A Private equity identifies a target company, goes through the business model, studies the business plan, performs a due diligence and then do the necessary discussions & negotiations before making a decision on the target company.
Term sheet comes into picture after a Private equity fund has decided to get into an agreement with Target Company. Term sheet is the first step of the transaction between the Private Equity fund & the Target Company. It has all the important & key points of the agreement.
The key points in the term sheet generally comprise of
- Binding Provisions Examples in Term Sheet
- Basic Provisions Examples in Term Sheet
- #1 – Type of Security Offered
- #2 – Capitalization & Valuation
- #3 – Dividend Rights
- #4 – Liquidation Preference
- #5 – Conversion Rights
- #6 – Anti-Dilution Provisions
- #7 – Board of Directors
- #8- Redemption Clause
- #9- Transfer Restrictions
- #10 – Pre-emptive rights
- #11- Rights of the first refusal
- #12 – Tag along & drag along provisions
- Additional Provisions Examples in Term Sheet
Binding Provisions in Term Sheet
A term sheet is not a legally binding document. However, certain sections of the Term sheet are legally binding. This areas-
#1 – Confidentiality Terms
Confidentiality terms – The term sheet has this clause wherein the sensitive information about the target company is protected from being shared by PE Fund to third parties.
#2 – “No- Shop” Provision
This clause is to protect the PE Funds. In this clause, the target company is prohibited from searching any other financing with any third party for a specific time. This provision helps PE Funds to save their time as well as their money by not getting involved in due diligence or negotiations with target companies who are already talking to other potential investors.
Basic Provisions in Term Sheet
#1 – Type of Security Offered
The most important & essential provision of the term sheet is the type of security offered – equity, preference shares, warrants etc and the price per share of that security. This is the initial deal term which is determined between the PE fund & Target Company.
#2 – Capitalization & Valuation
The next part under the basic provision is Capitalization & Valuation. This clause decides the price per share for the Target Company. As preferred stocks have more attractive terms so they are preferred over equity by the Private equity investors.
This clause also provides the information on pre-money & post-money valuations of the company. Pre-money valuation is the valuation which is based on the number of shares outstanding before the financing is done. Whereas, post-money valuation is based on the number of shares that will be outstanding post financing.
When a PE funds make an investment it shall analyze its investment based on “as converted basis”. As the name applies, “As-converted” is the number of shares that are outstanding plus the number of shares that would be outstanding when warrants and options of the target company are exercised and convertible securities are converted by the holders.
#3 – Dividend Rights
After capitalization, Term sheet would have a clause about the Dividend rights under basic provisions. It deals with the dividends to be paid. Dividends are paid either on a cumulative basis or noncumulative basis.
Since Target companies are either start-ups or mid-level companies so they hardly give any dividends. As Investors prefer cumulative dividends so the dividends keep accumulating and will be accounted for when preferred stocks are converted into common stock. This provision is important as it decides how much of common stock will go to preferred stockholders in the event of liquidation.
#4 – Liquidation Preference
Post Dividends, term sheet has the provision on Liquidation preferences. Preferred stockholders receive preference over common stock in case of liquidation.
Generally, liquidation preferences would be equal to the amount invested. However, at times, it would be a multiple of the amount invested. This multiple can be in the range of 3 to 5 times of the amount invested.
The target company should carefully understand the liquidation provisions before making the deal with PE fund. This is so as a low valued company then on liquidation the common stockholders would get a minuscule proceeds.
#5 – Conversion Rights
Conversion rights would be the next basic provision covered in the Term sheet. This provision gives the investor the right to convert to common stock. This right is rarely utilized by investors in normal conditions as preferred stock have more value than the common stock at the time of liquidation.
Investors convert their preferred stock into common stock prior to sale, merger or IPO of Target Company. Generally, when the company plans for an IPO, preferred stocks are automatically converted to common stock as underwriters do not prefer taking multiple classes of stock to the public.
#6 – Anti-Dilution Provisions
After conversion rights term sheet provides a clause for Anti-Dilution under the basic provision. This clause in inserted in term sheet as a protection measure. The clause protects the PE fund in future if the company sells additional shares for subsequent financing at a price that is below the per-share price paid by investors.
These provisions are such that if the subsequent financing happens at a lower price then conversion price of all shares that are purchased at a higher price are adjusted downward. This is done in such a way that percentage ownership of investors is maintained. This results in previous investors getting more shares and dilution of ownership of other holders who do not have price protection.
#7 – Board of Directors
Under basic provisions term sheet also have a clause on Board of Directors. This clause deals with the number of directors that would be in the Board, from investor side. Generally, a clause is added wherein if the required milestones are not achieved in stipulated time or if any pre-defined negative event occurs then the investor shall have the majority of directors in the Board.
Target company and its founder should carefully study the structure of board as will have to deal with the board when making any major corporate decisions.
