Term Sheets for Startups | Complete Guide (2024)

What is a Term Sheet?

A term sheet is a critical document in the financial and legal frameworks of startup investments. It outlines the preliminary agreement terms between a startup and its potential investors prior to the drafting of detailed legal contracts. In essence, a term sheet serves as the blueprint for the investment, detailing key aspects such as valuation, investment amount, equity stake, governance provisions, and other significant conditions influencing the business relationship.

The Indian regulatory environment, as governed by the Companies Act, 2013, and the Securities and Exchange Board of India (SEBI) regulations, necessitates stipulations to be detailed in term sheets, especially when dealing with securities issuance and investment structuring. For startups looking to raise capital through equity, a term sheet becomes a foundational document that precedes the Share Subscription Agreement (SSA) and Shareholder’s Agreement (SHA), laying down the groundwork for all subsequent legal documents.

Why are Term Sheets important for Startups and Investors

Term sheets are pivotal for both startups and investors for several reasons:

1. Clarifying Investment Terms: Term sheets provide a clear outline of the financial terms including the amount of money being invested and the equity stake being offered.
2. Setting Precedents for Legal Agreements: The terms agreed upon in the term sheet directly influence the drafting of legally binding documents such as the SSA and SHA. These agreements are vital for the enforcement of the terms under Indian law, particularly under the provisions of the Companies Act, 2013 which oversees the issuance and transfer of securities.
3. Governance and Control: Term sheets detail the governance structure that will prevail post-investment, including board composition and voting rights. This is essential as it impacts the degree of control both investors and founders retain in the startup. The Companies Act, 2013, mandates certain governance standards, which must be adhered to and are often first negotiated in the term sheet.
4. Risk Mitigation: For investors, term sheets help in laying down mechanisms such as anti-dilution clauses, liquidation preferences, and exit strategies, which are essential in protecting their investment against market fluctuations and adverse business conditions.
5. Alignment of Expectations: By stipulating the fundamental business and operational expectations, term sheets align the visions of the startup and the investors. This alignment is crucial for the long-term success of the venture, ensuring both parties are committed to a unified business strategy.

Important Elements of a Term Sheet

Equity and Valuation: Determining Your Startup’s Worth

When entering into negotiations with potential investors, understanding the equity and valuation of your startup is pivotal. Equity refers to the percentage of ownership offered to the investor in exchange for their financial investment. The valuation of a startup, conversely, represents the total value of the company before (pre-money) and after (post-money) the investment has been injected.

The legal and financial implications of these terms are governed under the Indian Companies Act, 2013, and the specific clauses of shareholder agreements. Additionally, valuation is influenced by methods recognized under the Income Tax Act, 1961, particularly when considering ‘fair market value’ for investment purposes. Common valuation methods used include the Discounted Cash Flow (DCF) method and Comparable method, which offer a way to project future cash flows or compare with similar businesses within the industry, respectively.

Investment Amount and Funding Structure

The investment amount outlines the total capital that the investor agrees to provide, while the funding structure details how this capital will be delivered—whether as a lump sum or in tranches based on achieved milestones. These details are essential for constructing the financial roadmap of a startup.

Under the Indian regulatory framework, particularly the Securities and Exchange Board of India (SEBI) regulations and the Foreign Exchange Management Act (FEMA), the investment amount and structure must be transparent and meticulously documented. This is particularly relevant if dealing with foreign investments, where remittance and usage of funds are closely monitored by regulatory bodies such as the Reserve Bank of India (RBI).

The term sheet should explicitly state any conditions tied to the funding, such as the achievement of specific development milestones or other performance indicators, which are common in venture capital deals. These conditions help investors ensure that their capital is being used effectively to grow the business.

Furthermore, the funding structure should address any special rights attached to new shares issued, such as preference shares, which often come with rights like liquidation preferences, dividend rights, and anti-dilution protections. These preferences are outlined in the Companies Act, 2013, which provides the legal basis for their enforcement.

Liquidation Preferences: What Founders Need to Know

Liquidation preferences define how the proceeds from a sale of the company are distributed among shareholders and are pivotal in protecting investor interests during a liquidation event. Under Indian corporate law, particularly the Companies Act, 2013, the terms surrounding liquidation preferences must be clearly outlined in the company’s shareholders’ agreement and the articles of association.

In a typical Indian startup scenario, there are primarily two types of liquidation preferences:

1. Non-Participating Preference: This is more founder-friendly and is commonly seen in early-stage investments. If an investor holds a non-participating preference share, they are entitled to receive an amount equal to their initial investment before any distribution to common shareholders. Once this investment is recovered, they do not participate in any further distribution of proceeds.
2. Participating Preference: This type allows investors to receive their initial investment back, as well as participate in the distribution of remaining assets pro-rata to their ownership.

These preferences are critical during negotiations as they directly impact the potential returns for both investors and founders. Founders must negotiate these terms wisely to maintain a balance between attracting investors and not diluting their potential upside in a high-growth scenario.

