Executive Summary
A term sheet arrived at a Kerala technology company with a valuation the founder was pleased with and a set of terms nobody had modelled. The round was institutional, the investor had backed many companies before and the document was entirely standard. Standard is not the same as neutral. JPKAD & Associates was engaged to model the economics of the document before it was signed, working alongside the company’s legal counsel who handled the drafting. Three provisions carried most of the effect. The option pool was to be created before the money came in, the liquidation preference was participating, and the anti dilution protection was on a full ratchet basis. None of those is unusual and none is improper. Together they meant the founder’s outcome at several realistic exit values was materially different from what the headline valuation implied. The round completed. Two of the three provisions were renegotiated and the third was accepted knowingly, with the founder able to describe what it would cost in the scenarios that mattered.
- A term sheet is mostly not binding, but the exclusivity and confidentiality clauses usually are.
- Where the option pool is created affects founder dilution more than a difference in headline valuation.
- A participating liquidation preference changes the outcome at every exit value except a very large one.
- Assured exit at a pre agreed price to a non resident investor is not permitted, so exit clauses need care.
- Reserved matters have to reach the articles to bind the company, not sit only in the shareholders agreement.
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Client Overview
The client is a technology company based in Kochi selling software to businesses in India and the Gulf. It had been founded four years earlier and had raised one earlier angel round from individuals. Ownership before the round sat with two founders and a small group of angel investors, with an informal understanding about employee equity that had never been formalised. Revenue was growing and the company had reached the point where an institutional round made sense, which is also the point at which investment readiness stops being optional and documents stop being simple. The finance function was one accountant and a bookkeeper, with the founders handling investor conversations themselves. The earlier angel round had been documented on a short agreement drafted from a template. Nobody had modelled its effect either, which became relevant once the new round was mapped.
Business Challenges
The founder was not negotiating badly. He was negotiating one number while the document did most of its work elsewhere, which is the ordinary experience of a first institutional round. Four provisions needed to be understood before anything could be discussed sensibly.
Why did the option pool placement matter so much?
Because a pool created before the investment comes in is carved out of the existing shareholders alone. The incoming investor does not share that dilution. The term sheet specified a pool sized as a percentage of post money capital but created out of pre money capital, which is the standard and least favourable formulation for founders. In arithmetic terms this matches a reduction in the valuation, and it is rarely described that way in conversation. The founder had read the pool clause as an administrative detail about employee equity. It carried more economic weight than anything in the document except the valuation itself.
What does a participating liquidation preference actually do?
It lets the investor take back its investment first and then also share in what remains, in proportion to its shareholding. A non participating preference gives the investor a choice instead. Take the preference amount, or convert and share proportionately, whichever is higher. The difference is invisible at a very large exit and substantial at every ordinary one, which is where most companies actually end up. Modelled across a range of realistic exit values, the participating structure changed the founder’s proceeds noticeably in the middle of that range.
Why is a full ratchet anti dilution provision aggressive?
Because it resets the investor’s effective price to the price of any lower priced future round, regardless of how small that round is. A broad based weighted average formula instead adjusts by reference to how much new capital comes in at the lower price, which is proportionate. In a down round the difference between the two formulations falls entirely on the founders and the earlier shareholders. The clause is easy to accept because it only operates in a scenario nobody plans for, which is precisely why it is worth negotiating while the mood is good.
What was wrong with the exit clause?
It contemplated a put option requiring the company or the founders to buy back the investor’s shares at a pre agreed return if no exit occurred by a stated date. Where the investor is a person resident outside India, exchange control rules do not permit an assured return or an exit at a pre agreed price. Exit must be at fair value at the time. A clause of that kind is therefore likely to be unenforceable in the form drafted, which helps nobody. The investor believes it has protection it does not have. This was raised with legal counsel, who redrafted the provision to operate at fair value determined by an accepted methodology at the time of exercise. Unsure how your option pool clause is worded? Read more about our corporate finance work.
