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When fundraising, it can be tempting to limit your focus to maximizing valuation. On face value, this seems great — you’re minimizing dilution for yourself (and for your existing investors and employees) and you’re sending a signal to the market that your company has strong revenues (or your team is so strong that you’re able to command revenue multiples higher than the norm).
This tunnel vision is more appealing the less you’re relying on investors for “soft” qualities beyond capital, and the more you’re dealing with sophisticated investors with a strong reputation for being fair. Pre-money valuation is the easiest and most obvious comparison to make — all things being equal between smart investors, why not take the term sheet with the highest valuation?
However, pre-money valuation is not the only important point of consideration. Accepting a clean term sheet at a lower valuation can be more advantageous depending on the specific exit scenario you’ll eventually face down the road. With that in mind, there are a few clear signs of a bad term sheet to watch out for.
1. Be wary of investors who include “review periods” but haven’t actually done much diligence on the opportunity.
Good VCs will get to know your business, build a relationship between your respective teams, and get most of the hard work done before actually creating a legal contract. However, some term sheets will include a “review period” that enables them to pull the term sheet after it’s been signed. Term sheets are technically non-binding, so including this term doesn’t actually grant the investor any additional ability to pull out of the deal. However, good investors won’t issue a term sheet until their business diligence is done and they are very confident that they want to do a deal with you. Including a review period is a signal that your investor assumes there’s a very real chance the deal will fall through, which is counter to investor norms.
When in doubt, if the only diligence left is legals and customer calls, you’re in the clear. If the investor hasn’t yet dug into customer engagement data, the competitive landscape, or market trends, they likely haven’t built enough conviction to put down a term sheet (or don’t have enough buy-in from the rest of their investment team to get the deal done).
Very few terms are absolutely positive or negative – as with most negotiations, it’s a balance of interests.
This is doubly concerning if it’s accompanied by a no-shop clause, as it effectively halts your ability to continue conversations with serious parties. No-shop clauses are relatively standard in term sheets and aren’t a cause of concern by themselves. A no-shop clause alone simply indicates a willingness on both sides to stop pursuing alternative investors/competitive investments and begin the negotiation process in earnest.
How should you respond? Force your investors to do the work before you sign the term sheet. If you feel like your VC hasn’t yet done enough diligence to get their investment team truly comfortable with the opportunity, you can sit on the term sheet. Make it clear that you’re having other conversations in parallel and don’t want to lock either side into a commitment until you both feel confident in moving forward.
2. Any term sheet that includes a guarantee of the exit horizon is a red flag.
A term sheet that promises a return to investors within some pre-determined exit horizon is an indication of an inexperienced or overly controlling investor. Wanting an eventual return of capital is a very fair expectation. Institutional VCs need to repay their LP base, corporate VCs need to demonstrate an ROI, and angels often have a finite pool of capital to invest in (and thus can’t invest in other startups until they’ve liquidated some capital).
However, lots of opportunities for capital to be returned will arise organically over the life of your company. Secondaries (where a VC invests new capital that buys out existing shareholders rather than directly adding to the balance sheet) are quite common and don’t necessarily have a negative signalling effect (especially when capital is going to an investor who’s either been in the company for a long time or has a very clearly defined investment stage and holding pattern).
Ultimately, expecting payment within a pre-planned timeline is a sign that your investor is focused on mitigating their downside – a strategy that will backfire as buyers will want to understand the cap table and term sheets in advance of a transaction, and this type of clause will lower your negotiating power in an acquisition scenario as potential buyers realize that you’re under pressure to get a deal done.
Ultimately, you can avoid seeing most of this financial engineering if you deal with investors who you have vetted.
How should you respond? Strike this from the term sheet. Technically you could update the language to reflect that the exit horizon is on a “best efforts basis,” but any investor who thinks this is a fair (or realistic) ask is one you don’t want to have on the cap table.
3. Financial gymnastics guaranteeing a return multiple aren’t an absolute cause for concern, but you should have a good grasp of the impact in various exit scenarios and current market norms.
When building a term sheet, investors will build a waterfall analysis to understand what the liquidation outcome looks like under a variety of exit prices. Almost all term sheets will include a 1x liquidation preference, which is relatively standard and fair. This provision essentially means that investors (that invested in preferred shares) get their cash back ahead of common shares if the company is sold for less than the valuation they invested. If the company is sold above that valuation, proceeds are split and each shareholder’s return will correspond to their fully-diluted ownership (FDO).
