In the high-stakes game of startup financing, founders must approach VC term sheets with a healthy dose of scepticism and due diligence. By understanding the potential red flags and negotiating for more founder-friendly terms, entrepreneurs can secure the funding they need while maintaining control over their company's destiny.
Founders first!
Over the past few years, I have encountered wi-fi passwords at Venture Capital offices that were either "Founder first" or similar.
It's fascinating how much you can learn about the culture by studying wi-fi passwords. They reveal a lot and hide a lot too. I meet at least two or three founders weekly, and almost all complain about how this "founder-friendliness" starts and ends with the wi-fi passwords for many VCs.
As a first-time founder, I still remember the thrill of receiving the bank credit message as part of the startup funding - "Your account has been credited with INR xx crore." At that moment, I remember feeling indebted and overwhelmed. But, all that happens after one has signed the term sheet, and that's where the devil lies.
The second baffling aspect about the whole process is that my startup has to pay all the legal, due diligence and related fees. It's "egregious", as Sam Altman said in his blog a decade ago.
In the fiercely competitive world of startups, securing venture capital (VC) funding can feel like a triumph. But as many unsuspecting founders have discovered, not all that glitters is gold. A term sheet brimming with draconian clauses is the sword of Damocles hanging over your startup's future.
"The best way to negotiate with VCs is to not need them." - Naval Ravikant, founder of AngelList.
As a founder, you have every right to demand fair terms that protect your interests and vision. So let's explore some red flags to watch out for and best practices for negotiating an ideal, founder-friendly term sheet.
Red Flag #1: Liquidation Preferences Liquidation preferences determine how shareholders distribute proceeds upon an exit event. First, founders must be wary of liquidation preferences. While a standard liquidation preference of 1x is relatively benign, a term sheet that includes a liquidation preference of 2x or higher should raise eyebrows. This means that in the event of an exit or liquidation, the VC will receive double its initial investment before the common shareholders - the founders - receive a dime. Beware of term sheets that include higher liquidation preferences or participating preferences, which enable VCs to take a disproportionate share of exit proceeds, leaving founders and employees with less.
Red Flag #2: Overreaching Protective Provisions While it's reasonable for VCs to have a say in significant decisions, overreaching protective provisions can hamstring founders. For example, overly broad clauses may allow investors to meddle in day-to-day operations, curtail hiring authority, or impose budget constraints. Scrutinise these provisions and push back against any that threaten your autonomy.
Red Flag #3: Excessive Anti-dilution Clauses Though designed to protect investors from dilution during future funding rounds, full-ratchet anti-dilution provisions can be devastating for founders. If triggered, they can severely dilute your ownership stake, undermine incentives, and thwart future fundraising. Insist on more equitable, weighted-average anti-dilution protection.
Red Flag #4: Onerous Vesting Requirements Unreasonable vesting requirements can result in founders losing control of their companies. Four-year vesting with a one-year cliff is standard, so be wary of terms that reset or accelerate vesting schedules or impose performance milestones unrelated to company growth.
To ensure a balanced, founder-friendly term sheet, consider the following best practices:
Best Practice #1: Comprehensive Due Diligence Before entering negotiations, conduct thorough due diligence on potential VC partners. Learn about their past deals and seek input from other founders who have worked with them. A VC with a reputation for founder-friendly deals is less likely to spring draconian surprises in the term sheet.
Best Practice #2: Legal Counsel Engage experienced legal counsel to help you navigate the complexities of term sheets. Your lawyer should be well-versed in startup law, have strong negotiation skills, and be someone you trust to act in your best interest.
Best Practice #3: Negotiate Thoughtfully"Term sheets are not meant to be fair; they are meant to be negotiated." - David Cohen, founder of Techstars.
Enter negotiations with a clear understanding of your priorities and what you are willing to concede. Be prepared to justify your positions with data and market comparables. Finally, remember that VC relationships are long-term partnerships; maintain a collaborative mindset and avoid turning negotiations into a zero-sum game.
Best Practice #4: Leverage Alternative Financing Options Finally, consider alternative financing sources for leverage during negotiations. Angel investors, accelerators, and government grants can provide initial funding without some harsh terms associated with venture capital.
In all the funding frenzy and media glare, where can you find cheat sheets for founder-friendly templates?
While securing venture capital can be vital to your startup's growth, don't let the allure of funding blind you to the potential dangers lurking in draconian term sheets. These cheat sheets can be incredibly helpful for founders who are new to the fundraising process:
1. The Founder Institute's "Term Sheet Template": This template provides a clear breakdown of the key terms and clauses that founders need to consider when negotiating a term sheet, including equity ownership, liquidation preferences, and anti-dilution provisions.
2. Y Combinator's "Startup Library": Y Combinator is one of the world's most well-known startup accelerators. Their Startup Library includes a wealth of resources for founders, including a "Term Sheets & Fundraising" section covering everything from valuation to board composition. Also helpful is A Standard and Clean Series a Term Sheet.
3. The National Venture Capital Association's "Model Term Sheet": The NVCA is a trade association representing the venture capital industry. Their Model Term Sheet is a comprehensive guide to the terms and conditions typically included in VC financing deals.
4. Wilson Sonsini's "Term Sheet Generator": Wilson Sonsini is a legal services platform that provides resources and tools for startup founders, including a Term Sheet Generator that allows founders to create customised term sheets based on their own specific needs and goals.
Another red flag to watch for is the issue of board control. It's reasonable for VCs to request representation on the board of directors, as they have a vested interest in the company's success. However, founders should be cautious of term sheets that grant VCs majority control or decision-making power that outweighs their investment.
This can lead to a loss of autonomy, hindering the startup's ability to innovate and make critical decisions that align with the founder's vision.
Now that we've highlighted the pitfalls, let's move on to best practices for crafting an ideal, founder-friendly term sheet.
1. Equity vs Dilution: To protect the founder's ownership stake in the company, it's crucial to negotiate reasonable equity distribution and dilution clauses. A founder-friendly term sheet should have a reasonable cap on the total dilution from future funding rounds, preventing the founder's stake from being eroded too heavily.
2. Anti-dilution Provisions: While it's understandable that VCs want to protect their investments, some term sheets include onerous anti-dilution provisions that can disproportionately dilute the founders' stake in the event of a down round. Founders should push for a "weighted average" anti-dilution provision, generally considered more equitable and balanced.
3. Vesting: Founders should negotiate for a vesting schedule that aligns with their long-term commitment to the company, typically over a period of four years with a one-year cliff. This ensures the founders' interests are protected while incentivising them to stick around and grow the company.
4. Right of First Refusal (ROFR): Founders should seek to limit the scope of the ROFR, which gives VCs the right to participate in future funding rounds. By doing so, founders retain the flexibility to bring in other investors and negotiate better terms in subsequent rounds.
5. Drag-along Rights: Founders should be cautious about agreeing to drag-along rights that allow VCs to force the sale of the company. If included, it's important to ensure that the terms are fair and reasonable and that the founder's interests are protected.
Finally, only some of the VCs are draconian. Keeping the founders happy and purposeful is necessary for their startup bets to fetch returns. Many realize this. But still, there needs to be more transparency in India's startup ecosystem when discussing the tricky term sheet clauses.
It's time to start a crowdsourcing movement for creating templates for a truly "founder-friendly" term sheet.
(Pankaj Mishra has been a journalist for over two decades and is the co-founder of FactorDaily.)
Disclaimer: These are the personal opinions of the author.