What not to sign as a Founder – Investment Term Sheet Clauses
A behind-the-scenes look at the worst investment term sheet clauses
Through my years of experience as a tech entrepreneur (then as a VC), I’ve come across tens of different investment term sheet clauses. Most are straight common-sense and quite to the point – you can’t deny their benefits or their fairness. But there are also those clauses that raise an eyebrow or two.
In this article, I’ll take you behind-the-scenes in the world of Venture Capital deals. Below you’ll find three things to consider before you get your pen out and sign that next deal.
Some time ago, I wrote a piece on “What matters most in an investment term sheet.” Its main focus was on the delicate balance between the clauses which govern control and those which govern valuation.
In this article, I want to revisit the subject of term sheet clauses, only this time I will touch on those clauses that founders should simply walk away from.
I think that the timing for this is right, as the economic downturn may tempt some investors to offer bad terms. Founders can be at a higher risk of falling victim to these investors especially if they lack the knowledge and sophistication to protect their interest in a highly technical negotiation.
1. Never take money based on milestones
This can be easily deceiving and I’ve seen it happen way too many times already: founders raising capital in installments based on pre-set milestones agreed with the investors.
At EGV, we’ve even turned down founders that came asking for milestones-based investments from their own initiative! Most often, though, we convinced them to take all the money upfront.
Don’t get me wrong though: taking money based on accomplishing certain milestones may work, but it might not be the case for early-stage startups.
More established companies, raising later rounds, may agree to such conditions. But you need to take into consideration that in the case of these companies, the business model is proven, and the newly raised capital is used for execution at scale, which is predictable to a certain degree.
But with early-stage startups, everything is a search for:
- a valid business model
- the correct pricing
- the right team
- the proper market
- the right investors.
Accepting pre-determined milestones is like pretending to know precisely what you will be doing, when, and where. Heck, we all know that the future can be foreseen, but not guessed with complete certainty. This approach will not only block your choices, reduce your flexibility, but also give the upper hand to your investors.
Try to talk to some investors, present your vision. You need to convince them that you are the right fit for them: you have the team, working on a fantastic product, addressing a big problem in a big market. Ask them to embark on a mission to explore the future and discover new lands, for which there are no predetermined routes.
Offer investors good terms and ask them to take risks in return. If they don’t get it, either you are not presenting a solid case, or they are the wrong investors for your endeavor.
2. Never accept warrants
One of the few occasions when you may accept a warrant is when your company is already mature, and you have a pretty clear vision on what lies ahead. But, when you are the CEO of an early-stage startup, trusting an investor to put more money on the same terms, but at a future moment in time can become a foolish decision.
Let’s go over how a warrant works: first, the founders negotiate with investors and agree to the terms for the investment. Then the investors reserve the right to add more money within the next X number of months. This is usually all done at the same valuation and on the same terms as the initial round.
As a rule of thumb, investors usually seek the upside of a deal – with no downside. So if the company is doing well, they will most definitely want to take full advantage of the favorable conditions that the founders were forced to agree to in the initial round, when the risk was much higher.
My advice would be to refuse a proposition of this kind, if it arises during the negotiation rounds. Tell investors clearly that this is not on the table. If they see value in your company, they should commit and invest on the spot.
They cannot have a warrant, but they can always lead the next round and offer terms that would adequately reflect their trust in the company at that future moment. That is the honest way of working together.
3. Never give investors both operational control and full anti-dilution protection
Some investors have a more hands-on approach, others have a lighter touch. The first will ask for veto rights on operations, the latter will ask for protection in downturn scenarios. Usually, it is advisable to grant investors with one or the other, but never with both at the same time.
For a more practical view, let’s take a closer look. Ask yourself: is the investor asking for a threshold, let’s say $100,000, above which the executives need to ask permission from the board to act? (for example, executives need the board’s approval for any acquisitions in excess of $100,000.)
That may seem fair at first glance. But if you grant this right to investors, they should forfeit their full protection, in case the company is doing poorly. So, the issue in question here is: how can they pretend full ratchet anti-dilution if they were part of the very decisions that led to a bad result and a down round?
Here at EGV, we try our best to engage and become one of your points of reference when discussing venture capital and investments. Although there are many questions that still arise, there is little to no reliable information available out there. And that’s especially accurate when talking about investment term sheet clauses, with all their pros and cons. I feel that this should become an open thread that I shall revisit and add to with future behind-the-scenes articles.
Look forward to our insights as we complete the image of all things to be taken into account by early-stage founders raising their first rounds in the current market conditions.
Want to make sure your next deal won’t catch you off guard? Drop us a line here.