FUTURECENTRAL PRESS · STUDY GUIDE SAMPLE
Venture Capital and Private Equity in India
Startup Financing, Deals, Contracts and Exits
Chapter 18: The Term Sheet I: Economics
Preference, participation, ratchets, and the price of downside protection
Study Guide Sample
The companion Study Guide supports revision and exam preparation. Each chapter guide contains a chapter summary, ten MCQs with an answer key, five short-answer questions with model answers, and three essay questions with frameworks, structural hints and pitfalls to avoid.
This sample includes the full chapter summary, four selected MCQs with answers, three short-answer questions with model answers, and two essay questions with hints.
Chapter summary
Every economic term in a venture term sheet is a rule for a range of exit values nobody in the room expects to see, which is why each is agreed in minutes and decides outcomes years later. Three variables define a liquidation preference. The multiple states how much the class receives before anything reaches the equity. Seniority states where it sits in the payment order. It is the variable founders miss: invisible above the total preference stack, decisive the moment proceeds fall short. Participation states whether the class also shares in what remains. Multiple and seniority decide a bad exit; participation decides how a good one is divided.
The total preference stack decides a bad outcome and appears in no term sheet. It is the sum of the preference amounts at their stated multiples, and no structure pays the equity a rupee below it. A capped participating structure can leave founders better off than plain one-times non-participating terms at a large exit, because the cap stops the investor while non-participating terms let it abandon the preference, convert, and take its whole percentage. Capped participation is also unstable at the top of the range, since each holder's best action depends on what the others decide.
Anti-dilution is three formulations whose names sit closer together than their effects. A full ratchet resets the earlier conversion price to the new round's price whatever the size of the issue; a weighted average resets it to a blend on a base including or excluding the option pool. Broad-based and narrow-based differ by a fraction of a point, while a weighted average costs the founders a little over two points and a full ratchet more than seventeen. Pay-to-play exists because an investor holding a strong ratchet may prefer to stand aside in a down round.
Multiple-choice questions
1. A company sells for ₹36 crore against a preference stack of ₹60 crore, made up of Series A at ₹30 crore, Series B at ₹20 crore, and Series C at ₹10 crore, with the most recent money ranking first. What does the Series A recover, and what would it recover on a pari passu arrangement?
Answer key: Question 1
Answer: D
2. At an exit well above the preference stack, a capped participating structure leaves the founders better off than plain one-times non-participating terms. What accounts for that?
Answer key: Question 2
Answer: A
3. An earlier investor paid ₹150 per share. A later round issues a small number of shares at ₹30. What does a full ratchet do, and why is that out of proportion?
Answer key: Question 3
Answer: C
4. Why does a pay-to-play provision exist at all?
Answer key: Question 4
Answer: C
Short-answer questions and model answers
1. Set out the three variables defining a liquidation preference and explain which of them decides a bad outcome.
Read the model answer
Model answer. The multiple states how much the class receives before anything flows to the equity, expressed as a multiple of the amount invested, and Indian rounds are predominantly written at one times. Seniority states where the class sits in the payment order relative to other preference classes. Under a pari passu arrangement all classes rank equally and each receives the same proportion of its claim where proceeds fall short. Under stacked seniority the classes are paid in reverse order of investment, so the most recent money is paid first. Participation states whether the class also shares in the residue. The multiple and the seniority decide a bad exit, because they determine how a shortfall is divided. Participation decides only how a good outcome is divided, since it operates on a residue that exists only above the stack.
2. Explain the total preference stack and why it is the most important number in a term sheet.
Read the model answer
Model answer. It is the sum of the preference amounts across all classes at their stated multiples. Below that figure the equity shares receive nothing, whatever structure the parties agreed, so it is the floor of the founders' economic interest and the value below which an option pool retains nobody. It appears nowhere in the term sheet. Every figure needed to compute it does. The ratio that matters is the stack against what the company would realistically sell for today. A company carrying ₹45 crore of preference with a realistic sale value of ₹28 crore has worthless common equity, and every conversation with founders and employees should start from that fact. Naming the number out loud changes the tenor of a negotiation more than any other single figure.
3. Set out the three anti-dilution formulations and state what each costs the founders.
Read the model answer
Model answer. A full ratchet resets the earlier investor's conversion price to the price of the new round without regard to how small that round is, so a single share issued lower triggers the adjustment in full. Broad-based weighted average resets the price to a weighted average of the old and new prices, with the weights reflecting the size of the new issue against the existing fully diluted capital including the option pool. Narrow-based weighted average applies the same formula on a smaller denominator that excludes the pool, producing a slightly lower adjusted price and slightly more shares for the protected investor. On a steep down round the two weighted average variants cost the founders a little over two percentage points. They differ by a fraction of one point. A full ratchet on the same facts can cost seventeen points and turn a minority holding into a controlling one.
Long-answer questions and essay hints
1. A founder is offered two term sheets. The first is ₹120 crore pre-money with participating preferred and a full ratchet. The second is ₹95 crore pre-money with a one-times non-participating preference and broad-based weighted average anti-dilution. Model both against a company carrying an existing preference stack, identify the exit value above which the founder prefers the lower-valuation offer, and set out how you would present the comparison to the founder. (600–900 words)
Read the essay hints
Frameworks to deploy. The Preference Stack, resolved in seniority order with each class re-tested against the residue it actually faces; and the Downside Test, run at all four of its exit values under both structures.
Structural beats.
Open by building the grid before arguing anything, since the two offers cannot be compared by inspection.
Work the downside range first, and state what each structure does at and below the total preference stack.
Work the upside, and identify the crossover explicitly, showing why participation and the ratchet behave differently as the exit grows.
Quantify the ratchet separately, since its damage falls on a down round, which the exit grid does not reach.
Close on presentation: say how you would put the comparison to the founder so the higher headline stops doing the arguing.
Pitfall to avoid. Comparing the two on the exit grid alone. The ratchet operates on a subsequent down round, and the exit is not where it bites, so an answer that models only the waterfall has priced one of the two provisions the first offer actually turns on.
2. A full ratchet on one company's facts costs the founders 17.41 percentage points and moves the investor from a minority holding to a controlling one on a ₹10 crore investment, while a weighted average costs them 2.23 points. Construct the strongest case an investor could make for a full ratchet, then assess it. (600–900 words)
Read the essay hints
Frameworks to deploy. The three anti-dilution formulations and their modeled effects in Section 18.3; the carve-out list, which is where the real negotiation happens; and the interaction with the option pool at the moment of a down round.
Structural beats.
Open by stating the investor's case at its strongest, in terms of what the ratchet is protecting against.
Give the argument its best evidence, including the circumstances in which a company would concede one.
Turn to the assessment, and confront the disproportion between a small issue and a total reset.
Bring in the retention consequence, since the ratchet dilutes the pool when the company can least afford to lose people.
Close by stating what an investor should ask for instead, and whether the carve-out list can do the work the ratchet was for.
Pitfall to avoid. Dismissing the ratchet as indefensible because the number is large. The question asks for the strongest case first, and an essay that argues only one side has not tested its own conclusion against the position it is rejecting.