Securing Seed or Series-A Funding impacts much more than just the company’s finances. It might impact equity, voting, control over the board, obligations of founders and investors, rights of exit and even the capacity to secure future financing. All these repercussions are decided by legal agreements executed by the parties in the course of this funding round.
Term Sheet, Shareholders’ Agreement (SHA) and Share Subscription Agreement (SSA) constitute the main building blocks of the structure of typical startup funding. These documents serve distinct purposes but must work together as one package of legal agreements. A term that was discussed and agreed upon in the process of valuation must not be used in the definitive agreements as an obligation. The draft of such legal instruments, thus, demands knowledge about the business transaction and the Indian law framework on it.
Why Funding Documents Need Careful Drafting
Founders often focus heavily on valuation because it determines the apparent percentage of equity given to an investor. However, ownership percentage alone does not reveal the full economic and governance impact of an investment.
An investor holding a minority stake may still receive extensive contractual rights through the SHA, including board representation, information rights, veto rights over specified decisions, anti-dilution protection and exit rights.
Before accepting funding, founders should understand the effect of:
- Pre-money and post-money valuation
- Fully diluted shareholding
- ESOP pool creation
- Liquidation preference
- Anti-dilution protection
- Board rights
- Reserved matters
- Founder vesting
- Share transfer restrictions
- Exit mechanisms
This is why startup investment agreements in India should be drafted around the actual transaction rather than copied from an earlier funding round or an overseas template.
The Companies Act, 2013, FEMA requirements where applicable, the company's Articles of Association (AoA), previous investor rights and the proposed securities all need to be considered together.
The Three Core Documents Have Different Roles
The Term Sheet, SHA and SSA are interconnected, but they are not interchangeable.
Term Sheet Establishes the Commercial Deal
The Term Sheet is usually the first detailed document negotiated between the startup and investor. It records the principal commercial terms on which the parties intend to proceed.
It commonly addresses:
- Proposed investment amount
- Pre-money or post-money valuation
- Percentage ownership
- Type of security
- Board representation
- Liquidation preference
- Anti-dilution rights
- ESOP treatment
- Reserved matters
- Founder commitments
- Exit expectations
- Conditions precedent
- Exclusivity and confidentiality
Most commercial provisions are generally intended to remain non-binding unless the document provides otherwise. Clauses relating to confidentiality, exclusivity, costs, governing law and dispute resolution may, however, be expressly binding.
Founders should therefore understand the Term Sheet before signing it. Although it may be described as non-binding, its commercial terms usually become the foundation for the SHA and SSA.
SHA Governs the Shareholder Relationship
The SHA governs the relationship between shareholders after the investment. It establishes the framework for corporate governance, transfers, investor protection and future exits.
A detailed SHA may contain provisions concerning:
- Board composition
- Voting rights
- Reserved matters
- Information rights
- Founder obligations
- Share transfers
- Tag-along and drag-along rights
- Anti-dilution protection
- Exit mechanisms
- Deadlock resolution
The agreement should also be examined alongside the AoA. If contractual rights are inconsistent with the company's constitutional documents, questions concerning their practical operation may arise.
The drafting of a shareholders' agreement in India should account for the startup's ownership structure, funding stage and existing shareholder rights. Its provisions should reflect the specific governance, economic and exit protections negotiated between the founders and investors.
SSA Records the Investment
The SSA documents the investor's commitment to subscribe to specified securities and the company's obligation to issue or allot those securities once agreed conditions are fulfilled.
It generally covers:
- Number and class of securities
- Subscription price
- Investment amount
- Conditions precedent
- Closing procedure
- Representations and warranties
- Covenants
- Indemnities
- Termination rights
- Regulatory obligations
The SSA is primarily transaction-focused, whereas the SHA governs the continuing shareholder relationship. The two documents should nevertheless use consistent definitions, ownership figures and commercial terms.
Drafting the Term Sheet Properly
Start With the Fully Diluted Cap Table
A founder should understand the proposed ownership structure before agreeing to valuation.
Suppose a startup has a pre-money valuation of ₹20 crore and an investor proposes an investment of ₹5 crore. The apparent post-money valuation is ₹25 crore, giving the investor 20% before considering other adjustments.
