The process of raising money for entrepreneurs has been demystified in recent years by an increase in the educational resources available. Numerous blogs and podcasts provide founders with materials to assist with their strategic decision-making and to make better-informed decisions.
Despite this increase in transparency, certain aspects of the fundraising process continue to be challenging for founders. In my work as a venture capitalist (VC), I often find that one of the areas where founders struggle the most is when it comes to term sheet negotiation, particularly with regard to certain clauses.
There have been numerous efforts aimed at outlining what a “neutral” term sheet should look like (e.g. Y Combinator’s SAFE Financing Documents and NVCA’s template resources). It’s very important for founders to familiarize themselves with these, because generally, an investor will be the one presenting the first draft term sheet.
To be clear, it is rare to see a term sheet full of aggressive terms that penalize the entrepreneur. A good investor knows that for their investment to succeed, they must have aligned interests with the entrepreneur. A happy and incentivized entrepreneur will ultimately work harder, and because of that, most investors act gracefully and transparently during negotiations.
Nevertheless, there are unfortunately cases where certain term sheet clauses can result in a founder unwittingly losing control or economics in their business. This article highlights potential pitfalls that can arise from this terminology and explains the potential consequences for founders.
N.B. While this article was written primarily with founders in mind, it can also serve as a useful resource for startup employees, who have stock-based compensation.
Before diving into the details of the term sheet clauses, it first makes sense to highlight some of the more basic groundwork that needs to be completed. Below are the areas that I find myself most-often counseling entrepreneurs on when asked for advice.
- Figure out vesting schedules: Internally, before entering negotiations with outside investors, make sure to put in place an appropriate vesting schedule. A sudden departure of a founder with vested stock leaves dead-equity on the cap table, which can have important implications upon the efforts of the remaining founders. Here’s a good guide to get you started on the subject.
- Do your due diligence: With regards to your investor(s), view the process as a two way due-diligence exercise. Their credentials should be assessed beyond how deep their pockets are. Choosing your investors means choosing long-term business partners who play a fundamental role in the development of your business. So make sure to do your homework. Here’s a useful article to get started.
- Be smart about your valuation: Be aware of how your valuation is benchmarked against other companies. A high valuation can certainly show some external validation and stronger paper wealth, and can be used as a good PR weapon. However, it also raises the bar for your performance levels if you want to get to a future round. Here’s a good post on the subject (commonly referred to as the “valuation trap”).
- Get good advice: Finally, in relation to other external parties, contract a lawyer with a track record in this area, and make sure to take your own decision on who to hire. Don’t necessarily choose your investors’ recommendations. This article offers some useful insights into tackling the legal side of things.
Term sheet Details
With the groundwork covered, we can now dive into the details of the most common term sheet clauses that create problems for founders.
Mechanics of Preferred Stock
Early stage investors generally opt for what is called preferred stock for their investments. Preferred stock is a different class (or one could say “family”) of equity from common stock. By having a different stock class, investors are able to add unique terms and conditions that do not apply to other classed shareholders. This can often be seen at IPO time, where voting rights tend to be unevenly distributed across the classes of stock.
Preferred stock sits above common stock in the debtor hierarchy, so holders enjoy the benefit of having their money returned before other stockholders. In a successful exit scenario, this is a forgotten formality, but in a distressed sale, it makes a material difference.
The term sheet clauses detailed in the rest of the article are therefore generally only going to apply to the class of preferred stock that your investors will be creating upon putting money into your company.
One of the most common startup term sheet clauses that you will come across is a liquidation preference. As the name implies, liquidation preferences determine the hierarchy of payout upon a liquidation event, such as a sale of your company. Liquidation preferences therefore allow investors to define the initial magnitude that they are guaranteed as a payout. Let’s look at an example.
A 1x liquidation preference means that investors are guaranteed to get 1x of their initial investment back. So if your investors put $10 million into your company, and the company gets sold for $11 million, they will receive their entire $10 million back before you receive anything.
Continuing on the above, a 2x liquidation preference signifies that they are obliged to receive double their investment. A 3x liquidation preference means they receive triple what they invested, and so on.
Remember that this all occurs before common stockholders (i.e. founders and employees) can begin receiving proceeds. If you accept the inclusion of a liquidation preference, you must adjust your own return expectations to account for this.
The mechanics of how liquidation preferences work are graphically displayed in the charts below.
In each example (the first example being a 1x liquidation preference, and the second example being a 2x liquidation preference), the investor has invested $20 million for a 20 percent post money consideration.
