Demystifying A Term Sheet

Term Sheet

Getting a term sheet, or several of them, is a moment of celebration for most startups. Also, due to lack of legal expertise, Founders have to depend on the guidance of lawyers or CAs to understand the term sheet, especially if they are raising external funding for the very first time. Here is a list of 10 clauses that are commonly seen in these documents:

  1. Drag Along Rights – Drag along rights are term sheet provisions which allow investors to drag along all other stockholders, including the founders of a company, to consent to a sale of the company. In simple words, once a majority of investors and shareholders agree to the sale of the business, all other shareholders must also sell their shares on same terms and conditions, regardless of whether they agree to the deal or not. Therefore, minority shareholders may negotiate a minimum price, minimum profit or a preferential price into a shareholders’ agreement.
  2. Liquidation Preference – Investors always insist on investing through a preferred stock as it is better than common stock, because holders of preferred stock be given priority treatment in the event of liquidation. The liquidation preference defines the return that an investor receives during a sale, merger or acquisition of the company, and it can have a significant impact on the founder’s return. It simply specifies which investor gets paid first and how much they get paid in the event of liquidation. There are two types of liquidation preference: a. Non Participating b. Participating.
    1. Participating Liquidation Preference – Under this preference, the preference holder will be entitled to receive his predetermined returns, but shall not be entitled to receive any portion of surplus proceeds to be distributed to equity shareholders.
    2. Non Participating Liquidation Preference: Under Participating Liquidation Preference, the investor after receiving his predetermined returns, shall also be entitled to participate along with equity shareholders in surplus proceeds.
  3. Tag Along Rights – It is also known as co-sale, it protects the minority shareholders. It gives a minority shareholder the right to have his shares bought on the same terms as majority shareholders. If a shareholder wishes to dispose of shares that are the subject of a co-sale or tag along right, the other shareholders who benefit from the right can insist that the potential purchaser agrees to purchase an equivalent percentage of their shares, at the same price and under the same terms and conditions.
  4. Anti Dilution – It protects investors in the event a company issues equity at a lower valuation then in previous rounds. Shares, options and convertible securities are adjusted so that the holder of these securities receives additional securities. It gives the right to the shareholder to receive such additional shares, without any cost at the same price on which the shares were issued to the other person so as to reduce the price per share held by him;
  5. Right of First Refusal/Offer – If the shareholder wants to sell any of the shares to an outsider or to a third party, the right of first refusal requires them to give the investors the first offer to purchase the shares on the terms offered by the third party. In case there is more than one investor, if the investor exercises their right of refusal, each investor may participate in the purchase pro rata based on the number of shares held by each investor. If the investors forego their right of first refusal, then the shareholder may sell his shares to a third party.
  6. Pre Emptive Rights – It requires the company to first offer to any newly issued shares to existing shareholders on pro rata basis. This gives the investor the right to participate in subsequent financing rounds to the extent that is required to protect their percentage equity stake. This ensures that the voting and other rights of existing shareholders exist in proportion prior to the new issue in the future. It simply allows investors to ensure that they have the ability to hold on to their shareholding on a pro rata basis and without being diluted.
  7. Shotgun Clause – It is also known as buy sell agreement. It acts as an escape mechanism for shareholders, if there is an unsettled dispute. It stipulates that the other shareholder may either sell his shares at that price, or buy the shares at that same price from the offering shareholders. It serves as a method for resolving disputes and also ensures that a fair price is being offered.
  8. Put/Call Option – A put option entitles a shareholder to require the other shareholders or just the majority of shareholders to purchase the shares of minority shareholders (holder of the right). The exercise of the put option can be made subject to a particular event or pre specified time period. A shareholder can obligate one or more other shareholders, or the company to purchase the shareholders interest. In Call option the shareholder is obligated to sell his interest to one or more other shareholders or the company. These clauses in most cases specify the conditions under which the right can be triggered like death, insolvency, bankruptcy etc. Usually, the price of share is predetermined.
  9. Veto Rights – It simply means the right to forbid or withhold assent to or reject. The giving of veto powers to shareholders increase the chance of deadlocks and creates a need for speedy means of resolving differences, or for a satisfactory method of dissolving the enterprise when corporate paralysis ensues. Shareholders can be given veto rights in relation to certain matters including, but not limited to, appointment of employees, financial and strategic decisions of the company.
  10. Equity Vesting – In this clause, the shareholder does not obtain the benefit of the shares until certain conditions have been satisfied, such as to remain in the company for a minimum period of time or achieving revenue targets or number of users. The company may have an automatic right to repurchase the unvested shares at the time of the founders involvement with the company ceases. The vesting period is typically between 3-5 years, the purpose is to ensure that the founders have legitimately earned his shares.

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  • John Britto

    Good going Sonam thanks for sharing