The result can change if an ESOP pool is created before the investment or if existing convertible securities are included in the fully diluted calculation.
The Term Sheet should therefore identify:
- Existing issued shares
- Existing options and ESOPs
- Convertible securities
- Proposed new securities
- Investor ownership
- Post-investment fully diluted ownership
A percentage without a clearly defined calculation methodology can create disagreement later.
Specify the Security Being Issued
The instrument selected for investment affects both legal and economic rights.
Institutional Indian startup transactions may use equity shares or preference shares, including CCPS where appropriate. If preference shares are proposed, the documents should clearly address conversion, voting, dividend and liquidation rights.
The conversion terms deserve particular attention. The agreement should identify the conversion ratio or mechanism, circumstances triggering conversion and how adjustments will be made following corporate actions or subsequent funding rounds.
Where a foreign investor is involved, the proposed instrument must also be assessed under the applicable FEMA framework and foreign investment rules. RBI's foreign investment framework regulates eligible instruments, pricing, reporting and related requirements. Transaction-specific compliance should be verified at the time of investment.
Negotiate Rights Alongside Valuation
A higher valuation does not automatically make a funding deal better for founders.
For example, accepting a higher valuation in exchange for extensive veto rights, aggressive liquidation preferences and broad anti-dilution protection may reduce founder flexibility and future fundraising options.
The Term Sheet should therefore be evaluated as a complete economic and governance package.
Drafting the SHA for Long-Term Governance
Reserved Matters Should Be Proportionate
Investors commonly require consent rights over decisions that could materially affect their investment.
These may include:
- Issuing additional securities
- Altering share capital
- Amending constitutional documents
- Taking significant borrowings
- Acquiring or selling substantial assets
- Entering material related-party transactions
- Mergers or restructuring
- Winding up the company
The difficulty arises when such provisions become too broad.
The need to obtain investors' approval for ordinary recruitment, expenses, customer agreements, or general business operations would be unnecessary. Still, reserved matters should safeguard investors' interests without giving them control over day-to-day business operations.
Board Rights Need a Practical Structure
The SHA should specify who can nominate directors, how vacancies are filled, how quorum operates and whether investors receive board observer rights.
It should also address what happens when:
- An investor's shareholding falls below a specified threshold
- An investor nominee resigns
- A founder leaves the company
- A subsequent funding round changes ownership
- A strategic investor acquires a substantial stake
Board rights that remain unchanged despite significant dilution can create governance problems during later funding rounds.
Founder Vesting Needs Detailed Drafting
Founder vesting protects investors if a key founder leaves prematurely, but it can substantially affect the founder's ownership.
A properly drafted clause should address:
- Vesting commencement date.
- Cliff period.
- Vesting frequency.
- Good-leaver events.
- Bad-leaver events.
- Treatment of vested shares.
- Treatment of unvested shares.
- Consequences of termination.
- Treatment following a change of control.
The agreement should clearly distinguish resignation, termination for cause, termination without cause, death, disability and other circumstances.
Change-of-control provisions also deserve attention. Founders should know whether vesting accelerates automatically following an acquisition or whether acceleration depends on subsequent termination.
ESOPs Can Change the Funding Economics
Investors often expect an ESOP pool to be available for future recruitment. The timing of its creation directly affects dilution.
Assume founders hold 100% of a company before a funding round and the investor requires a 10% ESOP pool on a post-investment basis. If the pool is created before the investor's ownership is calculated, the founders may bear most of the resulting dilution.
The Term Sheet should therefore state whether the ESOP pool is calculated:
- Before the investment
- After the investment
- On a fully diluted basis
This issue should be settled before the definitive documents are drafted because it directly affects the founders' effective ownership.
Liquidation Preference Needs Numerical Clarity
Liquidation preference determines how proceeds are distributed during an exit, liquidation or another specified event.
Consider an investor that invests ₹5 crore for 20% of the company. If the agreement provides a 1x non-participating preference, the investor may, depending on the exact drafting, choose between receiving its preference amount or participating according to its equity entitlement.
A participating preference can produce a different result because the investor may receive its preference first and then participate in the remaining proceeds.