As you can see from the exit values presented on the x-axis, for low value exits, the liquidation preferences give the investor the bulk of the security and relative value, which pulls back returns from common stockholders.
Real Example: A lawsuit that began from the Epinions and Dealtime merger was instigated by founders and employees of Epinions, who learned that their stock was worthless from the deal, despite their company being merged at a $23 million valuation. This was due to the total value of the liquidation preferences from their investors totaling $45 million, who thus received all stock proceeds from the merger.
If participating preference stock is issued, the investor receives opportunities for further upside after their liquidation rights have been fulfilled. This allows investors to not only reclaim their original investment back via the liquidation rights, but to then share the remaining proceeds on a pro rata basis.
There are three types of participation rights, which range in terms of their economic upside potential to investors. During negotiations, an entrepreneur must pay specific attention to what type is stated.
- Full Participation: The most investor-friendly option. The investor first receives their liquidation preference and then a pro-rata share of any remaining proceeds.
- Capped Participation: As per full, but the total return from liquidation and participation rights is capped at a defined multiple.
- Non-Participating: Most entrepreneur-friendly option. The investor must choose between their straight liquidation preference or a pro-rata share of all proceeds.
The consequences of these terms are that investors can often receive more economic proceeds from an exit than correspond with their actual ownership percentage of the company. Only in successful exits with 1x non-participation would the investor receive proceeds (via electing for their pro-rata) in accordance to their ownership stake.
These clauses are applied by investors as risk mitigants and rewards for showing early faith in a business or during rocky times later on. It is best to be fully aware of the terms agreed upon and to make some test scenarios, to avoid any unpleasant surprises in the future.
The liquidation preference and participation rights will often be included together within the termsheet. Below is a screenshot of the clause in NVCA’s model term sheet template so that you may begin getting accustomed to how it looks. Most term sheets will look similar to do this.
Example: Below you can see an expansion of the scenario that was introduced in the liquidity preference section. In this example, payouts are shown for the different participation rights that the investor could additionally attach to their stock alongside their 1x liquidation preference. Evidently, the full participation scenario results in the highest return profile to the investor. The capped investor follows a similar trajectory, before maxing out at their $40 million cap (2x). For the non-participating investor they first receive their 1x, but after returns of $100 million their payout (and the founder’s returns) will start to correspond with their actual percentage ownership.
In this Q3 2016 report from WSGR, 81 percent of respondents followed non-participation terminology. This dropped slightly for up-rounds, where investors will have responded to higher valuation terms by inserting more protection through capped and full participation rights. In general, a 1x liquidation preference with no participation is a fair offer for an early stage financing round.
Where the liquidation preference becomes interesting is in future rounds, in which new investors negotiate their seniority versus the older investors.
As the quoted report shows, 41 percent of respondents inserted higher seniority, compared to 54 percent opting for pari-passu (equal) against older shareholders. These figures are almost the inverse for funding in down rounds (53 percent vs 33 percent respectively).
A rational investor always enters into a deal because they believe that it will become a home run success. Despite this mentality, they will often look to put contingencies in place to secure their ownership stakes in the event of disappointing future outcomes.
This is particularly pertinent in down round (lower future valuation) scenarios. At this crossroad, a lower future valuation of their stock will not only harm their economic interests, but could also dilute their ownership stake and thus reduce their strategic influence over the company.
To mitigate lower future valuations, investors can insert anti-dilution clauses that act to readjust their ownership stake to avoid receiving too hard a hit. The main applications of this are via the weighted average and full ratchet methodology. You could visualize these as insurance policies for investors to protect them against down rounds, in the same way that put options would be applied in portfolio management.
Both methods involve converting the holders’ existing stock into a new allocation to account and compensate for the effects of a down round. The difference between the two is that weighted average dilution accounts for both price and the magnitude of the new issuance against the existing capital base. Full Ratchet just accounts for the effect of the new price.
By contemplating the magnitude of the new round, the weighted average method is more founder friendly. This article provides clear explanations, if you wish to learn more about the calculations behind these methods.
These days, a full ratchet can be a rare sight within early-stage investing term sheets. They are seen an extreme way of applying investor protection, because their application can actually result in investors increasing their ownership percentage once they are triggered. This is because a Full Ratchet will trigger a repricing of all the clause-holders’ shares, even if just one new share is priced at a value below theirs.