Understanding Vesting Schedules for Founders

Vesting schedules are an essential mechanism to ensure that founders and key employees are committed to the long-term success of the startup. Under the typical structure observed in India, founder shares are subject to a vesting period spread over a few years with a “cliff” at the beginning.

1. Standard Vesting Schedule: Most Indian startups adopt a four-year vesting schedule with a one-year cliff. This means that if a founder departs the company before the first year, they forfeit all their shares. Post the cliff, shares usually vest monthly or quarterly. This schedule aligns the founders’ incentives with the company’s long-term objectives and provides stability to the startup’s operations.
2. Accelerated Vesting: This clause can be triggered during certain events such as a merger, acquisition, or change in control. If such an event occurs, founders may fully vest their unvested shares. This provision protects founders in the scenario where the company is sold before the end of their vesting schedule.

Term Sheet Negotiation

Strategies to Negotiate Equity and Valuation

Equity and valuation negotiations are central to term sheets and directly impact the ownership distribution between founders and investors. The Companies Act, 2013, does not specify valuation methods for private companies, thus, in practice, startups in India often rely on negotiations based on financial projections and market potential.

Valuation Approaches

• Market Approach: This involves comparing the startup with similar companies that have recently raised capital. Such comparisons can provide a baseline for what investors might be willing to pay.
• Asset-Based Approach: While less common for startups, this could be relevant for those with significant tangible or intangible assets.

Setting the Pre-money and Post-money Valuation

• Pre-money Valuation: The value of the company before the investment. It is crucial to have a robust justification for this figure, supported by realistic financial projections.
• Post-money Valuation: This includes the total value of the company after including the investment amount. It is calculated as Pre-money Valuation plus the amount of new equity invested.

Negotiation Tips

• Use Milestones: If valuation is a sticking point, consider structuring the investment to release funds as certain milestones are reached, which might support higher valuations at each stage.
• Cap Table Analysis: Show how dilution affects all shareholders for different valuation scenarios, helping to align interests and set realistic expectations.

How to Handle Liquidation Preferences in Negotiations

Liquidation preferences determine the payout order to shareholders when a company is liquidated, sold, or undergoes a merger. They are critical because they directly affect the return investors will get on their investment.

Types of Liquidation Preferences

• Non-participating Preferred Stock: Investors get their investment back or convert into common stock, the latter typically only if it yields a higher return.
• Participating Preferred Stock: Investors receive their initial investment plus a share in the remaining proceeds as if they converted to common stock, leading to potential “double-dipping.”

Negotiating Strategies

• Cap the Preferences: Limit the multiple on liquidation preferences (e.g., no more than 1x or 2x the invested amount).
• Conversion Rights: Allow investors to convert preferred shares to common shares at their discretion, which can be an appealing compromise.
• Seniority of Preferences: Order the preferences based on the series of funding. Later investors might have senior rights compared to earlier ones.

Legal Considerations

• Ensure that the liquidation preference terms are clearly outlined in the shareholders’ agreement and comply with the relevant legal standards under the Companies Act, 2013.
• Consider the implications of these preferences on the financial rights of other shareholders, especially non-investing founders and employees with equity.

Founder Vesting in Term Sheets

Founder vesting refers to a legal mechanism where the founders of a company earn their shares over a period, typically four years. This structured approach ensures that founders are committed to the business over a significant period. In India, this is not regulated by specific statutes but is a standard practice defined in the term sheets and shareholder agreements under the broad scope of the Indian Contract Act, 1872.

Standard Vesting Schedule

The standard vesting schedule for founders in India includes:

• Cliff Period: Typically, a one-year cliff period during which no shares vest.
• Monthly or Quarterly Vesting: Post-cliff, shares begin to vest monthly or quarterly.
• Acceleration Clauses: These clauses may be triggered by specific events like a sale of the company (change of control) or an initial public offering (IPO).

Legal Framework and Best Practices

While drafting the vesting terms, it is critical to ensure that they are clear and unambiguous to avoid future disputes. Under the Indian Contract Act, 1872, the terms of the contract must be certain and enforceable. Founders and investors should ensure that:

• Vesting terms are explicitly stated in the shareholders’ agreement.
• Provisions for early departure of founders and the treatment of unvested shares are clearly outlined.
• Mechanisms for acceleration and dilution are agreed upon.

Voting Rights and Board Composition in Term Sheets

Voting rights and board composition are crucial elements of a term sheet as they determine the control dynamics within a startup. In India, these aspects are governed under the Companies Act, 2013, specifically dealing with the appointment and rights of directors and the conduct of board meetings.

Voting rights in a startup are often allocated based on the ownership percentages, and additional rights might be assigned to preferred shares typically held by investors. The Companies Act, 2013 allows companies to issue equity shares with differential rights, including voting rights, under Section 43.

Key Considerations for Voting Rights

• Preferred Shares: Often have enhanced voting rights on specific matters like sale of the company, changes in capital structure, etc.
• Protective Provisions: These might include veto rights for investors on specific issues, which need to be carefully balanced to not overly restrict the founders.

