. When the company proposes to issue additional shares, the company becomes obligated to offer the shares to the investors or shareholders who have the pre-emptive right.
• Rights of Board of Directors: The board of directors oversee the operation and management of a company; hence, constitution of the board of directors becomes an important point of negotiation between the parties to a transaction. The investors can also seek a right to appoint a non-executive director and to reconstitute the board of the investee company. The director appointed from the investor's side does not usually get involved in the day-to-day activities of the company. Sometimes, the board can also have an observer, who doesn't have any voting rights.
• Lock-in period: The lock-in period generally assures the investors that the founders are interested in the business of the company. The lock-in period clause restricts the founders of the company from transferring, selling, assigning, or pledging their shares for a specified period of time. The duration of the lock-in period is a matter of negotiation between the parties to the Definitive Documents. Investors usually restrict founders from selling their shares till the time the investors exit from the company.
• Transfer Restrictions: Transfer restrictions are provisions that are agreed between the parties to a transaction to restrict the transfer of securities of a company. This may include restriction on the transfer of securities of the investors, promoters as well as other shareholders. Gauging the requirements of a transaction and understanding amongst the parties thereto, restrictions including but not limited to right of first refusal, right of first offer, put option, call option and right of preemption may be implemented. 
  As a good practice, transfer restrictions are also incorporated in the articles of association of the company to enable the enforceability of such restrictions on transfer of securities. 
  In the case of B. Rangaraj vs. V.B. Gopalkrishnan and Ors.[4], the Hon’ble Supreme Court pronounced that the enforceability of clauses including the transfer restrictions in the shareholder’s agreement that are not referenced or mirrored in the articles of association of the company is unenforceable and that such a condition is only enforceable when it has been incorporated in the company’s articles.
  A similar judgement was passed by the Hon’ble Delhi High Court in HTA Employees Union vs. Hindustan Thompson Associates Ltd. And Ors.[5], where it was held that, once the modified articles of association of the company takes effect, no rights or claims that violate it can be enforced or considered genuine.
• Indemnity: While entering into a transaction, the company and the promoters provide representations and warranties for compliances, regulatory soundness and certain business-related matters. The breach of one or more of the representations and warranties gives rise to indemnity and thereby a right to the investor to seek indemnification from the indemnifying parties. Certain specific indemnity items may also be incorporated in the Definitive Documents at a later stage on the basis of the findings upon completion of the due diligence. The cap or threshold with respect to an indemnity claim and time limitations can be negotiated between the parties to the Definitive Documents.
• Exit Rights: Exit may be provided to the investors on the occurrence of any trigger event including cause or default, or at the end of the time period as may be agreed between the parties. Investors mostly try to secure a drag along right with them which allows the majority shareholders to drag the minority shareholders to sell their shares in the event of any breach or in an event as may be agreed between the parties or a tag along right which enables an investor to tag along with the promoters or the majority shareholders of the company in the event of sale of majority shareholding.
• Liquidation Preference: Liquidation preference determines the order of payment on occurrence of a liquidation event, in respect of the total proceeds from the liquidation event (less any amounts required by applicable law to be paid or set aside for the payment of creditors of the company) that the shareholders including the investors shall receive in a certain manner for an exit. A liquidation preference is a negotiated provision that gives an investor a preferential payout.
• Anti–dilution rights: Anti-dilution rights give protection to an investment from being diluted or getting less valuable. This clause protects the interest of investors as well as the existing shareholders of a company if the valuation of the investee company decreases in the subsequent funding rounds, generally known as the ‘down-round’.
• Initial Public Offer (“IPO”): Understanding with respect to initial public offering of the equity shares of the company and consequent listing of the shares on recognized stock exchanges may be captured in certain term sheets detailing the terms regarding providing an exit to the exit right holders and the exit beneficiaries from the investee company by way of completing an IPO on or prior to the exit date. The IPO may be undertaken by the investee company on a best-efforts basis or upon expiry of a certain period of time, as the case may be and as per the agreed understanding between the parties.
• Non–Competition: Founders are usually restricted from engaging themselves in other businesses of any kind so that they can concentrate on the company to their full potential. A non-compete clause restricts the founders from doing any business that competes with the business of the investee company and prohibits them from pursuing the same during the term of the agreement and for the particular period of time as specified in the Definitive Documents after the exit of the founders from the company or after the termination of their employment.
• Miscellaneous provisions: Certain other provisions may form a part of the term sheet of a transaction which may be more detailed in the Definitive Documents. These include but are not limited to milestones, dispute resolution mechanism and the process thereto, governing law, exclusivity, expenses, confidentiality, representation and warranties, obligations and other covenants.

Conclusion:

A term sheet therefore is a legal document that outlines the nature and structure of an investment or an acquisition transaction upon negotiations amongst the parties and their respective counsels. It forms an agreed premise and stipulates guidelines to prepare the Definitive Documents.

[1] (27.10.2021 - APTEL): MANU/ET/0060/2021

[2] 2014 SCC OnLine P&H 11490

[3] (2010) 3 SCC 1

[4] AIR 1992 SC 453

[5] RFA 247/2004