term sheets – legal issues by ms. neela badami of samvaad ventures

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Term Sheets – Legal Issues Indian Institute of Management - Bangalore, March 7, 2015 NEELA BADAMI

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Term Sheets – Legal Issues

Indian Institute of Management - Bangalore, March 7, 2015

NEELA BADAMI

‘What’s in a name? That which we call a rose…

– Term sheet,’

– ‘non-binding term sheet,’

– ‘indicative term sheet,’

– ‘Letter of Intent,’

– ‘Head of Terms,’

– ‘Memorandum of Understanding,’

– ‘Non-binding MOU’

Commonly heard terms in the private equity / venture capitalworld!

…by any other name would smell as sweet.’

• Simply put, a “Term Sheet”, by whatever name called, and whethera simple 2-pager, or a detailed tome, is a document that sets out keyfinancial, protective and governance terms of a proposedtransaction.

• We will examine the case of an investment by a venture capital or aprivate equity fund in a company looking to raise capital.

• What they all usually have in common is the understanding thatthey are not binding until the execution of ‘definitivedocumentation’ (typically a share subscription agreement and ashareholders agreement)

What is in it?• Typically, the financial provisions covered in a Term Sheet are:

– the proposed investment amount,

– valuation of the company,

– type of investment instrument,

– a timeline for the investor's exit, together with indicative exit mechanisms,

– Governance terms and protective provisions include the composition of the board ofdirectors, a lock-in over the founders’ shares, and sometimes, detailed provisionsgoverning share transfers,

– Protective provisions will seek to safeguard the fund’s investment in several ways, forexample, the right to receive detailed information about the company’s financialhealth (including management information system reports and unaudited monthlyfinancial statements),

– The right to veto certain actions, and anti-dilution rights in future financing rounds,are also commonly seen.

(For a detailed analysis of private equity fund formation and transactions in India, pleasesee http://www.samvadpartners.com/wp-content/uploads/2013/06/Getting-The-Deal-Through-India-Private-Equity-2012-Transactions-Chapter.pdf)

What ‘Instrument’?• Once the parties have agreed on the valuation of the company, the next question

is as to what kind of investment instrument is desired.

• Available options are:

– EQUITY SHARES,

– PREFERENCE SHARES,

– CONVERTIBLE INSTRUMENTS,

– PARTLY PAID SHARES,

– WARRANTS

• Note that in case of investments by non-resident funds, the price per share mustbe above the ‘fair value.’

• Also, convertible instruments must be fully and mandatorily convertible in orderto be reckoned as equity. Partly convertible or non-convertible instruments wouldbe reckoned as debt and subject to the more onerous rules applicable to externalcommercial borrowings.

• Partly paid instruments and warrants are subject to a specific set of rules as well.

Why choose one over the other?

• Several factors influence the fund’s choice of instrument. Theprincipal one is how the fund envisions its role in the company.

• Funds which want to have a hands-on, operational role in the day-to-day affairs of the company may choose large or controlling stakesof above 50% of the equity shareholding.

• Funds for which the investment is a purely financial one may chooseconvertible instruments.

• The fact that convertible debentures, while in the unconvertedstate, rank as debt; and in that form, rank higher than the holders ofequity shares in the queue of persons eligible to receivedistributions (in the event of the company being wound up), arefactors that funds take into account Such as convertible debenturesor preference shares.

What rights can the instrument have?

• Note that shares with differential voting rights (“DVR Shares”) cannot be freely issued bycompanies, without complying with certain conditions.

• In this context, the ‘Liquidation Preference’ clause assumes significance. In jurisdictionslike the United States, where (comparative to India) companies can be wound up orliquidated relatively quickly, the term ‘liquidation preference’ is used to imply that in theevent the company is liquidated or sold, i.e., an exit event is created, the fund would firstget its returns (1x, 2x, etc.) before the founders get their share.

• However, the use of this term in the Indian context gives rise to some confusion (since theword ‘liquidation’ suggests dissolution of the company, the process for which is prescribedunder the Indian company law).

• The Indian company law also prescribes the manner in which available moneys must bepaid out, and hence, any contractually agreed clauses on the manner in which moneysmust be distributed upon winding-up may not be given effect to by courts.

• The better expression is, therefore, a 'distribution preference' arising upon the occurrenceof a 'liquidity' event, namely, a transaction that realizes the 'value' of the company,typically, in cash (although a share or stock deal is not ruled out, except that achieving it isa regulatory challenge). Note however that there is no contractual restriction on agreeingas to how moneys must be distributed in case of other exit events such as sale to a thirdparty (who may be a strategic or financial investor), as long as applicable exchange controland taxation laws are complied with.

Exit provisions• Commonly used exit provisions include:

– INITIAL PUBLIC OFFERING,

– STRATEGIC SALE, TRADE SALE

– BUY-BACK,

– MERGERS / ACQUISITIONS

– PUT / CALL OPTIONS.

– Put / call options have received some welcome regulatory sanction recently. Over thelast few years, the ‘put option’ and ‘call option’ have been in the eye of a regulatorystorm in India. This is because the Reserve Bank of India (“RBI”) considered theseoptions as granting foreign investors guaranteed returns, giving the investmentinstrument debt-like features, as opposed to equity. The Securities Exchange Board ofIndia (“SEBI”) considered that all options must only be exchange-traded and cannot beoff-exchange, contractually agreed between parties. The RBI, has in January 2014,allowed issuance of equity shares and compulsorily and mandatorily convertiblepreference shares and debentures containing an optionality clause, but without anyoption / right to exit at an assured price, to a person resident outside India.These instruments are viewed as eligible instruments to be issued to a person residentoutside India by an Indian company, subject to certain terms and conditions.

