A well-known method for financing a company is to issue equity shares for a capital contribution. There is often much deliberation around the essential terms which regulate this transaction, before it’s recorded in binding transactional documents.
It is standard practice for a potential investor to withhold investment proceeds until transactional documents have been finalized. This results in the investee company having to bootstrap for another month or two to carry out operational activities while drafting and implementing documents.
The likelihood of a longer waiting period can be increased if parties fail to use a term sheet that sets out the salient terms of the investment. This instrument will assist a commercial attorney to glean insight and draft the investment documents quicker and prevent endless back and forth between a potential investor and an investee company.
The value is that the transaction parties state their intent on the most essential elements of the transaction upfront. This removes a lot of the friction out of the process of reaching consensus in the transaction documents.
A term sheet, also called a letter of intent or a memorandum of understanding in some circles, is a document outlining the material terms and conditions of a proposed transaction.
Unlike binding contracts such as a subscription agreement, term sheets are generally not binding. However, parties may elect to adopt a wholly or partially binding term sheet.
In most cases, only the confidentiality undertakings and provisions that bind the parties to exclusive negotiations will be binding. The remaining terms can only be enforced against a defaulting party if expressly accepted as having immediate force and effect.
In a term sheet, investors focus largely on terms that bestow economic advantages and controlling power in an investee company. As such, a representative of any investee company must have a firm grasp of the materiality of each provision on a term sheet before investment discussions. In this way, the representative’s focus is not misdirected to immaterial provisions of no value to existing shareholders in the long term.
Ideally, each provision must be negotiated separately, and the outcome thereon accurately recorded. For example, if a potential investor wishes to secure voting rights on board level, part of the completed term sheet must state that the potential investor will have the right to appoint a director to the investee company’s board of directors and that on some matters that require the affirmative approval of the investor representative, a board resolution passed without the appointee will be void.
Always remember that most signed term sheets merely demonstrate the intent to invest. Investors usually refrain from disbursing funds until the date when a subscription agreement or other transactional documents come into full force and effect.
The benefit of using a term sheet is to facilitate investment discussions, ascertain outcomes and speed up the process involved in drafting final transactional documents. The investment funds are then disbursed more quickly resulting in the investee company reverting their focus to the main business of the company and generating their next revenue.
We have also seen that in practice a potential investor is more likely to conclude an investment transaction once a term sheet has been signed than after a verbal discussion and a handshake.
A subscription agreement is a document in which at least, a subscriber, being a potential investor, is bound to advance a subscription consideration in return for a specific number of equity shares in an investee company.
Ideally, the terms and conditions surrounding the amount of capital to be invested together with the disbursement terms and the purview of privileges and limitations of the equity shares has already been settled through a term sheet and then detailed to a subscription agreement.
The real value of using a term sheet is the ease with which a subscription agreement is finalised as most of the hard work would have been completed and discussed during the negotiation stage and the outcome already accurately recorded therein.
Lastly, seek assistance from your trusted legal practitioner to create a legally sound subscription agreement. The binding effect of this agreement and its enforceability is dependent on the extent to which it is consistent with the Companies Act, 71 of 2008 and the following constitutional documents of the investee company:
- memorandum of incorporation;
- shareholders’ agreement; and
- the company rules (if any).
Good luck fund raising!