Term Sheet Terms Explained: Liquidation Preference, Anti-dilution, Pro-rata and Founder Protections

A term sheet sets out the main terms of an investment before the detailed documents are drafted. Valuation gets most of the attention, but the investor rights in the term sheet often matter just as much, because they decide who gets paid first on an exit, what happens in a down round, and how much control founders keep. This guide explains the common terms you'll meet in an Indian startup round.

Economic Terms

Valuation and instrument

The pre-money valuation and the amount raised set the investor's stake. In India, investors usually invest through compulsorily convertible preference shares (CCPS), which give them preference rights now and convert into equity later.

Liquidation preference

A liquidation preference decides who gets paid first when the company is sold or wound up. The most common in early rounds is a 1x non-participating preference: the investor gets back its investment first, or converts and takes its share of the proceeds, whichever is higher. Watch for:

• Multiples above 1x, which give the investor more than its money back first.
• Participating preferences, where the investor gets its money back and then also shares in the rest.

Anti-dilution

Anti-dilution protects investors if a later round is priced lower than theirs. It adjusts the conversion price of their CCPS so they get more shares.

• Broad-based weighted average anti-dilution is the market standard, and adjusts the price moderately.
• Full ratchet resets the price to the new, lower price, and can heavily dilute founders. Push back on it.

Pro-rata rights

Pro-rata, or pre-emptive, rights let an investor take part in future rounds to keep its percentage. They're common and reasonable, but check how they interact with new investors' expectations.

ESOP pool

Term sheets often require an ESOP pool to be created or topped up before the investment, which dilutes only the existing shareholders. Negotiate the size based on a real hiring plan.

Control Terms

Board seats

Investors often ask for a board seat or an observer seat. Keep the board balanced, so founders retain control of day-to-day decisions while investors have a voice.

Reserved matters

Reserved matters, or affirmative voting rights, are decisions that need investor consent, such as issuing new shares, changing the articles, taking on large debt, or selling the business. A reasonable list protects investors; an overly long one can slow the company down.

Information rights

Investors usually get regular financial statements, budgets and updates. Plan for the reporting you'll have to provide.

Transfer Terms

• Right of first refusal: if a shareholder wants to sell, others get the first chance to buy.
• Tag-along: if founders sell, investors can sell alongside on the same terms.
• Drag-along: if a set majority agrees to sell the company, others must sell too. Check the thresholds and minimum price.
• Lock-in: founders may be restricted from selling their shares for a period.

Founder Terms

Investors often ask for founder vesting, or re-vesting of existing shares, along with non-compete, non-solicit and full-time commitment clauses. Make sure good-leaver and bad-leaver terms are fair.

Binding and Non-binding

Most term sheet terms aren't binding, but some usually are, such as confidentiality, exclusivity, and who pays costs. Note how long exclusivity runs.

From Term Sheet to Closing

The agreed terms are set out in a shareholders' agreement and subscription agreement, and the key rights are written into the company's articles, so they're enforceable against the company. The articles must be amended by special resolution before or at closing.

Getting Help

Think Filing reviews term sheets, models their effect on the cap table, and handles the articles, allotment and filings needed to close the round.

Sources

• Companies Act, 2013.
• FEMA (Non-debt Instruments) Rules, 2019.