78. Investment Term Sheets: Explanations, Red Flags, and where to push back
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Money from investors should fuel your startup's exponential growth. But a lousy term sheet can leave the company spluttering on the launch pad, leaving you nothing to show for all your hard work.
In this article, I walk through the most common and important terms you will encounter and explain which are beneficial and which you should push back on.
Convertible notes and SAFEs leave most of the terms to be negotiated in your next priced round so their term sheets are very simple.
In a priced equity round, the first thing you will get from your lead investor is a term sheet spelling out the details of the transaction. These documents can be several pages long and hide essential items deep within. You must study and understand this document to avoid potentially catastrophic consequences. Some terms could cause massive dilution, loss of control of your company, disrupt later investment rounds or sabotage a desirable acquisition.
Short-term sheets are even worse. You need to negotiate all the details of the transaction sooner or later. However, once the term sheet is signed, you agree to deal exclusively with this investor, significantly reducing your negotiating leverage.
Push to get as many details as possible spelled out in the term sheet.
The most crucial advice is to talk to a lawyer. This is not the time for doing it yourself. Make sure your attorney has extensive experience with startups and early-stage investments. They should have seen countless other term sheets and know what is standard and fair.
Valuation
Typically, the first items are the company's valuation and the investment amount. In most cases, you will have already established this before the investor creats the term sheet. Valuations are a vast topic, more than I can cover here. Check out this article on pre-revenue startup valuations and this one on why high valuations can be a problem. The most significant variable here is whether the valuation is pre-money or post-money. You should have agreed on that already, but make sure it is correct in the document. It can make a big difference to how much dilution you experience.
Preferences
Most investors, at least in the US, expect to receive preferred stock. That is a separate class of stock with more rights than common stock. You will create a new type of preferred stock for each investment round.
One key aspect of preferred stock is the liquidation preference, which is usually expressed as a multiple of the initial investment. You might see a "one times" or "1X" preference, "2X", or even "3X." If you sell the company, the shareholder has the right to be paid this amount before anything goes to common stockholders or more junior series of preferred stock.
I think 2X or 3X liquidation preferences are abusive, and I rarely see investors asking for them. 1X preferences are standard, and you are unlikely to be able to convince investors to give them up completely.
Another aspect of the preference is whether it is "participating" or not. With a participating preference, the investor is paid their preference, and then their shares convert to common stock. At that point, they are paid their pro-rata share of the remaining funds alongside all the other stockholders. This feels like double dipping to me, and you want to avoid it. In a modest exit, this can substantially increase the payout they get and reduce or eliminate what you get.
A slightly better version is called capped participating preferred. This works like participating, except there is a limit to what they can get from the preference. It is usually expressed as a multiple, so the term sheet might specify a 1X preference with a 2X cap. If the preference value plus the common stock is more than twice their investment, they only get the cap. If the common alone is worth more than the cap, they can take that and forfeit the preference. This creates an odd situation where the investor gets the same return over a range of exit values.
What you want to see, and the most common situation, is non-participating preferred. In this case, the investor has a choice. They can take their preference or convert to common, but not both. The investor will only take the preference if the company is not doing well. If the company has grown, the common shares should always be worth more than the initial investment. In a fire sale, there might not be enough cash to pay the preferences in full, leaving nothing for the common stockholders.
Anti-Dilution
If your next investment round is at a lower valuation than the current round, it will hurt the investors. Anti-dilution terms protect them from this risk by retroactively lowering the effective price they paid for your shares.
Anti-dilution terms come in two primary flavors, "full ratchet" and "weighted average."
With a full ratchet, the investor gets to reprice all their shares as though they had paid the new lower price. This happens either by issuing them additional shares or adjusting the conversion ratio between the preferred and common shares. If the new price is half what they paid, they now own twice as much of the company, even if the new investment was tiny.
Weighted average anti-dilution calculations make this fairer by considering the size of the new investment. Even if the price is much lower, the repricing is modest if the latest round is small. In the case of a large round, the weighted average starts to approach the impact of a full ratchet.
Full ratchet anti-dilution is abusive and uncommon. You should push back hard on this.
Additionally, ensure that you exclude certain kinds of transactions from triggering anti-dilution. In particular, it should not include common stock grants to employees, vendors, or partners. Common stock is almost always priced lower than preferred, making it more enticing as compensation.