Many times a board representative from the investor group is more of a positive than negative. This is so as it can give brilliant direction, particularly if the group has industry-specific experience.
Term sheet would also have a provision on Information rights. Investors would require companies to provide “information rights”. These are ideally information related to financial statements, strategic plans, forecasts of the target company.
#8- Redemption Clause
Sometimes basic provision also contains Redemption clause. This clause provides the PE fund with liquidity. The provision is that the company is required to buy back the shares when it has the financial resources to do so.
Redemption will generally only be considered when the company has become profitable but there are no opportunities for liquidity through a sale, IPO or recapitalization
Some other provisions that are part of basic provisions are Transfer restrictions, preemptive rights, rights of first refusal , Tag along & drag along provisions
#9- Transfer Restrictions
Transfer restrictions are restrictions placed on transferability. These restrictions are placed to ensure that shares are not sold to a party which company does not want as their shareholders.
#10 – Pre-emptive rights
Pre-emptive rights are those rights which give the shareholders a right to purchase new securities if any issued by the company. This provision is included in the termsheet to so that investors can retain their relative percentage of total outstanding shares.
#11- Rights of the first refusal
Rights of first refusal are those rights wherein it is compulsory for the founders of the target company & the other shareholders to offer their shares first either to the company or to preferred shareholders. They can go to the third party only after refusal from the company or preferred shareholders.
#12 – Tag along & drag along provisions
If the sale to the third party goes to advanced stages of negotiation then Tag along rights give the PE fund right to sell their shares too on a pro-rata basis.
Under drag-along rights, investors who have a specified percentage of shares (generally majority) and who have identified a third party as a buyer are required to include other shareholders to participate. In this scenario, minority shareholders are forced to participate. This provision helps in the sale of the company if favorable terms exist even if other shareholders do not favor the sale.
Additional Provisions in Term Sheet
If the transaction between the PE fund and target company is that of leveraged buyout or recapitalization then such transactions will have debt component. A general provision included is that any purchase made of management’s stock and/or new equity shall be financed, using the cash flow of the company to back the debt.
LBO and recapitalization give the advantage to the founders of target company as well as option holders to receive a substantial dividend and retain ownership at the same time. They can also remain actively involved in the management of the company in the future. Apart from this, the company shall receive additional capital for growing in future.
#1 – Earnout Provision
Additionally, term sheet has Earnout provision wherein founders & other shareholder receive additional payments based on the future performance of the businesses sold. So if they are able to reach a specified target, goal, specified earnings multiple or certain level of profitability then they qualify for earnout. Earnout provisions are quite common in LBO & recapitalization transactions.
The inclusion of such provision reflects a reasonable expectation from an investor that company is able to reach a point where it has made itself financially attractive. Obviously, the risk of proving so under this provision lies with the management of target company.
Therefore, as a target company earnout provisions should meticulously studied and carefully negotiated with the PE fund. One of the provisions in earnout is that the management shall be entitled to same only when they remain with the company for a specific time period, else they are forfeited. So target company should accept the provision only if it plans to be with the company until the specified time.
However, it’s not easier for the management as it is highly probable that differences may arrive between founders & the team brought in by the PE fund investor or when the investor becomes too interfering in day-to-day affairs of the target company’s business.
Additional provisions would include miscellaneous details such as fees to paid to Investor’s accountant, lawyers, experts carrying out the due diligence process etc.
#2 – Conditions Precedent
Additional provisions also include Conditions precedent
Conditions precedent that is included in the term sheet would include information on what has to happen between the time from when the term sheet is signed and till the completion of the investment.
This provision would include
- Satisfactory completion of the due diligence process and
- Completion of the various legal agreements as required. This would include an agreement with the shareholders, and documentation of the warranties and indemnities.
- Sometimes condition precedent may specify that the target company should do certain specific things during that time period. This would include getting a contract with a specific customer (about whom you had mentioned to Private equity fund at the time of negotiation) or roping in a specific personality as Brand representative.
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The relationship between the target company & Private equity fund starts with negotiations on the term sheet, finalizing it after few meetings & executing the term sheet.These are the first step towards the relationship.
Private equity investments are a requisite for target companies to grow and prosper to their full potential. They are an important factor in the life of the target company as it helps to reap the rewards of the efforts put in by the founders of the company.
As the Private equity investors want to earn a return on their investment so a lot of emphasis is placed on the term sheet and it is developed and worded carefully. Due to this many a times, target companies find negotiating the term sheet and definitive documents as a cumbersome and antagonistic process. However, Investors are clear that they wish to work with target company without any ambiguities and for a satisfactory outcome for both the parties involved.
People, marketplace conditions both present & future (anticipated), the growth of the company & its earnings apart from the severity need of financing will all play important role in superiority of target company in dictating its terms. It is important that the founder of the target company has a business acumen and sense of the business, its growth prospects, present and the projected value of the company after taking into considerations the difficult decisions it might have to take during the entire process of funding.