Board Composition Best Practices

• Composition: Ensure a balanced board composition that includes founders, investors, and ideally independent directors.
• Independent Directors: Under Section 149 of the Companies Act, 2013, the inclusion of independent directors is encouraged for unbiased governance.
• Board Policies: Develop clear policies for board meetings, decision-making processes, and director responsibilities to ensure smooth governance.

Advanced Term Sheet Clauses

When crafting a term sheet for your startup, understanding the nuances of advanced clauses is crucial to protecting your interests and ensuring fair investor engagement. These clauses play a significant role in how control and financial outcomes are structured during and beyond the initial investment phase. This section delves into three key advanced clauses: anti-dilution provisions, pay-to-play provisions, and drag-along and tag-along rights, specifically under the Indian corporate laws and venture capital norms.

Anti-Dilution Provisions: Full Ratchet vs. Weighted Average

Anti-dilution provisions are designed to protect investors from the dilution of their equity stake in the event that new shares are issued at a lower price than what the investor originally paid. In Indian startup financing, these provisions are crucial during down rounds where valuation dips lead to potentially severe equity impacts on early investors.

Full Ratchet: This method offers the highest level of protection for investors. Under a full ratchet scenario, if new shares are issued at a price lower than the previous round, the conversion price of the original shares is adjusted downward to match the new lower price.

This means that the investor’s earlier higher-priced shares are now converted into a greater number of shares at the lower price, thereby maintaining their percentage of equity intact. It is particularly investor-favourable but can be punitive for founders because it does not take into consideration the amount of new money coming in.

Weighted Average: More common and founder-friendly, the weighted average method uses a formula to reduce the conversion price but factors in the number of new shares issued and the degree of the price difference. This approach dilutes the investor but not as drastically as the full ratchet method. The formula can be either broad-based, which includes all common stock in the calculation, or narrow-based, which might only include certain types of shares.

The Companies Act, 2013, along with SEBI guidelines if applicable, indirectly influences these provisions by dictating how shares can be issued, although specific anti-dilution rights are typically detailed in shareholder agreements and governed by the contractual freedom of the parties.

Both methods aim to recalibrate the economic arrangement between the investors and the founders, balancing investment risk with founder equity. When negotiating these provisions, it is imperative to consider the long-term implications on founder control and ownership, as well as investor protection.

Pay-to-Play Provisions: What They Mean for Future Funding

Pay-to-Play provisions require existing investors to participate in subsequent funding rounds to maintain their proportionate ownership in the company. These clauses are particularly significant where funding rounds are often critical lifelines for growth and scaling operations.

• Structure and Implications: Under a typical pay-to-play provision, if an investor chooses not to participate in a new funding round, their shares can be converted from preferred to common stock, thus losing certain rights such as anti-dilution protection or liquidation preference. This mechanism ensures that only committed investors retain their favourable terms.
• Legal Context: While not specifically regulated under Indian law, these provisions are enforceable under the Indian Contract Act, 1872, provided they are clearly articulated in the shareholders’ agreements and do not conflict with the Companies Act, 2013 provisions on shareholder rights.

These provisions align investor interests with company growth trajectories, encouraging ongoing financial support and deterring passive investment approaches that might not be conducive to a startup’s aggressive expansion goals.

Drag-Along and Tag-Along Rights

Drag-along and tag-along rights are critical in scenarios involving the sale of a company, protecting both majority and minority shareholders.

1. Drag-Along Rights: These rights allow major shareholders to force minority shareholders to join in the sale of a company. The Companies Act, 2013, does not specifically address drag-along rights, but they are enforceable under private agreements if they do not contravene any statutory provisions or principles of fairness.
2. Tag-Along Rights: Conversely, tag-along rights protect minority shareholders by allowing them to join in a sale and sell their minority stake when a majority shareholder is selling their stake. These rights ensure that minority shareholders receive the same benefits from a sale as the majority shareholders.

Both rights must be carefully structured in shareholder agreements to ensure they reflect the agreed strategic intentions of the shareholders and comply with applicable legal standards, ensuring equitable treatment and alignment of interests across all shareholder levels.

Concluding Remarks

In India, securing a favourable term sheet is crucial not only for immediate funding but also for the long-term viability of a startup. Founders must ensure that the term sheet meticulously outlines and legally binds aspects that are crucial for future governance and control, including liquidation preferences, anti-dilution provisions, and voting rights, in compliance with the Companies Act, 2013, and the Specific Relief Act, 1963.

A 1x non-participating liquidation preference is advisable to protect common shareholders in a liquidation event, while a broad-based weighted average anti-dilution provision can safeguard against equity value dilution in future funding rounds.

Furthermore, a clearly defined vesting schedule aligned with SEBI regulations ensures founder commitment and protects the company’s interest over time. Legal counsel is indispensable in navigating these negotiations, ensuring that all provisions are compliant with Indian laws such as the Indian Contract Act, 1872, and interpreting complex legal terms to safeguard the founders’ interests.

Find out what legal documents you need for startup investors and safeguard your capital. Learn more.