Business Objectives
The founder’s instruction was not to win the negotiation. It was to understand what he was agreeing to well enough to decide which points were worth spending relationship capital on.
What did the founder actually need?
A model showing what each clause does to his proceeds across a range of exit values, rather than a written summary of what each clause says. A ranking of the provisions by economic effect, so that negotiation effort went where it mattered instead of being spread evenly. Clarity on which points were genuinely market standard and which were investor favourable within a standard framework. And a view on what the earlier angel round had already committed him to, since two of its terms interacted with the new document.
Why was preserving the relationship treated as a constraint?
Because the investor would sit on the board and would be asked to support the next round, so the negotiation was the start of a relationship rather than a transaction. Contesting every clause signals inexperience and consumes goodwill that is worth more later. Ranking the provisions by effect made it possible to concede several points quickly and credibly, which strengthened the position on the ones that mattered. The founder also wanted to be able to explain his reasoning to the investor rather than simply pushing back, which changes how a counterparty responds.
What defined success for this engagement?
The founder able to describe, in his own words, what each material clause would cost him in three specific scenarios. A modelled cap table showing the position after the round and after a plausible next round, including the option pool. The exchange control problem in the exit clause identified before signature rather than during closing. And a decision on every material term that was made deliberately, including the terms he chose to accept unchanged. Success also meant the founders holding a model they could run themselves, since they intend to negotiate the next round without outside help. Want to know which clauses are worth negotiating? Explore our approach through our contact page.
Solution Strategy
The work was modelling rather than commentary. A clause described in a memo is abstract. The same clause expressed as a number at three exit values is a decision the founder can make himself. Legal drafting stayed with the company’s legal counsel throughout. The financial and tax analysis sat alongside it rather than replacing it.
How was the existing cap table reconstructed?
From the register of members, the earlier round documents and the board resolutions, rather than from the spreadsheet the founders had been maintaining. That spreadsheet turned out to be wrong in two places. One angel had been allotted a different number of shares from the number recorded informally. The informal employee equity understanding had no documentary basis at all, which mattered because the new pool was expected to cover it. Correcting the starting position before modelling anything is unglamorous and it prevents every downstream number being quietly wrong.
How was the term sheet modelled?
Clause by clause, with each provision expressed as its effect on proceeds rather than as a description of its mechanics. The option pool was modelled both ways, created before and after the investment, which showed the difference plainly without any argument about fairness. The liquidation preference was modelled as a waterfall across a range of exit values, comparing participating and non participating outcomes at each point. Anti dilution was modelled under a down round scenario using both full ratchet and broad based weighted average, since the difference only appears in that scenario.
How were the provisions ranked for negotiation?
By the size of their effect across the exit range that the founders and the board actually considered realistic, not across every theoretical outcome. That ranking put the option pool placement first, the liquidation preference second and the anti dilution formula third. Control terms were assessed separately, since their cost is not financial and cannot be modelled the same way. The ranking was deliberately short. A list of twenty concerns is not a negotiating position, it is an invitation to be dismissed.
How was the exchange control position checked?
By reviewing the instrument, the pricing and the exit provisions against the rules applicable to investment by a person resident outside India. Compulsorily convertible preference shares were confirmed as an appropriate instrument, since they are treated as equity for exchange control purposes. Issue price had to be not below fair value determined by an accepted methodology, and valuation support was arranged for the closing rather than after it. The put option at a pre agreed return was flagged to legal counsel, who redrafted it to operate at fair value at the time of exercise.
How was the tax position considered?
For the company, the question was whether any part of the subscription could be treated as income where shares are issued above fair value, which required the valuation to be properly supported. For the founders, no immediate tax arose on a primary issue, but the position on a future secondary sale was modelled so that nobody was surprised later. Employee equity carried its own consequences, since the perquisite arises at exercise and is a payroll obligation for the company. None of these changed the negotiation. They changed what the founders understood about the money they would actually receive. Need the arithmetic behind a clause rather than a description of it? Read more about our management consultancy work.