The agreement should specify:
- Preference multiple
- Participating or non-participating structure
- Priority among different investor classes
- Conversion rights
- Events triggering the preference
- Distribution waterfall
The expression "1x preference" therefore does not provide enough information by itself. The complete distribution mechanism must be examined.
Anti-Dilution Provisions Need Limits
Anti-dilution protection becomes relevant when the company later issues securities at a lower valuation.
A full-ratchet mechanism can provide a significant adjustment to an investor's conversion economics. A weighted-average mechanism generally produces a different outcome by considering both the price and size of the new issuance.
Founders should examine:
- Triggering events
- Calculation formula
- Excluded issuances
- ESOP issuances
- Strategic investments
- Conversion adjustments
- Duration of protection
Broad anti-dilution provisions can complicate future fundraising if incoming investors face significant restrictions because of rights granted during an earlier round.
Transfer and Exit Rights Must Work Together
ROFO, ROFR, tag-along and drag-along provisions should be drafted as a coordinated transfer and exit framework.
A minority investor may want protection from being left behind when founders sell. At the same time, a majority investor may need the ability to complete a genuine acquisition without a small shareholder blocking the transaction.
The SHA should establish:
- Trigger thresholds
- Notice requirements
- Response periods
- Pricing rules
- Completion obligations
- Allocation of transaction expenses
- Treatment of competing offers
These provisions should also be reviewed against the company's likely future funding and ownership changes.
Drafting the SSA and Managing Closing
Conditions Precedent Should Be Objective
Investors may require certain matters to be completed before releasing funds.
These can include:
- Legal and financial due diligence
- Board approvals
- Shareholder approvals
- AoA amendments
- Intellectual property assignments
- Founder documentation
- Regulatory approvals
- Resolution of identified compliance issues
Each condition should have a clear completion standard. A vague condition can give rise to disagreement over whether closing requirements have actually been satisfied.
Warranties Should Be Supported by Records
Representations and warranties may address:
- Share ownership
- Corporate authority
- Financial statements
- Tax matters
- Intellectual property
- Material contracts
- Employment obligations
- Litigation
- Regulatory licences
Founders should verify material warranties against company records before signing.
If an issue has already been identified during due diligence, it should generally be disclosed appropriately rather than concealed behind an absolute warranty.
Indemnities Should Allocate Specific Risks
An indemnity should identify the loss covered, claim procedure, time limit, financial cap and applicable exclusions.
The agreement should distinguish between ordinary business risks and identified historical liabilities such as:
- Tax exposure
- Regulatory violations
- Ownership defects
- Intellectual property claims
- Undisclosed litigation
- Breaches specifically identified during due diligence
Clear risk allocation prevents the investor from receiving unlimited protection for ordinary business risks while preserving appropriate protection for genuine historical liabilities.
Seed and Series-A Funding Are Different
|
Issue |
Seed Funding |
Series-A Funding |
|
Documentation |
Usually simpler |
More detailed |
|
Governance |
Limited investor control |
More structured |
|
Due diligence |
Core compliance checks |
Broader review |
|
Investor rights |
Limited to moderate |
More extensive |
|
ESOP |
Initial pool often negotiated |
Expansion frequently considered |
|
Board rights |
May be limited |
Usually formalised |
|
Exit provisions |
May be basic |
More developed |
|
Reporting |
Relatively limited |
More structured |
The distinction is not absolute. The size of the investment, investor profile, existing cap table, sector and previous funding documents can substantially affect the final structure.
Indian Corporate Compliance Matters
The contractual documents must operate within the statutory framework governing the company.
Section 42 of the Companies Act, 2013 addresses private placement of securities, while Section 62 deals with further issue of share capital. Applicable corporate approvals, records and filings must be completed according to the transaction structure.
For an allotment, the company should plan the relevant approvals and post-allotment filings. The applicable return of allotment, statutory registers, share certificates and capital records should be updated as required.
The transaction file should therefore include, where applicable:
- Board resolutions
- Shareholder resolutions
- Subscription documentation
- Allotment records
- Updated cap table
- Statutory register updates
- Share certificates
- ROC filings
Where a non-resident investor participates, FEMA, the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 and applicable RBI reporting requirements should also be examined.
Due Diligence Should Start Early
Founders should conduct their own legal health check before investors begin formal due diligence.
