Startup founders, if you thought the fundraising landscape was challenging before, the past few months have been getting even more brutal. As desperation and fear rise, investors come back with not-so-new term sheet clauses designed to benefit them and leave founders at a disadvantage.
These term sheets aren’t new. I survived three different crises, and (sadly) little has changed: dirty terms have been a part of the VC landscape for a long time and seem to re-emerge in every downturn. Unsurprisingly, they benefit investors by overprotecting them on the downside while ensuring they also get more prosperous outcomes, while founders get harsher terms and usually a higher risk of getting crushed.
Let’s get it straight: VC funding is the harshest form of capital you can raise. You can criticise all you want, search for alternative funding sources (recommended: RBF is on fire, for instance), hope for the best, or learn how the game works and the different terms you’re likely to be offered today.
My worst scenario: investors playing the clock.
Most founders don’t even realise they’re being played. Investors slow down the pace of the entire funding process to a grinding halt, add steps, bring in more people, more due diligence, more checks, more…everything. This typically ends with founders running out of cash, getting desperate and accepting any terms by then – simple equation, accept this, or your startup dies. Experienced investors play that game oh too well, and most founders don’t even realise it until it’s too late.
The only tool you have is information. You must define your timeline and avoid the clock game, set the minimum (and immovable) terms, negotiate assiduously, and ensure you always have enough alternative investors as plan B. Good investors exist but are rare – it’s your job to find them and set the terms straight from the get-go.
Without further ado, here are some term sheet clauses you should be expecting to deal with in moments of crisis:
Pro-rata anti-dilution is common. It’s designed to protect investors from a later “down round” (the company raises money at a lower valuation in a future round). I know it doesn’t exactly make your investor a true partner, there for you, for good and bad times as they claim to be, but… that’s another topic. Down round? You send them some of your shares to compensate for the loss between the valuation they came in at and the next round. However, it’s a typical clause, so expect it.
The dirty version is the “full ratchet” version, and it’s propping its ugly head up again during these hard times. And you must not accept it. To keep it short: instead of sending some of your shares to the investors to compensate for their ‘lost’ value, you send them shares for the entire amount invested. No pro-rata. It’s 100% of the investment you return from your shares (only).
It’s a famous clause, as it has wiped out entire cap tables, leaving founders with nothing (I mean it: zero per cent) at exit time. Now you know.
If you want the entire math of the anti-dilution clause and how it turns ugly, head over to this great article by Tim Wilson, from SeedCamp.
Multiple Liquidation Preferences
Multiple liquidation preferences is a clause that gives priority to the investor when the company is being liquidated, guaranteeing that they will get paid first – before everyone else, including founders and previous investors.
This clause can (and will) reduce the money founders and team receive, usually significantly, especially if the exit price is moderate (say £50m – £250m, the vast majority of exits here in Europe).
Today some rogue investors will try and demand a 2x liquidation preference (we heard of a 6x already!), meaning they’ve doubled their money before anybody gets one dollar out of the company sale proceeds.
The dirty trick: piling these preferences (two or three investors in each round, times 2 or 3 funding rounds) and adding some interest on the funds paid out to founders. Result: even with a £100m-200m value at exit, founders still leave with nothing. It’s crazy.
Participating liquidation preference (aka Double Dipping)
This one’s also known for being pushed today. And for taking out most (or all) exit proceeds, leaving founders with little…or nothing at all. Investors usually have an option: get a fixed, guaranteed multiple of their investment by the end of a period or convert their shares into common shares and sell them alongside the founders/team.
With the participating preferred, the investor gets to “double dip” by not only getting his preference but also sharing in the remaining proceeds, as if they were converted into common – further reducing the amount paid out to those who actually built the business.
Milestone-based tranched equity rounds
Few clauses create as much uncertainty for a startup as this clause. Milestone-based tranched equity rounds are sold by investors as a “reward” method, in which funding comes in instalments based on certain milestones being reached. Miss a milestone, and your next funding tranche evaporates. So founders, unsure of capital being available, play small hands, don’t invest in growth, don’t take risks, don’t hire the best staff or spend for growth. They hold back and miss their targets a lot of times. Self-fulfilling prophecy.
The venture category is about giving a company and its team the resources to execute, not starve them of oxygen and limit their growth. If your investor doesn’t believe you can achieve it, they shouldn’t invest, and you shouldn’t take them on, period.
This is a tiny sample of nasty term sheet clauses you should know, expect, and learn how to negotiate. There are many more, and at least eight that will rip you off, guaranteed. If you don’t want to be the next victim, join us.
This article might sound anti-VC, and I’m 100% not. I decided to write this to remind founders that without a proper funding plan and process, you can get squeezed, offered unsavoury terms and must have the knowledge to avoid the extra pitfalls.
Don’t blame VCs. Their job is to produce enough returns to protect their investments and investors. Don’t argue, you’d do the same thing if you were in their position. Learn, prepare and get ready for it – what they seek is not what the media tells you, so face the harsh realities and be the one who gets a fair deal.
Negotiate smartly, discuss everything with your network and fellow founders, ensure you’re not making textbook mistakes and know every clause of the deals on your table. Times are tough, and having support from a community of startup founders and experts is more important than ever – feel free to join ours.