Models and Documents Used
The tools were ordinary. What made them useful was that every figure traced back to a document rather than to a spreadsheet somebody had been maintaining by hand.
What went into the cap table model?
Every issue and transfer since incorporation, taken from the statutory registers and reconciled to the filings made with the registrar. The instrument type for each holding, since preference shares and equity shares behave differently in a waterfall regardless of how the spreadsheet describes them. The option pool, modelled as unissued, granted and vested, because those three states have different effects on a fully diluted calculation. A next round assumption, so the founders could see the position after the round they were signing and after the one they expected to raise next.
How was the exit waterfall built?
As a distribution of proceeds at a series of exit values, applying the preference stack in order before any proportionate sharing. Both preference structures were modelled side by side, which is what made the difference visible without any need to argue about it. Conversion was tested at each exit value, since a rational investor converts where conversion pays more than the preference. The model was handed over to the founders with the assumptions clearly separated from the calculations, so they could test other scenarios themselves.
Which documents were reviewed alongside the term sheet?
The earlier angel round documents, which contained a most favoured nation clause nobody had remembered and which interacted with the new terms, part of the wider discipline of contractual documentation review that preceded signing. The articles of association, since reserved matters and transfer restrictions have to be carried into the articles to bind the company. The register of members and the filings with the registrar, used to reconcile the cap table to the statutory record. Employment agreements for the founders, because the vesting provisions in the term sheet had to work alongside terms already in place.
Implementation Process
The engagement ran across about five weeks, which was set by the exclusivity period in the term sheet rather than by the work itself. Exclusivity had already started when the founder made contact, which is common and which shortens everything that follows.
What happened in the first week?
The cap table was reconstructed from statutory records and reconciled, which surfaced the two discrepancies in the founders’ own spreadsheet. The term sheet was read against the earlier round documents, which is how the most favoured nation clause was found. A short note listed the provisions that would need modelling and those that were purely legal and belonged with counsel. The founder was told plainly which parts of the term sheet were already binding, since exclusivity and confidentiality operate from signature of the term sheet itself.
How were the models presented to the founders?
In a single session, working through the exit waterfall live rather than presenting conclusions. Founders engage with a model they can interrogate. A memo describing the same conclusions is read once and set aside. The ranking of provisions by economic effect came at the end of that session rather than at the start, so it was a conclusion the founders reached themselves. One founder immediately tested an exit value that had not been modelled, which is exactly the behaviour the session was designed to produce.
How was the negotiation supported?
By preparing the reasoning behind each requested change rather than the request alone, so the founder could explain rather than assert. Three points were raised with the investor. The option pool placement, the participating preference and the anti dilution formula. Several other points were conceded explicitly and early, which made the three that mattered more credible. Legal counsel led the drafting exchanges. The financial reasoning sat behind them and was available when a number was questioned. Turnaround on each drafting exchange was kept short, because exclusivity was running and delay favours neither side once a deal is agreed in principle.
How did the round close?
The option pool was resized and its creation split between pre and post money capital, which is a common landing point. Preference terms moved to a non participating structure, with the investor retaining the choice to convert. The anti dilution formula was retained as drafted, accepted knowingly after the founder had seen what it would cost in a down round. The exit provision was redrafted by counsel to operate at fair value, and valuation support was arranged so that closing was not delayed. Signed a term sheet and started the exclusivity period? Explore how we can help through our contact page.
Business Results
Results are described here in direction of change rather than in figures. Transaction outcomes depend on negotiation and on facts specific to each round, and figures would suggest a precision that does not exist. What follows is what the founders reported after the round closed.
What changed in the terms themselves?
