Term Sheets and Shareholders Agreement: A Complete Analysis for Indian Startups

As an entrepreneur, raising capital for your startup can be a complex process involving several legal documents. Two of the most crucial documents are the term sheet and the shareholders agreement. Understanding the differences, purposes, and intricacies of these two documents is vital to secure funding and protect your interests. In this blog post, we’ll provide a complete analysis of term sheets and shareholders agreements in the Indian context. Let’s get started!

Table of Contents

1. Overview of Term Sheets and Shareholders Agreements
2. Term Sheet: Purpose, Components, and Negotiation
3. Shareholders Agreement: Purpose, Components, and Negotiation
4. Key Differences Between Term Sheets and Shareholders Agreements
5. Term Sheets and Shareholders Agreements in the Indian Context
6. Frequently Asked Questions (FAQs)

1. Overview of Term Sheets and Shareholders Agreements

Both term sheets and shareholders agreements are essential documents in the fundraising process. The term sheet outlines the preliminary terms and conditions of an investment, while the shareholders agreement is a more comprehensive, legally binding contract that governs the relationship between shareholders and the company. Although they serve different purposes, both documents play a crucial role in protecting the interests of founders, investors, and the company during the time of valuation.

2. Term Sheet: Purpose, Components, and Negotiation

A term sheet is a non-binding document that outlines the preliminary terms and conditions of an investment. It serves as a basis for further negotiation and drafting of definitive agreements, such as the shareholders agreement and the subscription agreement. Here are the key components of a term sheet:

1. Valuation: The valuation of the company, both pre-money and post-money, is mentioned to determine the price per share and the percentage of ownership for the investors.
2. Investment Amount: The amount of capital the investor(s) will contribute to the company.
3. Vesting and Founder Stock: Vesting schedules and conditions for the founders’ stock to ensure commitment to the company’s long-term success.
4. Anti-dilution Provisions: Mechanisms to protect investors from dilution in future funding rounds.
5. Liquidation Preferences: The order of priority and distribution of proceeds in case the company is liquidated or sold.
6. Board Composition: The composition and appointment of the company’s board of directors, including investor representation.
7. Information Rights: The rights of investors to receive regular updates and financial information about the company.

During the term sheet negotiation, it’s crucial to strike a balance between the interests of the founders, the company, and the investors. The goal is to reach a mutual understanding that lays the foundation for a healthy, long-term relationship between all parties involved.

3. Shareholders Agreement: Purpose, Components, and Negotiation

The shareholders agreement is a legally binding contract that governs the relationship between the shareholders and the company. It outlines the rights, obligations, and responsibilities of all parties involved and addresses various aspects of the company’s management and operations. The key components of a shareholders agreement include:

1. Share Capital and Ownership: Details of the company’s share capital, including the classes of shares, rights attached to each class, and any restrictions on share transfers.
2. Board Composition and Governance: The composition of the board of directors, the appointment process, and the roles and responsibilities of the board members.
3. Voting Rights: The voting rights of shareholders, including any special voting rights for specific shareholders or classes of shares.
4. Dividend Policy: The company’s dividend policy and the distribution of profits among shareholders.
5. Exit Provisions: The provisions governing the exit of shareholders, including tag-along and drag-along rights, rights of first refusal, and pre-emption rights.
6. Dispute Resolution: The mechanisms for resolving disputes among shareholders or between shareholders and the company, such as mediation, arbitration, or litigation.
7. Non-compete and Confidentiality: The restrictions on shareholders, particularly founders, from engaging in competing businesses and the obligation to maintain the confidentiality of the company’s information.

Negotiating a shareholders agreement requires a thorough understanding of the interests of all parties involved. It’s essential to find common ground while protecting the company’s long-term interests and fostering a collaborative environment among shareholders.

4. Key Differences Between Term Sheets and Shareholders Agreements

While term sheets and shareholders agreements both play a significant role in the fundraising process, they have several key differences:

• Binding vs. Non-binding: The term sheet is a non-binding document, while the shareholders agreement is a legally binding contract.
• Purpose: Term sheets outline the preliminary terms and conditions of an investment, while shareholders agreements govern the relationship between the shareholders and the company.
• Level of Detail: Term sheets are usually shorter and less detailed, focusing on the key terms of the investment, whereas shareholders agreements are comprehensive documents addressing various aspects of the company’s management and operations.
• Timing: Term sheets are typically prepared and negotiated before the shareholders agreement, serving as a basis for drafting the more definitive agreements.

5. Term Sheets and Shareholders Agreements in the Indian Context

In the Indian context, term sheets and shareholders agreements must comply with the Indian Companies Act, 2013, and other applicable regulations. Additionally, it’s essential to consider the unique aspects of the Indian market, such as the regulatory environment, cultural nuances, and local business practices, while drafting and negotiating these documents.

For instance, Indian startups often need to consider foreign investment regulations and exchange control norms, particularly if they’re raising funds from overseas investors. Furthermore, Indian founders should be aware of the tax implications of various provisions in the term sheet and shareholders agreement, such as vesting schedules, liquidation preferences, and exit rights.

6. Frequently Asked Questions (FAQs)

1. 1. Do I need a lawyer to draft a term sheet or shareholders agreement?

While you can draft a term sheet or shareholders agreement on your own, it’s highly recommended to engage a lawyer with experience in startup funding and corporate law. A lawyer can help you understand the legal implications of various provisions and ensure that the documents comply with the Indian Companies Act, 2013, and other relevant regulations.

1. 1. Can a term sheet be enforced in court?

Since term sheets are generally non-binding, they’re not directly enforceable in court. However, certain provisions in the term sheet, such as confidentiality and exclusivity clauses, may be legally binding and enforceable. The shareholders agreement, on the other hand, is a legally binding contract that can be enforced in court.

1. 1. What happens if there’s a conflict between the term sheet and the shareholders agreement?

In case of a conflict between the term sheet and the shareholders agreement, the provisions of the shareholders agreement typically prevail, as it is a legally binding contract. It’s essential to ensure consistency between the term sheet and the shareholders agreement during the negotiation and drafting process to avoid potential disputes.

1. 1. How can I protect my interests as a founder during the term sheet and shareholders agreement negotiation process?

To protect your interests as a founder, it’s crucial to understand the implications of various provisions in the term sheet and shareholders agreement. Engaging a lawyer and conducting thorough research on industry standards and best practices can help you make informed decisions during the negotiation process. Additionally, fostering open communication and building trust with your investors can contribute to a successful negotiation outcome.

In conclusion, understanding the differences, purposes, and intricacies of term sheets and shareholders agreements is essential for entrepreneurs raising capital for their startups. By considering the unique aspects of the Indian context and engaging experienced legal counsel, founders can successfully navigate the fundraising process and secure the best possible terms for their companies.