Below is an example of the term sheet wording for anti-dilution provisions, as per the NVCA template:
To demonstrate a comparison of the effects of each of these methods, a visual summary of their resulting ownership percentage changes can be seen below. In these examples, Series A investors have either held no anti-dilution protection or full ratchet/weighted average clauses and have just faced a Series B down round. Notice how in the Full Ratchet example, the Series A investor ends up with a higher percentage share in the company.
Note: Series A investors invested $20 million at a $80 million pre-money Series A valuation. The proceeding Series B round investor invests $30 million at a $60 million pre-money.
The WSGR report referenced above shows that the overwhelming majority of investors are now opting for the more egalitarian, broad-based weighted average method.
If dilution protection is being negotiated, unless your company is in a very distressed financial situation, you should strongly argue for broad-based, weighted average dilution coverage.
Real Example: In 2016, following a discovery of its light regulatory practices, Zenefits retroactively revalued its previous investment round (from $4.5 billion to $2 billion). This resulted in its series C investors increasing their ownership from 11 percent to 25 percent. To offset the effects of this dilution, previous investors received small adjustments, and common stockholders (diluted by 20 percent) were granted 12-month vesting stock grants.
Super Pro-rata Rights
Pro-rata rights are a mainstay of early-stage rounds and generally are positive factors to include in term sheets. They provide an option (the right, but not an obligation) for initial investors to invest in future rounds in order to maintain their ownership percentage, which would otherwise be diluted.
This allows them to double-down on their winners, maintain a material percentage of ownership and reward their initial faith.
Pro-rata rights also act as a catalyst for getting the ball rolling in new rounds and to cajole new investors to enter the fray. While demand for equity can get crowded on future rounds, and some new investors may grumble about ceding available stock to smaller investors, they are generally accepted.
Below is a wording example (again via NVCA) for a how a pro-rata right is applied into a term sheet:
Where the pro-rata right gets more complicated is when it comes in the form of a super-pro rata right, which allows the holder to increase (as opposed to maintain) their ownership stake in future rounds.
If this subsequent round is being hotly contested by new investors eager to enter, and earlier investors decide to exercise super-pro-rata rights, and increase their ownerships, the result may end up being that there isn’t enough equity for larger investors to buy.
Since larger funds generally need to invest larger ticket sizes, if they start finding it hard to hit their minimum investment amounts, they may decide to drop out of the round altogether. In such a situation, founders may be forced to sacrifice more of their ownership to appease both new and old investors’ allocation requirements.
The situation could also result in the super pro-rata right investor holding the company ransom. For example, if there is resistance against providing them with an increased allocation, they could disrupt the funding round by attempting to veto the transaction via protective provision clauses (see section below).
Even at the initial investment stage, if an investor asks for a super-pro rata right, it is a bad sign. By asking for this free, premium option to invest more in the future, they are basically saying: “We believe in you, but not enough right now.”
Information and Transfer Rights
These terms are not as quantifiable as the former but are still vitally important. They pertain to your investors’ conduct with relation to their ownership stakes in your company. Lax terminology in relation to these could disrupt progress through conflicts of interest. Here’s an example.
Having a right of first refusal clause permits that all current shareholders are notified and allowed to buy stock from an investor who wants to sell. This along with an approval of sale clause, which instructs the board to approve all transfers of ownership, prevents secretive transfers of stock from happening. Without these clauses, a disgruntled or incentivized investor could, in theory, sell their stock to your competitor without anyone knowing.
Here is the NVCA’s wording for a right of first refusal.
Confidentiality agreements and non-compete clauses prevent conflicts of interest arising when investors look to leverage their portfolio by sharing information, or indeed investing in competing business units. Not only do they prevent competing firms from gaining an unfair advantage, but they keep investors focused on your progress. If they lose interest, you will lose out on effective corporate governance counsel and someone to fly your flag externally.
Unlike other sections in this report, which discuss how the inclusion of some terms could be harmful to you, the inclusion of the above points could actually help you. I encourage you to push for the inclusion of information and transfer rights, with clear elaboration of their application.
Protective Provisions and Drag Along Rights
Protective provisions grant investors veto rights that they otherwise would be unable to exercise at the board level, due to their percentage stake not constituting a majority. In general, they are a very standard practice in relation to key issues, such as a company sale, or stock issuance, because it forces the discussion to include all involved parties.
Despite good intentions, these protective provision terms can sometimes go too far. If there are punitive veto restrictions on expenses and hiring sign-offs, they could cause friction and slow down decision making abilities.
Drag along rights for investors allow them to compel other classes of stock to agree with their voting demands for a liquidation event (i.e. a sale, merger or dissolution).
