What founders should actually understand before taking outside money

When a private company raises money from an investor, it does not borrow — it sells new ownership. The company issues fresh shares, the investor pays cash for them, and everyone who owned shares before now owns a smaller share of a bigger company. Three things decide whether that trade is good or bad for the founder: the price at which the shares are issued (valuation), how much of the company goes across (dilution), and what rights travel with those shares (the agreement). Most founders spend ninety percent of their energy on the first, and it is usually the third that decides who really runs the business five years later.

The price is not a fact. It is a negotiated number with a paper trail.

There is no market price for a private company. So the price gets built, not discovered. In practice three approaches are used, usually together. The first looks at what the business is expected to earn in future and discounts those future rupees back to today’s value — sensible for a company with predictable cash flows, close to useless for a two-year-old company whose forecast is a hope with a spreadsheet around it. The second looks at what similar listed companies trade at, or what similar private companies were recently bought at, and applies that multiple to your revenue or profit. The third, common in early-stage deals, is essentially a market rate for the stage — a number the investor is willing to pay for that kind of business at that kind of traction, then reverse-engineered into a justification.

Whatever method is used, the law requires the number to be supported. For a private company issuing shares to a new investor, the price has to be backed by a valuation report from a registered valuer under the Companies Act. If the money is coming from outside the country, exchange control rules add a second condition: the price cannot be below fair value calculated using an internationally accepted pricing method and certified by a chartered accountant or merchant banker. If a resident is selling to a non-resident, the direction flips — the price cannot be above fair value. The principle behind both is the same: money should not leave or enter the country disguised as a bad share deal.

A tax point worth knowing. For years, if a company issued shares above fair value, the excess was taxed in the company’s hands — the so-called angel tax. That provision has been removed. But the mirror provision still lives: if shares are issued below fair value, the investor can be taxed on the bargain. So the valuation report is not paperwork for the file. It is the defence for both sides.

Two words to keep straight, because entire negotiations turn on them. Pre-money is what the business is agreed to be worth before the cheque lands. Post-money is pre-money plus the cheque. The investor’s percentage is always calculated on post-money. “We valued you at fifty crore” means very different things depending on which one the investor meant.

How much of the company actually goes across

The arithmetic is simple and worth doing by hand once. Say the company has 10,00,000 shares of ₹10 face value, all held by two founders. The pre-money value is agreed at ₹40 crore, which makes each share worth ₹400. An investor puts in ₹10 crore. At ₹400 a share, that buys 2,50,000 new shares. The company now has 12,50,000 shares, of which the investor holds 2,50,000 — twenty percent. Post-money value is ₹50 crore. The founders still hold every share they held yesterday; they simply hold eighty percent of the company instead of a hundred.

That last sentence is the whole idea. Dilution does not take shares away from you. It reduces the fraction those shares represent, in exchange for the company being worth more. Owning eighty percent of ₹50 crore beats owning a hundred percent of ₹40 crore. Dilution is only a loss when the money raised does not create more value than the ownership given up.

How much is normal? A first institutional round typically moves fifteen to twenty-five percent. Below ten percent and the investor rarely feels invested enough to be useful. Above thirty percent in an early round and the founder has a problem later — after two or three more rounds and an employee stock pool, the founding team can find itself under a quarter of the company while still being the only reason it exists. The right question is never “what percentage do I give this round” but “what does my ownership look like after the three rounds I expect to need”.

Share premium: where most of the money actually sits

In that example the shares had a face value of ₹10 and were issued at ₹400. The ₹10 is share capital. The remaining ₹390 per share — ₹9.75 crore of the ₹10 crore raised — is share premium, and it sits in a separate reserve on the balance sheet.

This matters more than it looks. Premium is not profit, and it cannot be paid out as dividend. It is restricted money: it can be used to issue bonus shares, to write off the expenses of the issue, or in a buyback, and not much else. It is also why raising money never improves your profit and loss account — a large fundraise makes the balance sheet look strong while the profit line stays exactly where it was. Founders who confuse the two end up spending like a profitable company. Also worth noting: the face value is a legal minimum, not a valuation. Shares can be issued far above face value, never below it.

The mechanics around the issue are unforgiving on timing. A private placement runs through a formal offer letter to named persons, money received only through banking channels into a separate account, allotment within sixty days of receiving the money, and the return of allotment filed on time. Miss the sixty days and the company must refund within fifteen days or start paying interest. This is the part that gets ignored in the excitement and shows up as a problem in the next round’s due diligence.

The agreement is where control actually changes hands

A twenty percent shareholder cannot outvote you. But a twenty percent shareholder with a well-drafted shareholders’ agreement can stop you doing almost anything that matters. The agreement, and the articles of association that mirror it, are where the real negotiation lives.

Reserved matters are the heart of it. This is a list of decisions the company cannot take without the investor’s written consent regardless of shareholding — issuing new shares, borrowing above a limit, selling the business, changing the line of business, related party transactions, senior hires above a salary threshold, annual budget approval. A short, sensible list protects the investor from being cheated. A long, loose list means the founder needs permission to run the company. Negotiate this line by line; it is the single most valuable hour in the entire deal.