Investor obsession over downside loss prevention is a huge red flag. It suggests that the investor is inexperienced with early-stage startups. Returns from seed-stage investments are almost always binary. Either you get a significant payout, or you get little to nothing. The winners will drive all the returns in their portfolios. There is little point in fighting over the crumbs when things don't work. You want your investors focused on your massive potential instead.
Board Seats
Lead or major investors often demand board seats as a condition of their investment. At the pre-seed stage, you might have a three-person board of two founders and the investor or one founder, the investor, and a mutually agreed on outside board member.
Over time your board will grow as you raise more rounds. A large board can be unwieldy, so you should make sure this right has a sunset clause. They should lose the seat if their ownership falls below some threshold, typically 10%. They should also agree to step down if they don't invest in all follow-on rounds.
Just because they don't have a right to the seat does not mean you should kick them off. Keep them on if they add significant value and you have a good relationship.
A compromise between giving a seat, or nothing, is to offer observer rights. The investor can attend the board meetings and participate in the discussions but will not have a vote. This can give them visibility and input into the company without altering the power dynamics.
Guaranteeing board seats requires a side agreement. The company can't promise them because the shareholders elect directors. To ensure they get that seat, a majority of shareholders need to commit to voting for the investor.
Pro-Rata Rights
Pro-rata rights allow investors to maintain their proportional ownership of the company through any following rounds. If they own 10% of the company now, they have the right to take 10% of the next round, leaving their ownership percentage unchanged. They are not obliged to do so, but the next round will dilute their ownership if they don't.
You only want to grant pro-rata rights to significant early investors. Those rights should expire if they are not exercised in any round. They should not be able to pick and choose which rounds to participate in.
Some investors will ask for super pro-rata rights. That allows them to increase their ownership by some amount in future rounds. They might own 10% now but want to be able to take 30% of future rounds.
This is bad because it can scare off future investors. Venture capital companies often have ownership targets. If another investor takes a large chunk of the round, the VC might not be able to achieve their minimum ownership and will walk away from the deal.
If there is room in the round, you can always allow earlier investors to join, but you don't want to be forced to do so.
Option Pool Increase
Savvy investors will ask you to top up your option pool prior to their investment. They know you will need to continue to issue options as the company grows, but increasing the option pool dilutes the other shareholders. Investors want that to fall on you, not them.
Typically, investors will typically ask you to increase the unallocated pool to 20% of the total issued and outstanding shares.
They may also want you to provide estimates for future demands on the option pool so they can understand the dilution impacts down the road.
You will need to top up the pool anyway, so this is not a dangerous term. It would be better to do it after the investment, but that is hard to negotiate. Just take the dilution into account when considering the deal valuation.
Dividends
Some term sheets mention dividends. There are three forms of this term.
The first is guaranteed dividends which means that the company will pay shareholders a specific dividend on a regular schedule. This is bad! As a startup, you are almost always cash-strapped. You should put any money you have towards growth, and you could be in serious trouble if you can't make the required payments. Just say no to guaranteed dividends.
The second is cumulative dividends which are similar to guaranteed dividends in that it specifies how much the company owes. However, in this case, the amount simply accumulates until the company decides to issue a dividend. The board won't do that until you have enough cash and no uses for that money. It is not great, but it won't kill the company.
The third is discretionary dividends. If you agree to dividends, this is what you want. The board can issue dividends when it wants but has no obligation to do so.
Almost all dividend clauses also stipulate that you can't issue dividends to any other class of stock without including this one. That is fair.
Information Rights
Information rights entitle the investor to regular financial and business updates. I usually see a requirement for quarterly reports, which is not too demanding. An upside of this requirement is that it forces you to gather this information for your use, something that can get dropped if you are not obligated to deliver it.
Information rights are often limited to investors with holdings above some threshold, usually 10%.
Protective Provisions
Protective provisions provide investors control over the company beyond what they would have based on their ownership, most often expressed through veto rights. They require the company to get the investors' approval before taking specific actions.