The option pool was resized and its creation split between pre and post money capital, which reduced the dilution falling on existing shareholders alone. The liquidation preference moved from participating to non participating, with the investor retaining the conversion choice. The anti dilution formula was left as drafted. That was a decision rather than an oversight, made after the founder had seen the modelled effect. The exit provision was redrafted to operate at fair value, which removed a clause that would probably not have been enforceable as written.
What changed for the founders?
They can describe what each material clause does in plain terms, which matters because they will negotiate the next round themselves. The cap table is now reconciled to the statutory registers, and the two discrepancies in the old spreadsheet were corrected. The informal employee equity understanding has been formalised within the new pool rather than remaining a promise nobody had documented. They also understand which terms they accepted knowingly, which is a different position from discovering a clause later. They now hold a working model rather than a static spreadsheet, and one founder has already used it to test a scenario for the next round.
What changed about the investor relationship?
Conceding several points quickly and contesting three with reasoning was received well, which the founders had worried it would not be. The investor is on the board and the working relationship began on a footing of informed agreement rather than deferred misunderstanding. Raising the exchange control problem in the exit clause was useful to the investor too, since it had believed it held protection that would not have operated. The next round conversation will start from a documented and agreed cap table rather than from a reconstruction.
What changed structurally?
Reserved matters and transfer restrictions were carried into the articles rather than left only in the shareholders agreement. The cap table model sits with the company and is updated as grants are made, rather than being rebuilt whenever a question arises. Valuation support is now obtained ahead of any issue rather than at closing, which removes a recurring source of delay. The company keeps a single folder of round documents, which is what the next due diligence will ask for first. Want a cap table that reconciles to the statutory registers? Explore our advisory work through our contact page.
Lessons Learned
The founder was not naive and the investor was not predatory. The document was standard, and standard documents are written by the party that produces them.
What surprised the founders most?
That the option pool clause, which they had treated as administrative, carried more economic effect than several points they had been arguing about. That a participating preference and a non participating one produce very different outcomes at ordinary exit values and identical ones only at large exits. Nobody remembered that the earlier angel round contained a most favoured nation clause, and it interacted with the new terms. That their own cap table spreadsheet disagreed with the statutory registers in two places.
What worked better than expected?
Modelling rather than summarising. The founders interrogated a live model in a way they would never have interrogated a memo. Conceding several points early and explicitly. It made the three contested points read as considered rather than reflexive. Raising the exchange control problem in the exit clause. It helped the investor as much as the company and it changed the tone of the exchange. Keeping the negotiation list to three items. A longer list would have been easier to dismiss as inexperience.
What would be done earlier next time?
The cap table would be reconciled to the statutory registers before any fundraising conversation begins, not during exclusivity. The earlier round documents would be reread at the start, since old clauses interact with new ones and nobody remembers them. Employee equity would be documented when it is promised rather than absorbed into a pool years afterwards. Advice would be taken before the term sheet is signed, because exclusivity begins then and it removes the option of walking to another investor.
What should other founders check first?
Read the option pool clause and establish whether the pool is created out of pre money or post money capital. That single sentence carries real money. Establish whether the liquidation preference is participating, and model the outcome at exit values you consider realistic rather than aspirational. Look at the anti dilution formula, since full ratchet and weighted average behave very differently in the scenario nobody plans for. Confirm that any exit provision involving a non resident investor operates at fair value, because an assured return is not permitted.
