TRC 002: Deal terms for early stage startup foundersFeb 02, 2023
Read time: 5 minutes
It can be tempting as an early stage founder to just glance over the clauses in a term sheet.
When you are busy trying to close a round, whilst ensuring that growth or product development doesn’t drop off a cliff, the level of detail involved in legal documents can be the last thing you need.
But the wrong terms can have a material impact on a startup and its founders.
It goes without saying that we are not lawyers, so you shouldn’t rely on this as legal advice, but it does outline a lot of what we have seen from hundreds of rounds over the years.
Here are some of the things to watch out for.
OK - so that’s pretty obvious you say.
Well, yes, but there are some important things about getting your valuation right that may not be obvious when you are starting out.
- In trying to maximise your valuation to reduce your potential dilution, you may end up taking bad terms in other areas (e.g. see liquidation preference below) that will have a more detrimental impact on your financial outcome as a founder than the dilution you are seeking to avoid.
- Be careful about over-diluting early. Whilst it is important to ensure you have sufficient runway to get to the next capital raise, taking too much dilution early on can make it difficult to raise a round later. Investors will worry about a founder’s future engagement if they own too little of the business. The broad rule of thumb is they look for the founders and the team to retain c.50% at series A.
Don’t overthink it - the broad rule of thumb is take just as much as you need with a bit extra for contingency - typically up to 20% - because things almost never go to plan.
The liquidation preference clause determines how much of the proceeds from the sale of the company will go to the investors before the founders and other shareholders receive their share.
This can be particularly important if the company is sold for less than the valuation set in the term sheet. If the liquidation preference is too high, you may end up with little or no proceeds from an exit. This tends to happen more than is ever reported in the startup tech press.
If you are raising an early angel round, nobody should should be forcing you to have a liquidation preference and you shouldn’t say yes if a potential angel investor asks for it (unless you are absolutely desperate for cash, and even then you should think long and hard as it is a bad signal for future investors)
A liquidation preference is standard when getting a term sheet from VCs beyond an angel round.
Liquidation preferences are expressed as a multiple of the investment.
1x means investors receive a dollar back for every dollar invested; recouping their money in full, as long as there’s enough to cover this. Common shareholders (including founders) will share what’s left.
If your business has struggled to hit key milestones, or you are asking for a valuation that investors are less comfortable with, the VC investor may try to push the valuation up above 1. This more means they get more than the amount that they have invested back at an exit.
Be cautious when being offered terms that give your investors back a guaranteed multiple of what they have invested at the point of an exit. It could mean all your hard work gets you only a very small return - or none at all.
The board seats clause determines how many seats on the company’s board of directors will be held by the investors. This can be important because the board of directors has significant control over the company’s operations and strategic direction. If the investors are given too many board seats, the founders may lose significant control over the company.
Ultimately, loss of voting control on the board means a founder can be fired from their own company, so it is very important to ensure that your retain founder control.
One of the most typical ways that this can happen is that investors end up with the same number of votes on the board as the founders, and the final vote is from an independent director. This leaves the final vote up to influence.
It is important to question the intentions of any investor who is looking to put themselves in a position to take control of the board as part of their investment.
Rights and preferences (aka Investor Consent)
The rights and preferences clause outlines the special rights and preferences that the investors will have as shareholders in the company. These can include things like the right to veto certain decisions, the right to elect additional directors, and the right to receive additional dividends or other payments.
These rights and preferences can affect your control over the company and limit your ability to make decisions on its behalf.
It’s another kind of control that some investors can seek to exert over the company. It is often justified on the basis of governance and accountability, but is mostly just another form of risk mitigation on behalf of the investor.
Drag-along and Co-sale rights (often called drag and tag)
Drag along and tag along clauses become important when the sale of your business becomes a possibility.
The aim is to balance the interests of the major shareholders - typically the main investors, and, especially at the early stage, the founders, with those of the smaller investors
Drag-along: If a given percentage of shareholders want to go ahead with a sale then all shareholders must sell at that price. This is because most purchasers will look to buy 100% of the company and the major shareholders don’t want a deal founder because a few minor shareholders fail to approve the deal
The important thing as a founder, is to ensure that the terms are structured in a way that the investors can’t force you to sell too early, or at a price that might leave you with nothing after the liquidation preference has been accounted for.
One way to protect yourself and the minority shareholders is to have the following as linked provisions to trigger the drag-along:
A majority board vote.
A majority (or more) of the preferred vote (typically the major investors).
A majority (or more) of the common vote (typically the founders, team and earliest investors)
Tag-along: The tag-along clause is there to protect minority shareholders if the company is being sold. In the event of an exit share sale by a majority shareholder, tag-along extends the sales right to other shareholders, so that they can also sell their shares at the same price as the majority shareholder if they want.
This is something that can easily catch early stage founders by surprise when they go to raise their first VC round.
‘Well I already own the shares in my company don’t I?’
Well, yes, in essence, but not if you are raising external investment from a Venture Capital firm.
The principle is that a founder’s full equity share will build up (or vest) over a stated time period, typically 3 or 4 years. If the founder leaves the business during the commitment period, they lose the unvested portion of their shares.
Investor terms vary on founder vesting, but the most common period is that founder shares vest monthly over 3 or 4 years. This type of clause is used to motivate founders to stay involved in the business. The vesting period, frequency and percentage of shares subject to vesting are all open for negotiation.
When an investor seeks to put in non-standard or ‘aggressive’ terms, they are essentially trying to mitigate their financial risk. This is a reasonable guide to how they might behave if things are not going to plan.
Good investors have a much greater tendency to deal with this risk through negotiating valuation as they believe this is the best way to build long term value - something that they believe they are in a position to help you do.
As YCombinator eloquently puts it ‘…..when an investor says that they’re committed to partnering with you for the long-term - or that they’re betting everything on you - but then tells you something else with the terms that they insist on, believe the terms.’
Terms, not words or promises, are what people will come back to in the event of a dispute. It's better not to assume that this won't happen to you.,
- Always go through a term sheet in detail
- Never assume good intent
- Some of the key terms to understand and keep an very close eye on:
- Liquidation preference
- Board seats
- Rights and preferences
- Drag-along and Co-sale rights
- Founder vesting
- An investor's intent is best believed based on the terms than their words
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