Understanding Conversion and Dividend Rights In Early-Stage Investments - A Simple Guide for First-Time Founders

Editorial
Feb 3
5 min read

This article was written by Karthik Jayakumar, Partner.

When early-stage founders raise capital in India, especially through instruments like compulsorily convertible preference shares (CCPS) or compulsorily convertible debentures (CCDs), they often encounter two terms that shape the economics of the deal: conversion rights and dividend rights (not relevant for CCDs). Despite appearing technical, these rights influence how much of your company an investor ultimately owns and how they may receive returns along the way. This note breaks down the fundamentals in plain language, helping founders understand why these clauses matter, how they work, and what to watch out for during negotiations.

Why do conversion and dividend rights exist? - Context for India

Most institutional investors in India – angel networks, accelerators, venture capital funds, family offices – usually invest through preference shares, not ordinary equity shares. CCPS are preferred because they:

Come with contractual protections (preferential rights that attach better to preferred shares)
Allow delayed ownership determination (conversion at a later financing round or event)
Are compliant with RBI pricing guidelines when investing from overseas

Along with the preference instrument come various commercial rights. Among the most important are conversion and dividend rights - they dictate when and how CCPS will convert into equity shares, and whether investors receive dividends before or instead of common shareholders.

Part I - Conversion rights

Conversion rights define the process and terms by which preference shares convert into equity shares. Conversion matters because equity shares are what ultimately give investors voting power and ownership percentage.

1. What does conversion mean, in a practical sense?

Imagine you issue 1,000 CCPS to a VC. These CCPS are not counted as equity today. Later, at a defined point - say, your Series A round - they convert into equity shares (example: 1 CCPS = 1 equity share). After conversion, the VC appears on your cap table as a shareholder holding ordinary equity, meaning:

Their percentage ownership becomes clear
They receive voting rights equivalent to other equity shareholders
They participate in future exits and distributions like any other shareholder

Until conversion, it is as though the investor is “waiting outside the main shareholder room” but holding a ticket to enter with negotiated terms.

2. When does conversion happen? - trigger events

A typical term sheet defines a conversion trigger, often one of:

Trigger Event	Meaning
Qualified Financing	A future round above a minimum size (e.g., ₹5 crore Series A)
Time-based conversion	Conversion after a fixed period (commonly 20 years under the applicable law as it is on the day of writing this article, though contractually earlier conversion is typical)
IPO / Exit Event	Conversion before a sale, merger, or listing
Investor Optional Conversion	Investor may ask for early conversion

For founders, clarity on timing matters - converting too early may distort valuations and cap-table planning; converting too late may confuse governance.

3. Conversion ratio – what determines the final equity?

The conversion ratio determines how many equity shares a CCPS becomes. The simplest form is 1:1 (one CCPS converts into one equity share).

But term sheets may include:

Adjustments for valuation changes
Anti-dilution adjustments (covered in our previous article)
Different classes of equity at conversion

Illustration

Assume:

Investor buys CCPS worth ₹1 crore at a ₹10 crore pre-money valuation
Post-money valuation = ₹11 crore
Conversion ratio = 1:1

Investor ownership after conversion = 1 crore ÷ 11 crore = ~9.09%

But if anti-dilution later adjusts conversion to 1:1.5, the same investor would convert into more equity shares — increasing ownership.

4. Why conversion terms matter for founders

Conversion terms directly influence:

Future dilution
Control over voting
ESOP pool expansion needs
Future round negotiations

A small tweak in conversion mechanics today may cost several percentage points of dilution tomorrow — so founders should insist on simple ratios and conversion only upon qualified financing or exit unless otherwise negotiated.

Part II - Dividend rights

Dividend rights relate to whether preference shareholders receive payments before ordinary equity holders, and how much.

Although early-stage startups rarely generate distributable profits (hence dividends are uncommon), investors include dividend rights because:

They act as a return mechanic in case conversion is delayed
They provide priority in liquidation or distribution events

Types of dividend rights

Indian term sheets typically include one of the following:

Type of Dividend	Meaning	Example
Non-cumulative dividend (most common in VC deals)	Dividend may be declared by board; if unpaid in a year, it doesn’t accumulate	If 8% declared in Year 1 but startup can’t pay, there is no carry-forward
Cumulative dividend	Dividend accrues annually until paid; dangerous for cash-light startups	If 8% cumulative on ₹1 crore for 3 years, payout obligation = ₹24 lakh
Participating dividend	Preference holders receive dividends and share dividends with equity (rare in India)	Investor gets 8% preference + % of common dividend
Non-participating dividend	Investor only gets preference dividend; if they convert, they lose dividend right	Once converted, they participate equally

Illustrative scenario - non-cumulative vs. cumulative

Startup issues CCPS of ₹2 crore with 8% dividend.

Year	Company Profit?	Non-cumulative payout	Cumulative payout
1	No profit	₹0	₹16 lakh accrues
2	₹40 lakh profit	Only if declared	Pay ₹16 lakh + ₹16 lakh = ₹32 lakh

Cumulative dividends can create crippling obligations when a startup becomes marginally profitable - hence founders should avoid cumulative terms.

How dividends interact with conversion

A key question in drafting is: Do dividend rights survive conversion?

Once converted into equity, preference dividend rights fall away
Investor then receives dividends only like any other shareholder, if declared

Ensure this is explicitly written into documents to avoid double-benefit scenarios (the enforceability of which is a separate question that we have not analysed in this note.

Pulling it all together — what should founders ask for?

Before signing a term sheet, a founder should ensure clarity on:

For conversion

1. When will conversion occur?

2. What is the conversion ratio, and can it change?

3. Is conversion automatic or optional?

4. Does conversion affect voting or board rights?

5. Will ESOP pool expansion dilute conversion numbers?

For dividends

1. Is the dividend cumulative or non-cumulative?

2. What percentage is specified? (General early stage investments in India typically carry a very low rate of interest, most often, nominal – as startup investing isn’t turned to for a ‘dividend play’)

3. Do dividends accrue until exit or disappear upon conversion?

4. Will unpaid dividends affect liquidation preferences?

A good thumb rule to bear in mind: Early-stage startup investments should be clean and founder-friendly. Simpler terms attract more capital later. Many a time, founders think that offering preferential terms on dividend or conversion can keep then in the good books of an investor early on – but could come back to haunt the grander scheme.

Closing thoughts

Conversion and dividend rights are often seen as minor clauses buried deep within a term sheet, but they shape the investor’s eventual return and your long-term equity position. While most investors do not intend to exploit these terms unfairly, ambiguity benefits the stronger party - and in early-stage deals, that is seldom the founder.

Understanding these mechanics ensures that: