TL;DR: make your seed round a true growth avenue for your startup. Know the types of term sheet clauses and learn 3 ways to avoid falling into pitfalls inside tricky clauses:
There are two types of early-stage startup investors: those that want to grow with you, and those that want to grow to your detriment. Those that are in for the long run, and those that think of your business as a get-rich-quick scheme.
Luckily, term sheets are a good indicator of what type of investor you’re dealing with. Unluckily, red flags in those contracts are not in plain sight for the common folk. When you're negotiating the very first funding for your startup, these flags might blend into the background.
To avoid the tricky clauses that might lead you to pitfalls, you first need to know which ones they are. And you can only do that when you understand all the types of clauses you can see in term sheets. (This sounds like peeling an onion, unraveling a ball of wool, or rewatching Inception. Whoever got it on the first watch is lying.)
We could be in for a long and sleepy lesson – but we're all about GSDing and having some fun while doing it. Let's focus on what's really gonna put your knowledge to test, and make your seed round a true growth avenue for your startup.
What you should know before taking this "class": term sheets and side letters have some key clauses, standard ones, that mean no harm.
But additional clauses, that grant the investor more benefits, are not exceptions. Especially in Latin America, where many investors believe they are taking bigger risks. You know, all the political, economical, and social drama we eat for breakfast.
Here's the gold: some of the most common term sheet pitfalls relate to control clauses, liquidity clauses, and most favored nation rights.
The bad news is that there’s simply no way to avoid these tricky clauses altogether. Every single negotiation is a tango between founder and investor. It's the dance of give and take: give some control, take some money.
Even so, you shouldn't just go with the flow. Bad negotiations of these clauses can harm your position as a founder. And, once you raise a round with unfavorable rights, they’ll pursue you forever.
It’s all about finding the perfect balance. Let's see how to do just that.
Investors take a leap of faith with most early-stage investments. A lot can still happen with their investment that they can’t control, so they’ll try their best to get some decision-making power. The most common options are board seats and protective provisions.
First, there’s nothing wrong with giving board seats to investors. You just need to be picky. Like, really picky. More investors will ask for a board seat than you can allow.
As a rule of thumb, founders must have the majority of board seats until the Series B stage or longer. Late-stage investors will expect this. So, if two early-stage investors want a board seat, you need three founder seats.
The same is true for protective provisions, which are basically veto rights. They're one of the main control features an investor has over certain decisions of the company.
Protective provisions are a normal topic of discussion during term sheet negotiations. And some investors deserve them. Still, you must be careful with two things when talking about protective provisions in control clauses of term sheets:
First, avoid some protective provisions. It’s completely fine to accept protective provisions on dramatic changes to your company – think IPO, pivot, dividends, etc. But you want to avoid getting micro-managed. Investors who want protective provisions to veto budgets and operational decisions are a red flag.
Second, keep your voting threshold low. The voting threshold determines the minimum number of shares of preferred stock necessary to approve a company decision.
With that, a voting threshold also defines the other side of the table: how many shares of preferred stock a minority shareholder would have to hold in order to veto a protective provision.
Imagine you have a high voting threshold, like 85%. That means that an investor with over 15% of preferred shares could veto any decision. Basically, as the majority needed gets bigger, smaller investors can effectively veto what others have agreed upon.
Also, as your startup grows, investors will each have their own shares. With a high voting threshold, you'll need to convince more investors to not veto your decisions.
Don't fall into this pitfall. A 51% majority is ideal as it doesn’t give any party too much control. A 66% majority is more common and still acceptable. The threshold becomes problematic when it gets higher.
Follow this golden rule: you don’t want a single lead investor, with a 15% share or less, to have veto rights over major company decisions.
Every term sheet has liquidity clauses. They determine how and in which order investors will get paid, and also serves to protect them if startups exit at a value lower than expected.
A 1x non-participating liquidation preference is standard: about 80% of SAFEs follow this format. Investors detain preferred shares initially, and have two options when adopting a 1x non-participating liquidation preference:
1) Investors can recover exactly their investment value before common shareholders get paid. Whatever is left after the investor gets paid is distributed along these common shareholders, like founders and employees. If the startup is sold for less than what the investor put in, he will receive the entire proceeds. He will at least get something back.
2) Investors can choose to be common shareholders instead, receiving proportionately to their investment and associated shares in the startup. This is the option chosen in case the startup grows its valuation to the point where, in a liquidity event, the proceeds from the investor's shares represent more than the money he initially invested.
Other times, investors will want a higher multiplier or a participating preference. These conditions usually mean the investor is too focused on liquidity, so it's best to avoid these terms.
With a higher multiplier, for example, a 2x non-participating liquidation preference, the investor can choose to get twice their initial investment. With a 1x participating liquidation preference, they benefit twice: the investor recovers their total investment first, then also joins in on the liquidation split among common shareholders in accordance with their equity stake. Both cases leave less money to be distributed between the other shareholders, including the founders.
Let’s look at an example. Imagine investor Platita put US$ 1M towards company Yapita and now owns 10% of the company. Yapita, which was worth a total of US$ 10M when Platita invested, is now acquired by big tech Lanita for US$ 15M. This is what investor Platita would get paid based on different liquidation preferences:
Let's see the inverse situation: the investor Platita put US$ 1M towards company Yapita and now owns 10% of the company. Yapita, which was worth a total of US$ 10M when Platita invested, didn't perform as expected and got acquired by big tech Lanita for US$ 5M. This is what investor Platita would get paid based on different liquidation preferences:
In rare events, investors will set a drop-dead date. A drop-dead date means a certain action will happen if a deadline is not met, and this certain action is often related to an investor selling his shares and getting his money back.
A drop-dead rate could relate to further funding or even an IPO. We’ve seen examples where investors want the right to sell any stock if the company doesn’t file for an IPO within four years.
This usually isn’t ideal for founders. If you ever run into something like this in your early-stage startup, don’t even say goodbye. Just run.
The example of the IPO is often accompanied by drag-along rights. These enable a majority shareholder to force minority shareholders to join in a company's partial sale. If the investor finds a buyer who wants more shares than the investor can offer, other shareholders, like founders, could be required to also offer their shares and complete the deal under the same conditions.
Most favored nation rights are something many early-stage investors are eager to get. With these rights, they get better terms when future investors get better terms.
These terms usually apply to all rights, but it’s better to negotiate specific rights to keep as much control and ownership as possible.
You’ll probably need to concede these rights to early-stage lead investors, but again, be selective. And make sure the rights expire when SAFEs convert to preferred shares, so that these conditions don't last forever.
A similar care should be taken when negotiating pro-rata rights. These give the investor the right to maintain their percentage of ownership during future investments. So after another investment round, you’ll have to accept further investments and issue additional stock for companies with pro-rata rights.
The problem is that your ownership will get further diluted. And if that leads to you and your co-founders having a minority stake in your company before reaching Series B or C funding, VCs will be reluctant to invest in your startup. Learn more about how to avoid excessive founder dilution and keep your skin in the startup game.
Just like favored nation rights, when dealing with pro-rata rights, limit them to certain investors and set an expiration date so they don’t affect you in all your future rounds.
By now, you're well aware that there’s no way around some of these tricky little clauses. So, after doing your research, take all these learnings into the real world and be very rational. Consider how specific clauses will impact your company down the line, and accept the least painful clause if you need the money. Pros and cons.
Now that you’re familiar with the most common term sheet pitfalls, negotiating a fine first VC deal should be a bit easier. Our last, and dare we say best, advice is to join a community of high-caliber founders and mentors to trade experiences and support you on your journey, including the fundraising one. See you there – and may good term sheets find their way to you.