Frequently Asked Questions
1. Is a term sheet legally binding? Mostly not, with important exceptions. Confidentiality, exclusivity or no shop, governing law and the allocation of transaction costs are typically binding from signature of the term sheet itself. That matters because exclusivity removes the option of approaching another investor while it runs, so advice taken before signature is worth more than advice taken after it. 2. Why does it matter whether the option pool is created before or after the investment? Because a pool created before the money comes in is carved out of the existing shareholders alone, and the incoming investor does not share that dilution. The effect is arithmetically similar to a reduction in the valuation, though it is rarely described that way. It often carries more economic weight than anything in the document except the valuation itself. 3. What is the difference between participating and non participating liquidation preference? A participating preference lets the investor take back its investment first and then also share in what remains proportionately. A non participating preference gives the investor a choice instead, being the preference amount or conversion and proportionate sharing, whichever is higher. The difference is substantial at ordinary exit values and disappears only at very large ones. 4. What is anti dilution protection and which formula is fairer? It adjusts the investor’s effective price if a later round is priced lower. A full ratchet resets the price to the lower price regardless of how small the new round is. A broad based weighted average adjusts by reference to how much new capital comes in at that price, which is proportionate. The difference falls entirely on founders and earlier shareholders. 5. Can an investor be promised a guaranteed exit at a fixed price? Where the investor is a person resident outside India, exchange control rules do not permit an assured return or an exit at a pre agreed price. Exit must be at fair value determined at the time by an accepted methodology. A clause drafted otherwise may not operate, which is a problem for the investor as much as for the company. 6. Do reserved matters in a shareholders agreement bind the company? To be enforceable against the company, reserved matters and transfer restrictions generally need to be carried into the articles of association rather than sitting only in the shareholders agreement. This is a routine step that is sometimes left until after closing, and leaving it undone weakens provisions both parties believe are in place. 7. What should a founder model before signing? The effect of each material clause on proceeds across a range of exit values considered realistic, rather than a written description of what each clause says. That means a reconciled cap table, an exit waterfall applying the preference stack in order, and a down round scenario to test the anti dilution formula. A model can be interrogated. A memo cannot. 8. Which instrument is usually used for an institutional round in India? Compulsorily convertible preference shares are common, because they are treated as equity instruments for exchange control purposes while carrying preference economics. The instrument choice affects the waterfall, so a cap table that records everything as equity shares will produce the wrong answer regardless of how carefully the rest of it is maintained. 9. How many points should a founder negotiate? Few, and chosen by economic effect. In this engagement three provisions were raised and several others were conceded explicitly and early. A list of twenty concerns reads as inexperience and invites dismissal. Ranking provisions by their modelled effect makes it possible to concede credibly, which strengthens the position on the points that matter. 10. Who should do what in a round like this? Legal counsel drafts and negotiates the definitive documents. The financial and tax analysis sits alongside, covering cap table reconstruction, waterfall modelling, valuation support for pricing, the tax position on issue and on a future sale, and the exchange control questions. The two workstreams need to talk to each other, particularly on exit and pricing provisions.
Conclusion
A term sheet is a document about economics and control, and the valuation is only the part that gets discussed. This Kerala founder was negotiating the headline number while three other provisions did most of the work. The option pool was to be created out of pre money capital, so the dilution fell on existing shareholders alone. The liquidation preference was participating, which changes the outcome at every ordinary exit value. The anti dilution protection was on a full ratchet basis, which only matters in a scenario nobody plans for and is therefore easy to accept. Modelling those three provisions as proceeds at realistic exit values, rather than describing them in a memo, turned the conversation into a decision the founder could make himself. Two were renegotiated and one was accepted knowingly. Along the way the exercise found a most favoured nation clause in the earlier angel round that nobody remembered, two errors in the founders’ own cap table spreadsheet, and an exit provision that would probably not have operated because an assured return to a non resident investor is not permitted. If you are holding a term sheet, the two sentences worth reading again today are the option pool clause and the liquidation preference. JPKAD & Associates supports founders on transaction economics alongside their legal counsel, and you can read more through the contact page. See also our case studies on investment readiness for Series A funding and fundraising pitch recovery. This case study is published for general information only. Client identity and commercially sensitive details have been withheld. Outcomes are described qualitatively, without figures, because transaction outcomes depend on negotiation and on facts specific to each round. Legal drafting was handled by the company’s legal counsel. Nothing here is investment, tax or legal advice on any specific matter.