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Termsheet clauses — the worst of it

What not to sign as a founder

Some time ago, I wrote a piece on “What matters most in an investment term sheet.” That article can be found here and was focused on the delicate balance between clauses governing control and valuation.

I revisit the subject of the term sheet now, this time trying to 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 to founders that lack the knowledge and sophistication to protect their interest in a highly technical negotiation.

Never take money based on milestones

I’ve seen too many times this rookie mistake: founders raising capital in installments based on pre-set milestones agreed with the investors. (At EGV, we 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.)

Please don’t understand me wrong: taking money based on accomplishing certain milestones may work, but not for early-stage startups. More established companies, raising later rounds, may agree to such conditions. Still, in their case, 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: a search for a valid business model, for the correct pricing, for the right team, for the proper market, for the right investors. Accepting pre-determined milestones is like pretending to know precisely what you will be doing, when, and where, which is entirely false. This approach will only block your choices, reduce your flexibility, and give the upper hand to your investors.

Talk to investors, present your vision, convince them that you are the right team, working on a fantastic product, addressing a big problem in a big market. And ask them to embark on a mission to explore the future and discover new lands, for which there are no pre-determined 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.

Never accept warrants

You may accept a warrant when your company is mature, and your visibility on what lies ahead is pretty accurate. But, as the CEO of an early-stage startup, to grant investors the right to put more money on the same terms but at a future moment in time, is simply stupid.

For clarity, this is how the warrant works: 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, at the same valuation and on the same terms as the initial round. It’s like an extension that the investors ask: if the company is doing well, they want to take advantage of the favorable conditions that the founders were forced to agree to in the initial round when the risk was much higher. They seek the upside, with no downside.

Refuse to discuss something like this. 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.

Never give investors both operational control and full anti-dilution protection

Some investors are hands-on, some are light touch. The first will ask for veto rights on operations, the latter will ask for protection in downturn scenarios. It is ok to grant investors with one or the other, but never with both.

Let me elaborate. 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 be fair. But if you grant this right to investors, they should forfeit their full protection in case the company is doing poorly. 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?

Unfortunately, I feel that this would be an open thread that I shall revisit and add to in order to complete the image of all things to be avoided by early-stage founders raising their first rounds in unfriendly market conditions.



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