The review should cover:
- Existing shareholding and previous funding documents.
- AoA and statutory records.
- Intellectual property ownership.
- Founder and employee agreements.
- Customer and supplier contracts.
- Licences and regulatory approvals.
- Litigation and legal notices.
- Tax and corporate filings.
- Outstanding loans and security interests.
- Existing investor rights.
One unresolved issue can become a condition precedent and delay closing.
For example, an Indian vendor breach of contract could become relevant to a funding round if the dispute creates a material liability or threatens a critical supply arrangement. The investor may then seek disclosure, remediation or an indemnity before completing the investment.
Commercial Contracts Can Affect Due Diligence
Investors examine material customer, vendor, technology and strategic agreements because these contracts may affect revenue, intellectual property and operational continuity.
When considering what types of commercial contracts are, founders should look beyond categories and examine whether important agreements clearly address:
- Scope of services
- Payment terms
- Intellectual property
- Confidentiality
- Termination
- Liability
- Indemnification
- Dispute resolution
- Governing law
Cross-border contracts require additional attention to governing law, jurisdiction, enforcement and arbitration. These considerations can become particularly important when structuring arrangements for international contract dispute resolution in India involving overseas customers, vendors or strategic partners.
Common Founder Mistakes
Founders should avoid these mistakes before signing:
- Negotiating valuation without analysing dilution.
- Accepting broad reserved matters.
- Failing to understand liquidation preference.
- Ignoring anti-dilution calculations.
- Creating an ESOP pool without understanding who bears dilution.
- Giving warranties without checking records.
- Leaving founder departure provisions unclear.
- Failing to align the SHA with the AoA.
- Ignoring rights granted to previous investors.
- Treating post-allotment compliance as an administrative formality.
The earlier legal review begins, the greater the opportunity to negotiate problematic provisions before they become part of the definitive documents.
Final Pre-Signing Checklist
Before executing the Term Sheet, SHA and SSA, founders should confirm that:
- The fully diluted cap table is accurate.
- Valuation and ownership percentages are clearly defined.
- The security and conversion terms are understood.
- ESOP treatment has been agreed.
- Liquidation preference is commercially acceptable.
- Anti-dilution protection has appropriate limits.
- Reserved matters are proportionate.
- Founder vesting provisions are clear.
- Board rights reflect the agreed ownership structure.
- Transfer and exit mechanisms are workable.
- SHA provisions align with the AoA.
- Representations and warranties have documentary support.
- Conditions precedent are achievable.
- Corporate and regulatory filings have been identified.
FAQs
What is the difference between an SHA and SSA?
The SHA governs the continuing relationship among shareholders, including governance, transfers and exit rights. The SSA records the investor's subscription for securities and the conditions under which the investment is completed.
Is a Term Sheet legally binding?
The commercial terms are often intended to be non-binding, but the actual effect depends on the language used. Confidentiality, exclusivity, costs and dispute-related provisions may be expressly binding.
Should founders negotiate the SHA before signing the Term Sheet?
Founders should understand the principal SHA rights before signing the Term Sheet because the Term Sheet usually becomes the basis for negotiating the definitive agreements.
What happens after an SSA is signed?
The parties complete the agreed conditions, the investor funds the subscription, securities are allotted, and the company completes applicable corporate records and statutory filings.
Why should startup funding documents be reviewed together?
Because the Term Sheet, SHA and SSA establish connected rights and obligations. An inconsistency in valuation, ownership, investor rights or closing conditions can create problems during the transaction or later funding rounds.
Build Your Startup’s Funding on a Strong Legal Foundation
Term Sheets, SHAs and SSAs should be treated as parts of one legal and commercial framework rather than documents prepared independently. The Term Sheet establishes the bargain, the SHA governs the continuing relationship between shareholders, and the SSA records the actual subscription and closing obligations. Their provisions must remain consistent with the Articles of Association and applicable corporate and foreign investment regulations.
For founders, the most important review points extend beyond valuation to dilution, CCPS terms, liquidation preference, anti-dilution protection, founder vesting, ESOPs, governance and exit rights. A transaction-specific legal review before signing can identify inconsistencies while there is still an opportunity to negotiate them and can provide a stronger legal foundation for the startup's next stage of growth.
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