PE/VC Investment Documentation in India: Term Sheet Red Flags and Protective Provisions

Venture capital and private equity documentation in India has matured considerably over the past decade, borrowing heavily from US market standards but shaped by the requirements of Indian company law, FEMA 1999, and a domestic investor community that has developed strong preferences. Yet many founders approach term sheets without the legal literacy to distinguish founder-friendly terms from investor-protective provisions that can eliminate founder returns in a downside scenario. This post addresses the key economic and control provisions in PE/VC documentation — the Shareholders' Agreement (SHA), the Share Subscription Agreement (SSA), and the Articles of Association (AoA) — that every Delhi NCR startup founder must understand before Series A and beyond. ## The Liquidation Preference: Your Most Important Economic Term The liquidation preference determines who gets paid first and how much when a company is sold, merged, or wound up. In Indian VC documentation, two structures are common: **1x non-participating preferred** is the founder-friendly standard. At exit, the investor gets back their invested capital (1x) first. If proceeds exceed the liquidation preference, the investor converts to equity and participates alongside founders. This is the Silicon Valley standard, and increasingly the norm for well-structured Indian Series A rounds. **Participating preferred** is where founders get hurt. The investor first takes back their liquidation preference (1x or more), and then also participates in the remaining proceeds as if they had converted to equity. In a modest exit — say, a ₹100 crore exit where the investor put in ₹40 crore for 40% equity — participating preferred means the investor first takes ₹40 crore, then takes 40% of the remaining ₹60 crore (₹24 crore), leaving founders with only ₹36 crore from what should have been a 60% share of ₹100 crore. With a non-participating structure, founders would take ₹60 crore. **Multiples above 1x** compound this effect. A 2x liquidation preference means the investor takes ₹80 crore off the top before any equity participation. Anything above 1x non-participating should be resisted. ## Anti-Dilution: Broad-Based Weighted Average is the Standard Anti-dilution provisions protect investors when a company raises money at a lower valuation than their investment round (a "down round"). The two main flavours are: **Full ratchet** is draconian: if any share is issued at a price lower than the investor's price — even one share for an ESOP grant — the investor's conversion price resets to the new lower price. This can cause massive dilution to founders and is rarely seen in clean documentation today. **Broad-based weighted average** adjusts the investor's conversion price based on a formula that accounts for the number of new shares issued and the price at which they are issued. The "broad base" includes all dilutive securities (options, warrants, convertibles) in the denominator, reducing the anti-dilution adjustment. This is the market standard and founders should insist on it. Watch out for "narrow-based weighted average" which uses only issued shares in the denominator, producing a larger adjustment that benefits investors at founders' expense. Under the Companies Act 2013, anti-dilution adjustments are implemented through adjustments to the conversion ratio of Compulsorily Convertible Preference Shares (CCPS) — the preferred instrument of choice for VC investment in Indian companies under FEMA's pricing rules. ## Drag-Along vs. Tag-Along: Control at Exit **Drag-along rights** allow a majority shareholder (typically investors once they cross a threshold) to force minority shareholders (founders) to sell their shares in an acquisition on the same terms. Drag-along is not inherently bad — it enables clean exits — but the trigger threshold matters enormously. A drag triggered by a simple majority of investors, or at a valuation below the liquidation preference, can force founders into a below-watermark sale. Founder-protective drag-along terms include: requiring a supermajority of both investor and founder shares to trigger; minimum price floors; protections ensuring founders receive at least their pro-rata share without preference haircuts. **Tag-along rights** (or co-sale rights) protect minority shareholders by giving them the right to participate in any sale of shares by a majority holder on the same terms. For founders, this is primarily relevant when early investors seek secondary exits — founders can insist on tagging along at the same price. Both rights are typically in the SHA and must be reflected in the AoA to be enforceable under Section 58 of the Companies Act 2013, which allows restrictions on transfer only if they are contained in the articles. ## Board Composition and Reserved Matters Investor board seats give disproportionate control relative to economic ownership. Standard provisions at Series A: - 5-member board: 2 founder seats, 1 investor seat, 2 independent directors (one nominated by investors) - Investor consent for "reserved matters" — a list of decisions requiring investor approval regardless of board majority The reserved matters list is where deals are won and lost in practice. Founders should scrutinise every item. Common overreaches include requiring investor consent for hiring above a salary threshold (₹50 lakh per annum clauses can paralyse senior hiring), any new office lease, any expenditure above a monthly cap, and any new business line. Negotiate these to reasonable thresholds and carve out ordinary course business. Under the Companies Act 2013, certain decisions require shareholder approval by special resolution regardless of the SHA — related party transactions under Section 188, buybacks under Section 68, and changes to capital structure under Section 61. The SHA operates alongside the statute, not in substitution. ## FEMA and the CCPS Imperative Foreign VC investment into Indian private companies is governed by the NDI Rules 2019. Foreign investors cannot hold ordinary equity shares at a price below fair market value (Rule 21). This is why virtually all VC investment into Indian startups uses **Compulsorily Convertible Preference Shares (CCPS)** — they satisfy FEMA pricing requirements at issuance and convert to equity at a later stage. The CCPS must be compulsorily convertible within a defined period (typically at the earlier of an IPO, a specified date, or a trigger event). Optional convertibility would classify the instrument as debt under FEMA, subject to External Commercial Borrowing (ECB) regulations and interest rate caps. Convertible notes, while common in US seed rounds, face a complex FEMA landscape in India — discussed in a separate post. ## Information Rights and ROFR **Information rights** — monthly MIS reports, quarterly financials, audited annual accounts — are standard and reasonable. Watch for provisions requiring consent to fundraising materials or investor updates being shared with competitors. **Right of First Refusal (ROFR)** gives existing investors the right to match any third-party offer before a founder sells shares. Combined with co-sale rights, this can make secondary sales by founders practically impossible without investor cooperation. Founders approaching secondary liquidity should ensure ROFR windows are short (5-10 business days) and waiver provisions are clear. ## The SHA Must Be Board-Approved and Notarised Under Indian law, the SHA is a contract between shareholders. For it to bind the company, it must be adopted alongside amended Articles of Association — the SHA alone is insufficient. Any transfer restriction, board composition right, or reserved matter that is not reflected in the AoA is unenforceable against third parties under Section 58 of the Companies Act 2013. This is a drafting failure that Corpus Juris Legal encounters regularly in startups that have previously relied on template SHAs without corresponding AoA amendments. Corpus Juris Legal's Corporate & Startup practice advises founders and investors in structuring, negotiating, and documenting VC and PE investments. From our Connaught Place office, we work with Series A through pre-IPO rounds, with particular depth in FEMA-compliant documentation and SHA negotiations where investor and founder interests diverge sharply.