Transfer restrictions cut both ways. A right of first refusal means you must offer your shares to the investor before selling to an outsider. A tag-along right lets the investor sell alongside you on the same terms if you exit — fair, and rarely contested. A drag-along right lets the investor, in defined circumstances, force you to sell your shares in a sale of the company. Tag protects the minority. Drag can strip a founder of a business he built. Watch the threshold that triggers it and the minimum price it must be exercised at.

Downside protection comes in two common forms. A liquidation preference says that on a sale, the investor gets his money back before anyone else shares in the proceeds — one time the amount invested, non-participating, is the reasonable standard. Anything richer means that in a modest exit the founder gets little. An anti-dilution clause protects the investor if the next round is priced lower than this one, by giving him extra shares to restore his effective price. There is a broad-based weighted average version, which adjusts partially and is fair, and a full ratchet version, which reprices his entire holding as though he had come in at the lower price and can be brutal for founders. Push hard for the first.

Founder-side terms run the other way and are usually reasonable. Expect a lock-in on your own shares, a commitment to work full-time, a non-compete, and vesting of a portion of your holding over three or four years. These exist because the investor is buying the team as much as the business.

The board is not a formality

Most rounds come with a board seat, or at least an observer who attends without voting. Once appointed, the character of the board changes. Directors owe their duty to the company, not to whoever nominated them — that is the legal position, and it is a genuinely useful one to remind everyone of when a nominee starts behaving like a representative. Practically, watch the quorum clause: if a valid meeting requires the investor director to be present, that director can stall the company by simply not turning up. Ask for a fallback — if a meeting is adjourned for want of the investor director, the reconvened meeting proceeds without him.

The board is also where the useful part of the relationship lives. A good investor director brings pattern recognition from twenty other companies, opens doors, and asks the question nobody internally will ask. Treat the board pack as a management discipline rather than a compliance chore and the round pays for itself twice.

Every round after this one dilutes you again

The mistake founders make is treating dilution as a single event. It is a sequence. Three things will reduce your ownership after this round, and all three are foreseeable today.

The first is the employee stock pool. Investors almost always ask that a pool of ten to fifteen percent be created for employees — and they usually ask that it be carved out before the investment, out of the pre-money value. That means existing shareholders alone bear it, and the investor’s stated percentage is effectively higher than the headline. Ask for the pool to be created post-money, or at least share the burden. This one clause is often worth more than a few crores of valuation.

The second is the next round itself, and the one after that. Each new investor buys new shares, and everyone existing shrinks proportionately. If you hold eighty percent after this round and expect two more rounds at twenty percent each, you are heading for roughly fifty percent before the pool is even counted. Model it now, on one sheet, and decide whether the path is acceptable.

The third is conversion. Much of the money in private companies comes in as compulsorily convertible preference shares or convertible debentures rather than plain equity, partly because exchange control rules treat only fully and compulsorily convertible instruments as equity, and partly because preference shares carry the protective terms more naturally. These sit quietly on the cap table until they convert — and the conversion ratio can move if there is an anti-dilution adjustment or a milestone clause. Any instrument that converts must be shown in your fully diluted cap table from day one, not on the day it converts.

Two defences are worth negotiating for. A pro-rata right lets you, not just the investor, participate in future rounds to maintain your percentage — useful once founders have personal liquidity. And simple cap table hygiene: one authoritative sheet, updated at every issue, showing every share, option and convertible instrument on a fully diluted basis. A messy cap table costs real money in the next round’s diligence and has killed deals outright.

The short version

Take the money for what it buys, not for the number in the press release. A high valuation with a full ratchet, a three-times participating preference and a twenty-item reserved matters list is a worse deal than a modest valuation with clean terms. Do the dilution arithmetic three rounds out before you sign this one. Read the reserved matters list yourself — not just your lawyer. And remember that the investor is buying a relationship of seven to ten years, which means the terms you find slightly annoying today are the ones you will live with through every difficult decision ahead.

This is a general explanation, not advice on any specific transaction. The provisions referred to change, and the right structure depends entirely on the facts. Take proper legal, tax and valuation advice before you issue a single share.

How SRC can help

We work with founders on both sides of the table — the arithmetic and the paperwork. On the numbers, we build the valuation, prepare or review the valuer’s report, model the cap table three rounds forward so you can see where your ownership actually lands, and stress-test the price against what the terms are really worth. On the documentation, we review the term sheet and the shareholders’ agreement clause by clause — reserved matters, preference, anti-dilution, drag, vesting — and tell you plainly which lines to fight for and which to concede. We then run the issue itself end to end: instrument selection, board and shareholder approvals, the private placement offer, the sixty-day allotment window, the filings, and the tax position for both the company and the investor.

If you are heading into a round, the cheapest hour you will ever spend is the one before you sign the term sheet. Talk to us then, not after.