Traditionally, they have been deployed to allow the majority shareholder to cleanly force through a sale, by exercising their majority (>50 percent) over the minority shareholders to follow their choice of action. I say traditionally, because if all stockholders are of the same class and terms, the demands of the majority investor will most likely be economically aligned with the minority shareholders.
When different classes of shares, and their separate terms are introduced, as we have discussed earlier, it increases the importance of drag-along rights provisions.
In this instance, the majority vote required to trigger the drag-along can just come from the majority solely within the preference stock class. If this decision does not need ratification by the board, common stockholders may have to follow a decision that is out of their hands.
The base template from NVCA demonstrates how the terminology for this clause can be adapted in many ways.
There are situations in which an investor may be keen to sell, but the founders are not. An unexpected buyout offer during stressed operating times can an appealing option to an investor who holds attractive liquidation and/or participation rights. By exercising drag along rights, these investors can force founders to sell.
Negotiation tactics that entrepreneurs could apply in order to avoid the above, would be to increase the majority vote required (try higher than the opening gambit of 50 percent) to trigger the drag along clauses.
Also, resist the exclusion of the board approval ratification, to add another security layer to the decision making process. Additionally, adding a covenant of minimum sales price to the drag along provision can ensure that if it is triggered, there is enough space between that and the liquidation preferences to leave economics on the table for the entrepreneur.
The most friendly application of this provision is when it applies to just a majority of common stockholders. In this event, preferred stockholders face their own trade off of converting to common stock to participate in the vote, and if they then do so, sacrificing their liquidation preference rights.
In recent years, convertible notes have become increasingly popular. The fundamental difference between a convertible note and a straight equity structure is that it is a debt instrument with provisions to convert into equity at a later date.
Convertible notes serve a very important purpose. They avoid the valuation discussion at a stage in the startup’s life, when valuations are really just guesses. Since negotiations regarding valuation at this stage can be complicated and frictious, the convertible note is a useful way to satisfy both parties’ needs.
They are also cheaper (in legal fees) and faster to negotiate than straight equity.
Notwithstanding, while convertible notes are generally classified as “entrepreneur friendly,” in reality, there are certain clauses that can heavily swing the balance in favor of the investor.
There has been much said about convertible note terms and what their ramifications are for conversion. For that, I will only focus on the high-level numeric terms and how you can position yourself around them.
- Cap: A HIGHER cap is better because if triggered, the investor will own less equity at conversion due to being priced closer to the equity round terms. A survey from Silicon Legal Strategy (Q3 2015) showed that the median cap size from U.S. deals was $7.5 million.
- Discount: A LOWER rate is better as investors will be converting closer to the fundamentals included in your future priced round. The same data as above gave guidance that a 20 percent discount is par for the course.
- Interest Rate: Often overlooked; due to recent years of low interest rates and because generally, no interest coupons are ever actually exchanged. As a formality, a LOWER interest rate will benefit you, when the interest is accrued up into issued stock. The majority of rates within the SLS survey fell between the four to eight percent range, but this will be tied to the underlying floating benchmark rate for your market.
Also important to note are the scenarios related to when and how the note converts.
The obvious intention for investors is for the note to convert during your next round: a priced equity round.
But pay attention to other events that could trigger conversion, to remove any ambiguity. Having pre-agreed floor multiples of return in the event of M&A, or an aqui-hire sale, will ensure clarity should these unexpected events occur.
If there are no defined terms, beyond the standard priced-round conversion event, the investor may only be legally obliged to receive their original investment back. This could result in an ugly and/or drawn-out end to your relationship with them.
Also, pay attention to the maturity date of the note and what happens at this point.
Is it stated that the note is to be repaid, or is there a stated conversion price to equity? Bear in mind the interest rate, as the longer that the note lasts and the higher the rate is, the more that will accrue into equity.
Term sheets are complicated, but are a source of protection
This article demonstrates the intricate trade offs that can exist when negotiating investment rounds. An investor’s involvement does not end once the check is cashed, and the explanation of these clauses shows how they can significantly influence the outcome of their investment in other ways.
Nevertheless, if armed with the correct knowledge, founders can look to not only avoid these pitfalls but actually use these terms as effective protective measures.
I hope that this guide has provided you with a useful high-level summary of what to look out for as you head into any term sheet negotiations. Returning to an earlier point, should you have additional questions, having an experienced lawyer by your side can be extremely helpful. Nevertheless, feel free to post any questions or comments here and I’ll try and address them where possible.