Most founders never receive a term sheet. 

But if you’ve dedicated your life to a startup and finally made it to this stage of the game – congrats! 

The only problem is now you’re facing a new ‘boss’, one that has played the game hundreds and maybe even thousands of times before. 

But likely this is your first time sitting at the table across from a seasoned VC – so we’re writing this blog to even up the match and help you get the best possible outcome in your term sheet negotiation. 

Vulture Capitalists

These are VCs that will offer you predatory terms and try to steal an outsized chunk of both ownership and control. 

Some refer to these folks as ‘Vulture Capitalists’ who work to extract a ‘pound of flesh’ from your cap table. 

Not all VCs are vulture capitalists, but unfortunately, in down markets like these even VCs with the shiniest logos, largest assets under management, and sharpest jawlines will stoop to these levels. 

At the end of the day, talk is cheap but the terms are your source of truth and give you great insight into who you are actually going to be working with for the next 5-10 years. Below are some terms to help you figure out if you have a VC that is ‘in it to win it’ with you or a Vulture Capitalist.

How Much Do Investors Make at Exit?

Play close attention; here are the two terms where most of the games are played:

Liquidation preference greater than 1x

• • 1x means that the investors get paid their money back first before anyone else. This is standard. 
  • BUT if someone asks for 2x it means that they get 2x their money back before anyone else gets paid. That means if you get a small exit the VCs might be the only ones that get paid. 
  • This is a predatory term. If someone asks for anything other than 1x liquidation preference; run, or at least understand what you’re getting into.

Participating preferred

• • After receiving their liquidation preference the investor will also receive the return on their equity investment. 
  • This is a non-standard term because investors will receive BOTH their liquidation preference return AND the return on their equity. 
  • They should be offering you non-participating which means that if they take EITHER their liquidation preference OR the return on their investment. If someone is asking you for participating… they are likely a vulture capitalist.

1x non-participating

• • Hopefully this is what’s in your term sheet. If not, ask for it. If they push back, be prepared to find another investor.

Board Seats

It is always better to give away as little control of your company as possible. Irrespective of how much value you think the VC will bring or how confident you are in your role as CEO. This is how founders lose companies.

When is the right time to have an investor join your board? 

• • Try to not let anyone onto your board until they have invested at least $1m. If you can do this you can probably make it to your Series A without any outside additions to your board. 
  • This is useful because during your A you’ll probably need to give up 1 seat, and your B another seat. If you have two founders and then one neutral party… this is how most boards tend to shake out and puts the founders on about equal footing with the investors – 2:1:2
  • If you have to take an investor onto your board during your Seed round then the scales are likely to tip into your investors favor.

Expanding the board is one of your best cards

• • Many investors are required in their bylaws to take a board seat. If this is the case then you must give them a seat if you want their money and there is no point in trying to negotiate this. 
  • However, you may get them to approve expanding the board. So use this as a counter-offer: ‘Yes, I will give you a seat at the board but I would like to expand the board from 3 to 5 seats’. 
  • You can give those to yourself (yes you can do that) or to people that you trust and are aligned with.
  • The investors you want are those seeking oversight and not necessarily control, so this could check the box for them while still keeping you firmly behind the wheel.

Anti Dilution Protection

Here are a few ways that investors may try to avoid getting diluted should you have a down round in the future. Note that some anti-dilution protections are standard, while others are clearly predatory.

Full Ratchet

• • This is the most draconian form of anti-dilution protection during down rounds, should be avoided, and is a clear sign you are dealing with a ‘Vulture Capitalist’.
  • How it works: in the event of a down round the investors receive more shares to maintain their percentage ownership and are not diluted. It is as if they are investing in the current down round.
  • This term is very uncommon and predatory for later staged priced rounds.
  • However, surprisingly it is used frequently for earlier-stage companies. Convertible notes and SAFEs effectively have full ratchet’s built-in. They don’t call it a full ratchet but the effect is the same – if you raise a priced round below the cap the investors get the future ‘down round’ price and receive more shares than if you raised at or above the cap.
  • One of the benefits to pricing your round is you get to lock in a price and thus if you have to raise a down round in the future the investors will dilute with you.

Narrow-Based Weighted-Average

• • This also provides investors with anti-dilution protection during a down round, however, it is not as extreme as the full ratchet since it takes into account the weighted average of the total number of outstanding preferred shares when setting the new weighted average price.
  • TLDR: if you have to get an emergency small investment to keep the company afloat it will only trigger a small amount of dilution protection. 
  • This term is fairly standard. If you have leverage in the negotiation you can remove it when you counter-offer.

Broad-Based Weighted Average 

• • This is even better for the founder – when calculating the new weighted average of the price per share, this formula provides even less dilution protection to the investors because it references the entire cap table*, instead of just the outstanding preferred stock.
  • *Some refer to this as the ‘fully diluted capitalization’ and includes all outstanding common stock, preferred stock, warrants, options, & convertible securities – get familiar with this term; you’re going to see it everywhere.
  • If an investor asks you for Narrow-Based, you might suggest removing it all together and end up using Broad-Based as a happy compromise.

