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Decoding the Term Sheet: Chapter IV (The Restrictive Clauses)

If a company is not doing as well as expected and ends up issuing common stock at a price lower than the issue price of Preferred Stock (known as a down round), the original investor’s shares will be diluted or less than what was paid for them.

This is our fourth chapter on Decoding the Term Sheet and through this series, we have tried to help startups understand and negotiate a venture capital term sheet. So far barring a few, most of the topics we have covered, impact the everyday functioning of a business. This part is about restrictive clauses which are triggered in exceptional circumstances and how founders and investors can protect their interests.


Drag along provision comes into play when the major stockholders decide to sell their stake to a third party. The stockholders with this right (mostly major stockholders) can compel (or drag) the minority stockholders including founders and smaller investors or angels to sell their stake on the same terms and conditions that they are receiving from the buyer. This clause is most likely to get triggered when the buyer is interested in buying 100% of the company instead of just the majority stockholder’s stake to avoid the complication of having to deal with potentially uncooperative minority stockholders later. This may also happen when founders fail to provide promised exit to the investors and in such a case investors must look for some workaround for their money and return. Sometimes called the “squeeze out” provision, the investors perceive this as an important protection, when they are seeking liquidity or an exit route.

Drag along also applies in case of merger or other liquidation events and ceases when the company goes for an IPO. There can be a few variations to this provision, such as the third-party offer must meet a minimum agreed price or minimum time frame to trigger drag along. Also, another variation has recently been seen where a drag along provision pertains to following the majority of the common stock and not the preferred – practically drag along is defined by the terms negotiated more than the shareholding of the company but often it favours majority stakeholders. The form in which this provision will appear in your term sheet and agreements depends on how you negotiate the deal with your investors. Consider the illustration below:

The holders of the Common Stock or Founders shall be required to get into a drag along agreement with the holders of Series A Preferred whereby if a majority of the holders of Series A Preferred agree to a sale or liquidation of the company, the holders of the remaining Series A Preferred and Common Stock shall consent to the transaction.

Tag Along, as a concept, is the converse of the drag along provision and gives the stockholders (usually minority) of the company, the right to be tagged along on the same terms and conditions as the majority stockholders in case the latter are selling their stake to a third party. This right is important to minority stockholders so that they can sell their stake along with the majority stockholders without being forced to work with the new majority owner against their will. Most of the initial/ angel investors take advantage of Tag Along to exit the deal.


If a company is not doing as well as expected and ends up issuing common stock at a price lower than the issue price of Preferred Stock (known as a down round), the original investor’s shares will be diluted or less than what was paid for them. Anti-dilution protects investors from dilution in a down round either by issuing them additional shares or by lowering the conversion price of the existing preferred stock so that each preferred stock can convert into more common stock.

Anti -dilution provision can be of two types:

Full ratchet: It sets the conversion price of the investor’s existing preferred shares or convertible debentures in relation to the price of the new round of shares, regardless of how many new shares are issued. This provision is also applicable in the case where investors or stockholders are holding ordinary class of shares. Let’s consider an example: In the last round of financing an investor paid $1 each for 100 preferred shares. In the new round, the company just needs a little cash, so is issuing just one share, for $0.50. In a full ratchet scenario, the issuance of that single share will lower the conversion price of each of the investor’s existing 100 shares from $1 to $0.50. He can now convert to twice as many common shares as before. As a result, the common shareholders are significantly diluted just because they issued a single new share. In practice, full ratchet provision is rarely present in term sheets since most founder consider it detrimental to their interests.

Weighted average: It is considered more moderate and reasonable since the weighted average formula considers the share price of the new issuance as well as the number of shares issued. In the above example, since the number of shares issued is less, the adjustment to the conversion price is also less. Weighted average anti-dilution provision has two variants: broad based and narrow based. The broad-based method is based on a consideration of the fully diluted capital stock of the company i.e. it assumes conversion of all preferred stock, warrants, stock options and other convertible securities/debentures. In case of narrow based, convertible securities are not taken into consideration.