The right may belong to a particular series of stock or apply to all preferred shareholders. Because the interests of early and late investors might conflict, you are better off if the preferred stock votes as a single unit rather than needing to get approval from each series independently. In the latter case, the holders of any single series could veto an action even if all the others approved it. That often comes up when considering an acquisition. The offer might appeal to most investors, but the valuation might be at or below the price paid in the last round.
You may see veto rights over any number of decisions that could substantially impact the investors or alter their existing rights. Most of these rights are reasonable, and you should allow them. They commonly include:
Changing the articles of incorporation or bylaws
Authorizing new stock or a series of stock
Taking on substantial debt
Acquiring another company
Selling the company
Making major purchases outside the course of normal business
As I mentioned, the right to veto the sale of the company can be problematic. You should try to negotiate constraints on that. If a single series of stock can vote to block an acquisition, that should be limited to cases where the investor's return is below some threshold. For example, if they make at least five times their money, they lose their veto right. They can still vote their shares against the deal but will have no more influence than any other shareholder.
Avoid rights that would let the investors micromanage you. They should not be given a veto over ordinary hiring and expenses. I have seen cases where the term sheet required shareholder approval of purchases over $10,000. That is too low even for a pre-revenue company and would quickly become absurd as the business grows. The executives and the board need the ability to operate freely and react with agility.
Drag Along Rights
Drag-along rights are somewhat like the mirror image of protective provisions. Drag along rights force everyone to accept a decision if a defined group of shareholders approves it.
For example, the right might specify that if a majority of all shares vote to sell the company, everyone else will have to go along with it. It would be a problem if the right belonged to some small minority. A single series of stock should not be able to drag along every other shareholder.
However, drag-along rights are very helpful in getting deals done. You are less likely to need to chase down every last shareholder for their approval once you already have a large majority onboard. I once had to hire a private investigator to find an investor on extended summer vacation away from their computer so they could sign some critical documents. You don't want to do that.
One thing to add to the drag-along rights is a provision that the board of directors must also approve any sale of the company or other transaction under this right. That prevents a group of shareholders from forcing a transaction that is not in the best interests of the company or the rest of the owners.
Right of First Refusal
Many term sheets include a right of first refusal. If someone, usually a founder, wants to sell some of their shares, the investor can step in and buy them instead. Once the seller has an offer for the shares, they must offer them to the investor on the same terms.
After the company has been growing for several years, many founders want to cash out some of their stock to pay immediate expenses. Being a theoretical multi-millionaire is not as satisfying as having some extra cash in the bank.
This term makes it much harder to sell your shares before a significant liquidity event. Few buyers will want to take the time to negotiate a deal and conduct due diligence when they know somebody else is very likely to take the deal instead.
If you can't negotiate out of this provision, talk to the investors about their attitude towards early partial stock sales. When you want to sell, talk to them early on to see if they would like to buy the shares or to get a verbal agreement to allow you to sell to an outside party.
Right of Co-sale
The right of co-sale is almost the opposite of the right of first refusal. In this case, if you are trying to sell some of your stock, it lets the investor sell too. If you sell 10% of your shares, they have the right to sell up to 10% of theirs as part of the same deal.
The main problem is this may limit how much stock you can sell. For simplicity, assume that you and the investor have equal ownership in the company, and you want to sell $5 million of your stock. That means the investor could also sell $5 million to the same buyer. But, if the buyer only has $5 million to spend, you would each sell $2.5 million, which might not achieve your objectives.
Co-sale rights are widespread, so you probably need to live with them.
Redemption Rights
Redemption rights protect against the situation where a growth company turns into a lifestyle company.
The investors expected the company to drive towards a lucrative exit in three to seven years. If the company stops growing with no prospect of an exit, their money is trapped in the company.
Redemption rights let them ask the company to repay them after some period of time. They usually need to wait at least five years to request redemption. The repayment amount could be anything but typically is the same as the original investment.
Most redemption rights give the company three years to pay the redemption, so you don't need to come up with all the cash at once.
Investors rarely invoke redemption rights. If the company is struggling, you probably don't have the money to pay them, even over a few years. It might make sense if the company is thriving but plans to stay private for the foreseeable future. However, in that case, there are better ways of allowing the early investors to exit with a reasonable return.
Warrants
Warrants are the right to purchase additional stock at a specified price. It is a sweetener for your investors who want to be able to increase their holdings if things go well. The price can be the current value or something higher, often allowing them to buy the latest series of preferred stock.
