Start-up Investment: Essentials of a Term Sheet and Methods of Valuation – An Indian Perspective (Part 1)

 

In today’s business environment, several startups are cash strapped and running their business on negative margins, fund raising from investors at an early juncture has become crucial for enabling a start up to achieve its business objectives. Angel investors and early stage venture capital investors invest small amounts ranging from 1 crore to 6 crores in such ventures.

Upon conclusion of the preliminary discussions (and sometimes right at the outset) the start up is offered a term sheet (binding or non-binding) which identifies the most important options, rights and obligations of each of the parties. Upon obtaining all necessary regulatory (if applicable) and corporate approvals the parties crystallize their relationship with the execution of the other definitive agreement. The term sheet is intended to reflect the desires and concerns of the parties in a manner which is mutually agreeable to the participating parties.

One of the heavily negotiated subjects while negotiating a fundraising process involves agreement on an appropriate valuation of the company. Choosing the most suitable method of valuation for a business may hold the key towards receiving the maximum value for the securities of the company. A chartered accountant with valuation experience or a merchant banker would assist with the task of valuation. With the liberalization of the FDI policy which now enables the companies and the investors to adopt any internationally accepted method of valuation, the study of the various methods of valuation has become important.

This post sets out the essential terms which are usually encompassed in a term sheet from an Indian perspective.

WHAT TO EXPECT FROM YOUR TERM SHEET

Information about the company and investors:

The term sheet should capture corporate information of the target company, details of the promoters, their shareholding in the target company, details of any existing investors and the proposed investors.

Conditions for the consummation of the transaction:

Investors would conclude their due diligence of the entity and impose conditions that are required to be fulfilled prior to the infusion of funds. Promoters may be able to negotiate certain conditions being a condition subsequent to the infusion of funds depending upon (A) the relevance of the condition to the core business and (B) the risk appetite of the investor or (C) relation of investor with the promoter(s). If conditions are not fulfilled on a prior to the maximum time provided in the definitive document, the investors will not be required to infuse funds into the company.

Affirmative Rights:

The target company and the promoters agree that any decision pertaining to certain matters that either (a) affect the investors rights as a shareholder (such as amendment to the articles) or (b) the valuation of the shares (settling of high value litigation, related party transactions and borrowings) held by the investor shall require prior written consent of the investors.

Anti-Dilution Protection and Preemptive Rights: An anti- dilution clause is a price protection mechanism which provides that in future, the target company can’t issue securities to any new investors at price which is lower than the price paid by previous set of investors. A preemptive right in case of any further issuance of securities of the target company is a privilege that may be extended to the investors that grants them the right to purchase additional securities in the company proportionate to their existing shareholding at the time of any future issue of securities to new investors at the same price at which they are being issued to the new investors.

Promoters lock in period and restrictions on rights: The term sheet may provide that a pre-determined percentage of the securities of the promoters shall be locked, i.e the promoters may not dispose of such securities during the term of the lock in. Further, should the Promoter seek to offer his shares for sale to a third party an offer to the investors to acquire that share must be made.

Exit Rights:

A financial investor such as a VC or an angel investor, not being strategically invested or interested in the target would primarily rely on the exit provisions to offer them the protection of a downside or capitalisation of the upside of their investment. Some commonly agreed exit rights are

a) IPO by the Target (with an option to the investor to offer its shares with the IPO)

b) Right of strategic sale usually with an attendant right to drag along the Promoters should the incoming investor so require.

c) Buy-back or other such right which is intended to largely cut the losses of the investor or protect any downside of the investment.

Other exit rights are typically linked to an exit or encashment  by the Promoter, like the tag along right. The term sheet would stipulate that the investors would have a right to sell the relevant investor’s securities on the same terms as the Promoter to a third party.

Investors are also vary (particularly in a start up scenario) of any restructuring or failure of the business due to non-receipt of certain statutory approvals etc and would like to protect themselves from such events. A host of such events are described as “liquidation event” on the happening of which the investor would first be entitled to receive X times its investment along with any other amounts such as dividends due / accrued. The investor would get a preference vis-a-vis the other shareholders and would be entitled to exit the Company.

Governing law and Dispute resolution: Important to bear in mind the mechanism of arbitration is fair and reasonable to both parties while the governing law will always be Indian laws.

Validity and Exclusivity clause: The parties usually agree upon the period within which the definitive agreements should be drawn up. However, such a term may be mutually extended by the parties. Further, an exclusivity provision may also incorporated which provides that during the term of the term sheet the target company shall not approach any other investors. This is to ensure that a target company doesn’t take unfair leverage out of an ongoing negotiation.

The Road to Valuation

The pulse of the investor is in his standard term sheet. Of course, deviations and carve outs may be negotiated depending on the experience of the promoters and/or the legal advisor or merchant bankers assisting on the deals. Each term sheet comes with its unique set of promises largely based on the above concepts and forms the foundation of stone of definitive documents that ultimately shape the relations between the investor, the target and the promoters. The term sheet may also contain a price band or base valuation from where the investor and promoter would commence negotiation of the final price and certain antecedent rights.

The next post contains details of the different methods of valuation of a security as commonly accepted in India.  

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