Why do Startup Investors favor CCPS over Equity Shares?

Behind every venture funding news that you come across, if you look deeper, you will find one thing common in almost all deals - startups issue Compulsorily Convertible Preference Shares (CCPS) to investors, and not equity shares. Your instant thought could be that this must be for convertible rounds where the valuation is unknown and dependent on the next fundraise. However, this is also true for the priced rounds i.e. where the valuation is known and agreed upon. In such cases, the conversion clause usually says that the CCPS are convertible into equity in 1:1 ratio. Naturally, most founders raising their first institutional funding have this question -

Why is CCPS issued, and why not straight away issue Equity Shares if the conversion ratio is 1:1?

In India (and globally), CCPS are preferred over straight equity shares in venture rounds because they give investors a standard “rights stack” that common equity can’t offer, while still ending up as equity on conversion. Some of the most important rights that make CCPS more favored over equity shares are:

1. Anti-dilution (ratchets): If a later funding round happens at a lower price, the conversion price of the CCPS is often made to adjust through an anti-dilution clause so investors are either entirely protected from dilution in their stakes, or they are not diluted as harshly. Explained in detail below.

2. Downside protection: During stressed liquidity events i.e. a distress sale or a wind-down, CCPS carry a liquidation preference (in India - typically 1× non-participating) over equity shares, so CCPS investors get their money back (up to the preference) before equity holders.

3. Flexibility to convert: CCPS are designed to compulsorily convert into equity shares on specified triggers (e.g., acquisition, IPO), so they function like equity when it matters but protect investors until then.

Ratcheting (Anti-Dilution) explained:

Anti-dilution adjusts the conversion price of existing preferred shares if the company later issues shares at a lower price (“down round”). This is implemented on the SHA/SSA through any of the two methods:

1. Full Ratchet (investor-friendly) - A Full Ratchet helps the investor to completely protect them from future down rounds. If in a new round, shares are issued at ₹Q, the old CCPS conversion price resets to Q regardless of round size. Here's an example:

   • Series A price (OIP/CP₁) = ₹200 per share

   • Original conversion ratio = 1:1

   • Later Series B at ₹100 per share (down round), any size

   • New conversion price CP₂ = ₹100

   • New conversion ratio = OIP/CP₂ = 200/100 = 2:1

   • Each Series A CCPS now converts into 2 equity shares (double), completely offsetting dilution.

2. Weighted Average (founder-friendlier) - A ratchet based on weighted average computation partially safegaurds the investors from future down rounds. It adjusts the conversion price based on how low and how much was raised. The common broad-based weighted average formula is -

   CP₂ = CP₁ × [A + (C/CP₁)]/[A + (C/Q)]

   Where:

   • CP₁ = old conversion price (often equal to the Series price)

   • A = total shares outstanding pre-round on an as-converted basis

   • C = total cash consideration raised in the new down round

   • Q = price per share in the new down round

   • CP₂ = new, adjusted conversion price

   
   

   Here's an example:

   • Pre-round shares (as-converted) A = 1,00,00,000

   • Series A CP₁ = ₹200

   • Down round raise C = ₹40,00,000 at Q = ₹100

   • Computation:

     • C/CP₁ = 40,00,000/200 = 20,000

     • C/Q = 40,00,000/100 = 40,000

     • Therefore, CP₂ = 200 × [1,00,20,000/1,00,40,000] = 199.60

   
   

   Interpretation: A small down round barely moves the conversion price (₹200 → ₹199.60). If the down round were larger or at an even lower price, the adjustment would be more. Weighted average protects investors proportionally without being as punitive as full ratchet.

Conclusion

If the investor invested in traditional equity shares, they would not be able to protect themselves against dilutions from down-rounds or irrecoverability of their capital during distress sale, both common outcomes if the startup venture does not perform as expected. If the investor invested in debt instruments, they wouldn't be able to enjoy the upside when the startup does well. CCPS helps investors to enjoy the best of two worlds - upside of equity investments and protection against downside in the form of anti-dilution and liquidation preference, making it the most favored instrument for startup investments.

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Disclaimer: The material herein is provided for informational purposes only. The information should not be viewed as professional, legal or other advice. Professional advice should be sought prior to actions on any of the information contained herein. CKA is not responsible for any matter concluded by any person based on the contents of this article.