I don't see warrants included in most deals, but they are not rare. Consider how exercising them would impact your cap table. Large blocks of warrants can cause substantial dilution.
Insurance
Experienced investors will often require you to get certain kinds of insurance. In addition to the typical fire, loss, and liability insurance you may already have, there are two kinds with which you might not be familiar.
If the investors take a board seat, they will require you to get directors and officers (D&O) insurance. That protects the board members from lawsuits against them for their actions as directors. Once you start bringing in outside investors, you should seriously consider this insurance even if nobody asks you for it.
D&O insurance is inexpensive and can be a real lifesaver.
The other thing they might want is key person insurance. This life/disability insurance policy pays the company if one of the founders or critical executives can't fill their role anymore.
For example, investors might want you to have a $5 million policy on your Founder/CTO, so if they are hit by a bus while biking to work, the company will have the funds required to quickly recruit and hire a high-quality replacement to keep the business on track.
Investor Expenses
Many investors will ask you to pay some of their expenses. Often, they want you to cover their legal costs for the investment. It strikes me as odd that they pay you, and you immediately reimburse them. However, it is not uncommon.
Demand a cap on these expenses. They should not be able to spend unlimited amounts that will come out of the company's pocket.
Anyone on your board will expect compensation for expenses related to their service. The company would reimburse any travel, hotel, or meal expenses associated with board meetings. This is entirely standard and appropriate.
Founder Vesting
In one of your early rounds, investors will probably ask the founders to vest their shares. This protects against the founder, or one of the co-founders, departing the company early while continuing to own a substantial fraction of it.
Most founder vesting works on a similar schedule to options—one-quarter vests at the end of a year and the remaining vests monthly over the next three years. Unlike options, founder vesting is a repurchase right for the company. The company can buy back your unvested shares at a specified price if you leave.
An important implication of this structure is that you own and can vote all the stock, whether it is vested or not. The vesting does not change your power or control within the business.
Vesting can be particularly valuable when there are co-founders. Frequently one or more of them don't work out. That can be because they don't have the skills, passion, or time required. It could also be that they need to take a job that offers a paycheck to cover their addiction to food, shelter, and clothing.
By leaving early, they will contribute much less to the company than the remaining co-founder(s), and their ownership should reflect that. You don't want some ex-co-founder owning a third of the business (and a third of the voting power) when they are not involved anymore.
Founder vesting should only happen once. It is not fair or reasonable to ask you to re-vest your shares in every round. If you have worked in the business for a few years, you should not have to vest all your shares. You are not starting at zero. In many cases, only a fraction of your shares would be vested, somewhere between 50-100% depending on the situation.
Standard Terms
Ask your investors how they created their term sheet. If they developed it themselves, you and your lawyer must go over it with a fine-toothed comb. Handmade term sheets could contain all kinds of abusive provisions. Additionally, they are more likely to have errors and loopholes that could cause problems.
Ideally, investors should use a well-tested mature term sheet from an unbiased reputable source. They take that template and fill in any required details. They should specifically call out any changes to the template.
Standard term sheets rarely include problematic terms and strike a balance balanced between favoring the investors and the founders. These term sheets can also save on legal fees as your attorney is probably already familiar with most of the common templates.
Here are a few of the most used standard term sheets:
Final Thoughts
Watch out for investors in your pre-seed round who typically play in much later rounds. First, if they don't invest in those later rounds, it is a huge black mark for the company and will make raising much more difficult. If an angel sits out a round, that is normal. A late-stage investor stepping aside says something is not going well.
Late-stage investors are usually less familiar with the realities of young startups. There is a level of chaos and uncertainty inherent to that stage which will disturb them. If they are on the board, they will cause trouble by asking or expecting things that don't make sense for the company at that point. Don't be their only pre-seed investment.
Remember that negotiating a term sheet is a game of give and take. Neither of you should get everything you wanted, but neither should feel like they are getting screwed. Abusive terms are a warning that things won't get better once you tie the knot and take the investment.
Finally, don't think that this article has given you enough information to negotiate on your own. Find an attorney with extensive experience with early-stage startups and keep them glued to your hip whenever you contemplate any kind of investment or other transaction.
Until next time, ciao!