Gimme More

Sometimes investors just… want… more. VC investors make their money off of the upside in their preferred shares so traditional venture capitalists will rarely ask for warrants or dividend payments; however, there are a lot of new players in the venture capital space these days. Family offices, hedge funds, and PE firms are becoming increasingly active in later stage rounds and might try and sneak these terms in to juice their returns:

Warrants 

• • Warrants give investors additional upside in your startup. It gives the holder the right to buy your equity at a future date at a predefined price. 
  • It is quite common for accelerators to ask for warrants. These warrants can vary widely so play close attention, talk to your advisors/lawyers, and be prepared to defend them during due diligence.
  • However, it is rare to see late stage priced round investors to ask for warrants on top of their investment.
  • Warrants reduce the price investors are paying for your equity, but it can be challenging to figure out by how much. This is because warrants can get complicated. EG giving an investor the additional right to buy your stock at 2x its current price may not sound like a lot… but if you 100x it is worth a ton.
  • It is cleaner to just give investors a lower price.
  • The fact that they are asking for warrants, especially if they have strange or unclear terms, may show that they aren’t ‘in it to win it’ and are trying to get one up on you. Proceed with caution and make sure you know the value of what you are selling.

Dividends

• • Note that the board has the power to issue a dividend suspension and turn off dividends for all preferred shareholders. 
  • Cumulative dividends allow all dividends to accumulate. The dividend payments continue to build up over time and are due when dividends are finally issued.
  • Non-cumulative dividends are better for your startup because if dividends aren’t paid in a specific year, they aren’t owed in the future.

Pressure Tactics

Nothing like starting a 5-10 year working relationship like ‘sign over your life’s work to us and the clock is ticking. These terms give you great insight into what kind of investors you are dealing with and may indicate you are sitting with a Vulture Capitalist. Alternatively, it’s an indicator that your investor may be insecure, really wants to invest in your company, and is worried you will take someone else’s money. In either case, this is a good spot to negotiate firmly, if they are insecure they will fold, and if they are a Vulture Capitalist you probably don’t want to be working with them anyways. 

24-Hour Exploding Term Sheets

• • This is a line sent in the email body or tucked quietly at the end of your term sheet that says something like “sign this document by 7 pm tomorrow or the offer expires” 
  • This is not a great way to do business, is a yellow flag, and a hint you may be dealing with a Vulture Capitalist. 
  • But if you are excited to work with the investor, or really need the money, I’d recommend politely responding that you’ll need more time to review with your lawyer and stakeholders.

90-Day No Shop Clause

• • After you sign the term sheet you won’t be able to negotiate with any other investors. It is understandable that VCs won’t want you to shop the deal since that will take away their leverage.
  • However, once you have signed the term sheet the VCs will have to invest both money and time into the final due diligence so some amount of no-shop is reasonable. 
  • Push back on this and ask for two weeks; 30 days is likely a reasonable compromise.

International Terms

The focus of this blog has been on United States startups and investors. What is standard outside of the US can vary widely. Lean on your lawyers and advisors to guide you on terms, and trust your intuition about people.

Strong But Fair

There is no harm in reaching for more when you have the leverage to do so. And don’t think you are immediately dealing with a Vulture Capitalist just because they are doing the same. Your exit, however great, will be finite. Some will make more than others; this creates a natural tension.

But use that tension to your advantage – use this blog to negotiate with strength & confidence…. as well as transparency and openness. 

Demand the same of the people you do business with and you’ll increase your chances of achieving your startup dreams. 

And while we’ve spent most of this blog talking about how to best view your investors… it’s good to be reminded that they will be performing the same calculus on you as they try and assess what kind of founder you are.

On this front my advice is simple: it is easier to act honorably than to pretend to be honorable. 

Good luck!
–Dustin Byington Co-Founder & CEO of TWO12

PS > Guide to Priced Round Terms Webinar

If you have any questions on the topics of priced round terms or term sheet negotiations we’ll be hosting a webinar on this topic soon, please email us at hello@two12.co to be notified. 

About Dustin Byington

I started my career at Goldman Sachs, have led two unicorn fintech companies, and am currently working on constructing the equity rails that Web2 forgot to build. My goal is to bring digitization, automation, and transparency to the startup asset class. You can sometimes find me on LinkedIn and Twitter.  

About TWO12

TWO12 is on a mission to help founders realize their startup dreams. In addition to providing educational content focused on startup finance we also offer Unlimited $240/year Cap Table Management, 409a Valuations, Fundraise Valuations, Fund Administration, SPV Formation, Syndicate Backend Management, and more…https://two12.co/

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