Some term sheets will include some multiple on the liquidation preference (i.e. a 3x liquidation pref) or specifically that the liquidation preference is participating (which lets investors participate fully in any remaining proceeds after they’ve withdrawn their first pool of capital). In these instances, your investors will get a larger share than their FDO. These are less common terms for straightforward early-stage investments, but become more frequent for distressed companies, when the perceived risk of investment in higher, and/or when the investor has more negotiating power.
An early-stage investor being over-focused on terms does indicate that investors are optimizing for downside protection and/or don’t fully understand the binary nature of venture returns.
How should you respond? The ultimate inclusion of this depends a bit on your alternatives and what’s normal in the market when you’re raising. I highly recommend picking up a copy of Venture Deals to familiarize yourself with the specifics of terms. Asking your investors for a coherent rationale (beyond “it’s standard”) for including specific terms is a fair request, but as with all negotiations, you’ll have better leverage if your investor perceives you to have other financing alternatives.
As highlighted in the opener, this might be an instance where you’re better off lowering your pre-money valuation in exchange for removing liquidating terms, as a multiple liquidating preference essentially cuts the pre-money value. If you’re insisting on a pre-money valuation that’s dramatically above what your investors think is fair, don’t be surprised if they offset it with a multiple or participating preference to bring the effective valuation back to what they’re comfortable with.
When calculating your FDO and building your own exit waterfall, you should also clarify details related to the option pool. Specifically, confirm if the option pool is calculated pre-money or post-money. Post-money is the most “founder-friendly” as it includes the new investor in the dilution, but pre-money is the most likely as it maximizes the new investor’s ownership. Both are acceptable – just make sure you know which you’re agreeing to so you fully understand what the cap table will look like post-financing.
4. An undiscussed change in management is clearly concerning.
Terms specifying a change of management are unlikely to be explicitly written into the term sheet as your board of directors can ultimately replace your CEO without specifically including the term (depending on the number of directors and ensuing founder/investor/independent voting split).
There’s no right way to run your company and bringing an experienced executive on board to join the management team can be a solid executional decision that helps propel your company to success.
However, some term sheets are written after a prior discussion of an advisor or third-party joining as CEO with founders transitioning into a CTO or COO role. There’s no right way to run your company and bringing an experienced executive on board to join the management team can be a solid executional decision that helps propel your company to success (albeit a decision that typically comes after working with an executive coach and weighing the impact of losing the moral authority that a founding CEO brings to the role). However, an undiscussed mention of replacing you as CEO should give you pause as it’s both unnecessary, and frankly, rude.
How should you respond? If you haven’t talked about this with your investors before the official term sheet, remove it. Investors rarely want to invest in a company where they immediately hope to remove the CEO, so this is hopefully indicative of naiveté rather than malice.
Closing Thoughts
Ultimately, very few terms are absolutely positive or negative – as with most negotiations, it’s a balance of interests and the most important thing is to feel that both sides are working together towards a fair outcome. Seeing how your investor negotiates the term sheet gives you a window of insight into how they approach other tough conversations and negotiations.
Christian’s take:
Great investments are built on a strong partnership between investors and founders. Term sheet negotiation is a give and take where ultimately, the goal should be that both sides should win big in the end. Sarah has done an exemplary job of outlining the major pitfalls and warning signs that the partnership being considered may not be a strong one.
That said, this can’t be an exhaustive list as investors are always coming up with new and innovative ways to financially engineer term sheets. Some examples I’ve seen include taking common shares, warrants and/or options along with their investment into preferred shares (this effectively is creating a uncapped multiple liquidation preference, as discussed above) to special committees of the board, controlled by the investors, to effectively wrest control from the CEO, and many zany things in between.
If you aren’t familiar with term sheets, everything may look out of the ordinary. This is why having both mentors with term sheet experience and great counsel is so critical to have at your side as you go prepare to fundraise.
Ultimately, you can avoid seeing most of this financial engineering if you deal with investors who you have vetted. Do your due diligence on your potential investors and avoid those who don’t pass muster.
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