First in a series of articles that simplifies a term sheet, clause by clause, helping the investor and promoter steer clear of ambiguity
Term sheets are contentious, mysterious documents for a company. The drafter of the term sheet document is always the investor since it is at his discretion that the term sheet is offered to the promoter group. It is a conditional offer to the promoter group of certain terms and conditions based on which he desires to make an investment.
Promoters think of this as a long drawn valuation game. This can be terminal to the promoter who is not thinking through the process until its closing stage. An experienced attorney can help immensely in negotiating the first stance taken by the promoter and the investor.
All terms in the term sheet are capable of being classified as economic control and behaviour control issues. Everything else does not warrant a lawyer to help negotiate.
In this article, we shall focus on Protective Provisions / Affirmative Rights.
Venture capital and private equity investors generally insist on shareholders affirmative rights or protective provisions in the definitive agreements that they execute with their investee companies. These are then incorporated in the subsequent amendments of the Articles of Association of the investee company for such provisions to be enforceable.
A typical section of the agreement that deals with affirmative rights would include the following
1. Any change in the equity share capital structure of the company
2. Any changes to the charter documents of the company
3. Any decisions for investing/divesting in subsidiaries;
4. Any appointment and/or removal of key employees
5. The issuance of capital
6. Any increase or decrease in the number of directors
7. Any listing of the shares in any stock exchange
8. Making any investments other than in the Ordinary Course of Business;
9. Any scheme or decision for a rearrangement, reconstitution, merger or amalgamation
10. The suspension of business activities of the company;
11. The liquidation, winding up or dissolution of the Company;
12. Any change in the Business of the Company;
13. Appointment or removal of the auditors of the Company;
14. The conveyance or other disposition of the assets of the Company the value of the assets being in excess of a pre-agreed amount which are not used in the ordinary course of business
15. Issuance of debt in excess of a pre-agreed amount
These provisions are important as the investor, while letting the promoters operate on their core competencies, nevertheless would like to retain some control in the operations of the company. While the idea is not to interfere in the day-to-day operation of business, the threshold limits set in the way the clauses are drafted ensure the protections kick in only on the occurrence of certain events.
While negotiating such a clause promoters should bear in mind that having these clauses in the agreement does not eliminate the possibility of the company carrying on any of the items mentioned here. It just means they require the investors’ blessing before the particular action is taken by the company.
Some promoters of companies usually seek that such clauses are prefixed with the word ‘material’, for example in points 2 , 8 and 12 – this while being ‘legally’ right leaves a lot of ambiguity open to both sides of the contract. Instead, parties may opt to be clear and be in the know of what the investor seeks and what the promoters fear than mask the whole understanding with the insertion of the word ‘material’. Case laws are also vague on terms such as ‘material’, ‘reasonable’ and ‘best interests of the company’.
These provisions also gain more teeth when the investee company has more than one set of investors. In a situation where the company has completed Series A, B and C, the series D, the investor will seek all the protection provisions made available to A, B and C. The promoter and the company thus, need to be wary of each new protection they offer to each investor. Separate investor class protective provision should be avoided by the company and the promoters. Normally, new investors will ask for a separate vote, as their interests may diverge from those of the original investors due to different valuations, risks and a false need for overall control.
It also helps to remember the company and each class of shareholders interests vary. For example as a board member the investor nominee director shall act in a way that is in the best interests of the company and shall not fall back on a protection measure as a shareholder. This is a clear case of conflict and while the company consciously knows the area of conflict, it can do nothing about it at the stage of seeking a vote at the board and at the shareholder level.
We also hear at times, the argument that if the shareholders in a company are permitted by law to transact any particular item of business pursuant to an ordinary or special resolution, the shareholders cannot restrict the ability of the company from doing so by placing such restrictions in its Articles of Association. There is no clear cut answer in law to this and there is some case law that speaks to this effect. Invariably, the commercially savvy company and investor do not tow this line at the completion of a transaction.
In private equity transactions, acquisition of ‘control’ as defined under Takeover Code has often been litigated. Drawing on the recent SEBI Appellate Tribunal ruling (Subhkam Ventures India Private Limited v. SEBI), one can arguably conclude that if the investor is a mere financial investor wherein protective clauses has been provided in the shareholders agreements to protect the investments through affirmative rights, that alone shall not be the decisive factor to arrive at the conclusion that the acquirer is being vested with control over the target company.
In September last year, the Reserve Bank of India had amended the definition of control to include control of the management or policy decisions including by virtue of their shareholding or management rights or shareholders agreements or voting agreements, in addition to the right to appoint a majority of the directors.
Last, but, not least, the contentious issues aside, the company should not view this as a case of the investor not trusting the company, but, more as a question of settling the mechanics of who is the decision maker, avoiding vagueness and injecting preciseness.
Note: For open source legal documents- Wilson Sonsoni Goodrich and Rosati has a great automatic term sheet generator that can help you. The Funded.com and the National Venture Capital Association have great tools for the term sheet as well.
This article first appeared in Smart CEO and was authored by Aarthi Sivanandh.