As our readers are now aware, investors are usually issued preferred stock, which differs from common stock due to the rights associated with it, conversion being a key right. Conversion is also important to understand in case of issuance of convertible debentures that convert at an agreed discounted price of a future qualified equity round or any other triggering event.
A conversion right is the right to convert preferred stock into common stock. It allows the holder of the preferred, to convert to common, should he perceive he stands to gain from getting paid on a pro-rata common basis instead of the liquidity preference and participating amount. Conversion rights can be of two types:

Automatic or Mandatory Conversion:
All of the preferred stock gets automatically converted to common at the applicable conversion rate. A typical sample may look like:

All of the Series A Preferred shall be automatically converted into Common Stock, at the then applicable conversion rate, upon (i) the closing of a [firm commitment] underwritten public offering of Common Stock at a price per share not less than {X} times the Original Purchase Price (subject to adjustments for stock dividends, splits, combinations and similar events) and [net/gross] proceeds to the Company of not less than $_______ ; or (ii) the written consent of the holders of ___% of the Series A Preferred.”

The threshold of the automatic conversion is critical to both founders and investors and worth negotiating as entrepreneurs would want it lower for more flexibility while investors would want them higher to be able to control the timing and terms of an IPO.

Optional Conversion:

The holder of preferred stock may choose to convert his shares initially on a one-to-one basis. This right is related to the investor’s liquidation preference. For example, let’s assume that the Series A investor has a $5 million, non-participating liquidation preference (with a 2x multiple) representing 30 percent of the outstanding shares of the company, and the company is sold for $100 million. The investor would thus be entitled to the first $10 million pursuant to its liquidation preference, and the remaining $90 million would be distributed pro rata to the common stockholders. If the investor chooses to exercise his Optional Conversion right, converting preferred stock to common, waiving off the liquidity preference, he would receive $30 million.


A dividend is the distribution of the firm’s profits to its shareholders, in the form of cash or stock. For a startup, in the early stages, there is usually no profits or cash to distribute. Stock dividends are usually not viewed favourably by founders due to their dilutive effect. There are two types of dividends: cumulative and non-cumulative.

Cumulative Dividend: The dividend is calculated for each fiscal year and the right to receive the dividend is carried forward, i.e. accumulated unless paid or until the right is terminated. Investors sometimes seek compounding in case of cumulative dividend.

Non-cumulative Dividend:
If the Board of Directors does not declare a dividend during a particular fiscal year, dividend does not carry forward and becomes null for the year.

In reality, cumulative dividend is relatively rare and less than 10% of Term Sheets have them. However, investors sometimes push to have some sort of cumulative dividend as a protective device to provide a minimum annual rate of return on their investment, which is tied-into their liquidation preference.


A restriction on sales provision is a right of first refusal (also known as RoFR) for the sale of stock by an existing stockholder. If a founder wants to sell stock on a secondary market, a typical restriction on sales provision would enable first the company, and then other (preferred) shareholders, the right to purchase that stock. A restriction of sale clause may read like:

Restrictions on Sales: The Company’s Bylaws shall contain a right of first refusal on all transfers of Common Stock, subject to normal exceptions. If the Company elects not to exercise its right, the Company shall assign its right to the Investors.”

It is customary to have most of these terms in the term sheet as they are standard and not worth negotiating too much.


Atal Malviya

Atal Malviya is the Chief Executive Officer of – India’s first European Accelerator. Atal is a successful entrepreneur and an angel investor based out of London. He has founded and exited VC funded technology startups and invested in handful of technology startups in Europe and India. He writes and speaks about Tech Startups, Startups investment, Accelerators and Incubators, Tech innovations and Big data analytics.

Swati Suramya

She is Content Manager at Swati has joined Spark10 Blore last month from Goldman Sachs.

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