Governance Terms: Board and Shareholder meetings.

• Funds would want a say in the way the company is run, on certain important items, atleast, and will typically nominate at least 1 director to the company’s board, coupled witha list of items on which the board cannot proceed unless such nominee director hasconsented.

• This list is typically replicated at the shareholder level as well, such that no resolution canbe passed by the shareholders in general meeting on the specified list of matters, unlessthe fund, as a shareholder has consented (whether at the shareholders’ meeting, throughits authorized representative, or through a separate written consent).

• While most funds seek to nominate a director(s) on the company’s board, there has beena rise in the trend where certain funds prefer to appoint an “observer” on the company’sboard instead of a director.

• These rights carry greater weight in private companies, while in public and public listedcompanies, the legal implications of these kinds of rights is very much a grey area.

‘Control’• When the question of whether these ‘affirmative rights’ or ‘veto

rights’ amount to the fund acquiring ‘control’ over the investeecompany for the purpose of the takeover regulations came upbefore the SEBI, SEBI ruled in the affirmative.

• The Securities Appellate Tribunal (“SAT”) reversed SEBI’s order. Thematter went up before the Supreme Court, but was unfortunatelysettled before the Supreme Court could pass an order on themerits. The Supreme Court did however expressly state that theSAT’s ruling was not to be treated as precedent. There is a likelihoodthat in the future a regulator or court could take the view that fundsenjoy ‘control’ over their investee companies, with attendant legalimplications.

Restrictions on Share Transfers.

• The ability to restrict the transfer of shares in private companiesis important from the investors’ point of view.

• Typically, such investors would want to ensure that the founders/ promoters of their investee company cannot unilaterally decideto jump ship in the event the company’s business is floundering –therefore, elaborate provisions governing the transfer of shares istypically included in transaction documents and replicated in thearticles of association of the company, most common beingfounders’ lock-in.

• Exceptions?• Other commonly heard terms include rights of “tag-along,”

“drag-along,” “come along”, ‘right of first offer’ and ‘right offirst refusal.’ While these rights are now fairly common in theindustry, their enforceability in court is yet to be tested.

De-jargoned!

• Tag- Along. If A decides to sell his shares to X, then B can tag-along with A and X isobligated to purchase not just A’s shares but also B’s. Needless to say when A is adeparting promoter shareholder / investor, A will need to find a buyer X who will buy notjust A’s but also B’s shares.

• Drag-Along. If A (usually the investor) decides to exit the firm and sell his shares to a buyerX, he can compel the founder / promoter shareholder B to sell his shareholding also, suchthat the sale is a more attractive proposition for X, who receives total control of theinvestee company.

• ROFO: If A decides to sell his shares, he must first offer them to B (who enjoys the ROFO),who in turn may offer a price for the shares to A. If satisfied by the price offered by B, or ifA is unable to obtain a higher price from a third party, then A only has the option to sell itsshares to B. However, if A receives a price higher than that offered by B from a third party,A is free to sell shares to the third party at the higher price.

• ROFR: On the other hand, if B enjoys the ROFR, then A is first required to offer his sharesto third parties and obtain a price from them. A is then required to approach B with suchprice offered by third parties. If B can match or better the price offered by third parties, Amust sell his shares to B.

Enforceability of Term Sheets in India

• There have not been significant judicial pronouncements on the question of enforceabilityof a venture capital term sheet.

• To summarise, term sheets are preliminary agreements, evidencing an intention of theparties to enter into a contract at a future date.

• Such ‘agreements to agree’ are not enforceable under both English and Indian law,although, there may be exceptions depending on the facts and circumstance of each case,the conduct and the intention (whether express or implied) of the parties to create legalrelations.

• Whether or not a term sheet is binding on the parties depends on the provisionscontained therein. Therefore, the parties must employ a clear and unambiguous languageto avoid disputes. Certain clauses like Exclusivity, Confidentiality and ‘No-Shop,’ and therelated Dispute Resolution provisions, must be expressly stated to be valid and binding,independently of whether or not the deal goes ahead with the execution of definitivedocumentation.

• Importantly, clauses dealing with costs or fees, and who is to bear them, whether or notthe deal goes through, must also be clearly indicated to be binding, so as to avoidunpleasant shocks later. The concept of ‘break-fees’ and its payment, is another clause,that must be made so binding irrespective of deal closure.

Questions?

Thank you!

Bangalore • Chennai • Mumbai • New DelhiSamvād: Partners is a partner-led, solution-oriented, full service law firm, formed by the

merger of Narasappa, Doraswamy & Raja and V Chambers of Law, having a deep and

diverse international perspective.

With offices in Bangalore, Chennai, Mumbai and New Delhi – comprising over 30 lawyers

– the Firm’s partners (and its legacy firms) have regularly received the highest accolades and

rankings from our peers, including recognition in Chambers & Partners and Legal500,

over the past several years.

The Partners of the Firm – Mr. Harish Narasappa, Ms. Poornima Hatti, Mr. Rohan K.

George, Mr. Siddharth Raja, Ms. Vineetha M. G., Ms. Nivedita Nivargi and Ms. Neela

Badami – are leaders in their respective fields of practice, having a rich mix of domestic

and international experience, having worked in several legal and financial capitals around

the world, including London, Hong Kong, Singapore, Mumbai, New Delhi and the Hague.

© Samvad Partners16

Neela Badami ([email protected])

# 62 / 1 Palace Road, Vasanth Nagar, Bangalore 560 001

(+91.80.4268.6000 / 30)© Samvad Partners

Bangalore • Chennai • Mumbai • New Delhi

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