Term Sheet Red Flags for Indian Founders

Is a term sheet legally binding in India?

Mostly not, by design. Under Section 10 of the Indian Contract Act, 1872, an agreement is a contract if it is made by free consent of competent parties for a lawful consideration and object. Whether parties intended to be bound is a question of the document as a whole, and a term sheet that says its commercial terms are non-binding and subject to definitive agreements will usually be read that way. Section 29 adds that agreements whose meaning is not certain, or capable of being made certain, are void, and many term sheet terms are deliberately left to be finalised.

The exception is the clauses the term sheet itself says are binding. These typically include exclusivity, confidentiality, costs, governing law and dispute resolution. They are enforceable in the ordinary way, and they apply even if the deal never closes.

In practice, the non-binding parts bind you commercially. Once a founder agrees a liquidation preference or a vesting schedule in the term sheet, reopening it in the definitive documents is treated as a renegotiation and carries relationship cost.

How does liquidation preference work?

A liquidation preference determines what the investor receives before ordinary shareholders on an exit, which usually includes a sale of the company as well as a winding up. A 1x non-participating preference means the investor takes the greater of its money back or its pro-rata share. A participating preference means it takes its money back and then also shares in the remainder.

The difference is invisible in a large exit and decisive in a modest one, which is the more likely scenario. Take an investor that puts in ₹10 crore for 25% at a ₹40 crore post-money valuation. The table shows what happens at three exit values, ignoring other preferences and costs.

Reading the liquidation preference table

At a ₹30 crore exit, the participating structure moves ₹5 crore from founders, employees and earlier investors to the new investor. At ₹200 crore the difference is ₹7.5 crore but a much smaller share of the total. That is why a founder should model a sale at two or three times the post-money valuation rather than at ten, because that is where the structure actually bites.

Watch also for multiples above 1x, such as a 2x preference, and for stacking, where each later round's preference sits above the earlier ones. Both are more common in difficult markets. If a participating preference is unavoidable, ask for a cap, for example that participation stops once the investor has received three times its investment.

Finally, read the definition of a liquidation event. It usually includes a sale of the company, a sale of substantially all its assets, a merger in which existing shareholders lose control, and sometimes an exclusive licence of key intellectual property. A broad definition means the preference applies to more transactions than a winding up.

Anti-dilution: weighted average or full ratchet?

Anti-dilution protects the investor if a later round prices shares below what it paid. In Indian deals it usually works by adjusting the conversion ratio of compulsorily convertible preference shares, so the investor receives more equity shares on conversion.

Broad-based weighted average is the common and more balanced formulation. Full ratchet reprices the earlier investment as though it had been made at the lower price. A worked example shows the gap. An investor bought at ₹100 per share. The company has 10,00,000 shares on a fully diluted basis and later raises ₹5 crore at ₹50 per share, issuing 10,00,000 new shares. Under full ratchet, the earlier conversion price falls to ₹50, doubling the investor's shares. Under broad-based weighted average, the new price is ₹100 multiplied by (10,00,000 + 5,00,000) divided by (10,00,000 + 10,00,000), which is ₹75. The ₹5 crore would have bought 5,00,000 shares at the old price, which is where that figure comes from.

Full ratchet transfers a great deal of value away from founders and employees in exactly the situation where the company is already struggling. Where the investor is non-resident, foreign exchange rules generally require the conversion price or formula to be fixed upfront at issue and not to result in a price below fair value at the time of issue, which affects how aggressive an adjustment can be.

The clauses that bind even when the term sheet does not

Exclusivity deserves the closest reading. A ninety-day no-shop with no fixed end date, or one that extends automatically while diligence continues, takes you off the market during the period when a competing offer is most valuable. Ask for a fixed period, commonly 45 to 60 days, that ends early if the investor withdraws or materially changes the terms.

Expense reimbursement obligations that survive a failed deal are worth capping. An uncapped obligation to pay investor counsel on a transaction that never closes is a real exposure for an early-stage company. A cap, for example ₹5 lakh or a small percentage of the round, payable only on closing, is a common compromise.

Founder terms hidden in the term sheet

Term sheets increasingly include founder obligations: vesting or re-vesting of existing shares, leaver definitions, full-time commitment, lock-in on selling shares, and non-compete and non-solicit covenants. These are personal to you and survive long after the round.

On non-competes, note that Section 27 of the Indian Contract Act, 1872 makes agreements in restraint of a lawful trade or profession void, subject to exceptions, including one for a seller of goodwill who agrees to refrain from carrying on a similar business within specified local limits. Restrictions during your time with the company are generally treated differently from restrictions after you leave, and a broad post-exit non-compete for a founder who has not sold their shares may be difficult to enforce. Do not rely on that: negotiate a reasonable scope at term sheet stage.

Red flags at a glance

The India-specific layer

Where an investor is non-resident, the investment engages the Foreign Exchange Management Act, 1999 and the Foreign Exchange Management (Non-debt Instruments) Rules, 2019, which include pricing guidelines and reporting requirements. Instruments matter: equity shares and compulsorily convertible preference shares or debentures count as equity, while optionally convertible instruments are treated as debt under a different regime. That is why Indian venture rounds are usually done through compulsorily convertible preference shares.

Constructs common in offshore term sheets, particularly assured returns or an unconditional right to exit at a pre-agreed price, sit uneasily with those rules. Domestic company law also applies: issuing shares to investors involves the private placement and preferential allotment procedures in Sections 42 and 62 of the Companies Act, 2013, which need valuation, shareholder approval and filings, and those timelines should be built into the closing plan.

This is an area where requirements change and the application is fact-specific, so treat it as a prompt to take advice rather than something to resolve from a general article.

What should you do after receiving a term sheet?

• Read the binding clauses first: exclusivity, confidentiality, costs, governing law and dispute resolution. These apply from the day you sign.
• Build a simple exit table with three exit values, using the actual preference, participation and any multiple in the draft.
• Run the anti-dilution formula against a hypothetical down round at half the current price.
• List every founder obligation: vesting, leaver terms, lock-in, non-compete, full-time commitment.
• Check whether each investor is resident or non-resident, and whether any is from a country sharing a land border with India, since that changes the approval route.
• Mark the reserved matters that are operational rather than protective.
• Send one consolidated set of comments, prioritised, rather than a series of separate emails.
• Only then sign, and diarise the exclusivity end date.

Reading order

Founders read valuation first, which is natural and slightly misleading. The terms that determine outcomes are, roughly in order: liquidation preference structure, anti-dilution formulation, the reserved matters list, founder vesting and leaver definitions, board composition, and exclusivity.

A higher valuation with a participating preference and full ratchet can be worth less to you than a lower valuation on clean terms. Before signing, run the exit table above with your own numbers for each competing offer, and discuss it with someone who has seen both structures play out.