Some terms to watch out for
It would be hard to make a comprehensive list of all the bad terms out there, but here are some to watch out for:
- Anti-dilution – where an investor maintains their ownership through subsequent financing without having to invest more.
- Liquidation preferences greater than 1x – where an investor is guaranteed a particular level of return before distributions are made to other equivalent sharelholders in an exit. (http://www.learnvc.com/2008/07/liquidation-preference/)
- Super pro-rata – where an investor has the sole option to increase their ownership at the next round of financing. (http://www.bothsidesofthetable.com/2011/09/25/why-super-pro-rata-rights-are-not-a-good-deal-for-entrepreneurs/)
- Cramming down the pro rata of earlier angels/investors
- Asking for extra advisory shares on top of an investment. This is actually something you might give to incredibly helpful investors who don’t have the cash to invest as much as they’d like. It should be your option, though, not a demand.
How to avoid bad terms
There’s no way to list out all of the bad terms that investors can put into term sheets. There are, however, things that founders can do to stop this badness from hurting them:
- Read every word of every financing that you sign. Make sure you understand each clause, and what that clause will do in the future in different scenarios. If there’s anything a doc that you don’t understand, don’t sign the doc until you do understand those things.
- Get a lawyer that understands startups. It’s important to find someone with experience. Not only can a good lawyer explain what’s going on with terms of your agreement, he/she can tell you if those terms are standard. Lawyers can also help you negotiate, though this is usually more relevant in priced rounds.
- Be really careful of side letters. If you’re using a standard doc, like the YC safe, it’s probably already well balanced and understood. When an investor wants a side letter, they want something non-standard. This isn’t necessarily bad, but it should make you extra cautious.
- Get help from more experienced founders, particularly ones that have seen multiple financings. They’ll be able to give you perspective on what makes sense and what you should push on. They may also be able to help you negotiate.
- Know that, ultimately, if you are desperate for financing, you may have to accept bad terms. While that’s suboptimal, it is ok if you understand what you are agreeing to. It’s rare that a single bad term you understand will kill your company, though the aggregate impact of terms you don’t understand can materially change your outcome.