5 Red Flags in Term Sheets That Every Founder Should Be Aware Of
You finally did it. After months of pitching, hustling, and negotiating, you landed a term sheet from an investor for your startup. Before you pop the champagne, take a close look at the details. Some terms in the sheet could signal the investor isn’t as founder-friendly as you hoped. Watch out for these red flags that indicate you should proceed with caution. If you see more than one or two of these warning signs in the term sheet, you may want to keep pitching other investors. Your startup is your baby, and you want investors who will help it grow into a thriving business, not constrain it from the start. Read the fine print, consider negotiating the terms, and make sure this investor is the right fit before you sign on the dotted line. The decisions you make now will impact your startup for years to come.
What is a term sheet?
A term sheet is a non-binding agreement that outlines the basic terms of an investment deal. It’s like a blueprint for the actual contract that will follow if both parties agree to move forward.
Before you sign on the dotted line, scrutinize the term sheet for these potential red flags:
- Excessive control provisions. Look out for terms that give investors an inordinate amount of control or decision making power over your company. Things like veto rights over budgets, hiring/firing executives, future funding rounds, or a board seat. Some control is standard, but too much can hamper your autonomy.
- Unrealistic deadlines. Be wary of tight timelines for due diligence, closing the round, or meeting key milestones. Rushing important processes or deliverables often leads to mistakes and regrets. Push back on unreasonable deadlines whenever possible.
- Onerous liquidation preferences. Pay close attention to the liquidation preference, which determines how proceeds from an exit are distributed. A 3x participating preferred liquidation preference, for example, would require common shareholders to receive 3 times their investment before other shareholders get paid. That can seriously dilute founders and employees.
- Misaligned incentives. Look for terms that motivate investors to maximize their own gains above all else. Things like uncapped returns, cumulative dividends that accrue at high interest rates, or ratchet provisions that continually increase an investor’s ownership. Those types of provisions prioritize investors over the company and common shareholders.
- Burdensome reporting requirements. Make sure any reporting obligations, like monthly financials or KPI updates, are reasonable given your team’s bandwidth and the investment amount. Ongoing reporting should never become an unnecessary distraction or burden. Push back on requests that go above and beyond industry standards.
With careful review, you can spot potentially problematic terms before they cause trouble down the road. Don’t be afraid to negotiate the best deal for your company. The terms you agree to today will have consequences for years to come.
Vague Valuation Terms
Vague valuation terms in a term sheet could mean trouble down the road. If a term sheet says something like “a $10 million pre-money valuation” but doesn’t specify how that number was calculated, that’s a red flag. Without details on the methodology, that valuation could be unrealistic or misleading.
Some key things to look for are:
- The valuation method used. Was it based on revenue multiples, profit multiples, discounted cash flow, or something else? Each method can yield very different results, so know which one was applied.
- Relevant comparables. The valuation should take into account metrics from comparable companies. If not, the number could be way off base. Ask to see the list of comparable companies used and how their metrics compare.
- Growth and projection assumptions. Valuations are often calculated based on estimated future performance. Make sure any projections seem reasonable and aligned with your actual growth trends and plans. Unrealistic “hockey stick” growth curves can lead to inflated valuations.
- The capitalization table. Understand how many shares will be outstanding after an investment and your percentage ownership. A high valuation means little if it comes with a tiny equity stake!
- Anti-dilution terms. Look for provisions that protect your ownership if more shares are issued in the future at a lower price. “Full ratchet” anti-dilution is most protective of investors.
In summary, don’t just accept a valuation at face value (pun intended!). Make sure you understand all the assumptions, inputs and terms behind it. With the right questions, you can determine if that tantalizing $10 million valuation is solid gold or merely fool’s gold. Better safe than sorry!
Lack of Vesting Terms for Founders
One of the biggest red flags is a lack of vesting terms for the founders in the term sheet. Vesting means that founders earn or vest their equity in the company over time to ensure they stick around for the long haul. Typically, founder shares vest over 4 years with a 1-year cliff. That means if a founder leaves in less than a year, they forfeit all their shares. After a year, shares begin vesting monthly or quarterly.
Without vesting, founders could walk away with a large chunk of equity after a short period of time. This poses a huge risk to investors that the founders won’t stick around to build the company. Imagine investing in a startup and a month later, 50% of the shares belong to a founder who decides to quit! Vesting protects investors and ensures founders have proper incentive to make the company a success over many years.
Some reasons vesting may be left out of a term sheet include:
- Inexperienced founders who don’t understand vesting and why it’s important. Do your research and push back on this!
- Founders who want an easy payout and exit. This is a major red flag that the founders may not be dedicated to the long-term vision.
- Poor legal counsel. Reputable startup lawyers will always advise founders to include vesting terms to protect both founders and investors.
- Unreasonable founders. Some founders may think they “deserve” their equity right away. But vesting is industry standard and benefits everyone in the long run.
If vesting is missing from the term sheet, request that it be added before moving forward with the deal. Vesting should always be included to ensure proper incentives and protection for a startup. The specific vesting schedule is negotiable, but its existence should not be. This is one term worth pushing back on if needed.
Broad 'Drag-Along' Rights
Broad 'drag-along' rights give investors an enormous amount of control over the startup and founders. These provisions allow investors holding a certain percentage of shares, often a majority, to force other shareholders to join in the sale of the company. This means if a few large investors want to sell, they can 'drag along' all other shareholders and force them to sell their shares as well.
As an entrepreneur, you need to be very careful with drag-along rights. They can allow investors to sell the company out from under you, even if you disagree with the sale. The investors are primarily concerned with getting a large return on their investment, not your vision for the company. If they see an opportunity to make a profitable exit by selling the company, they may exercise their drag-along rights and force you and other shareholders to sell.
Some tips for negotiating drag-along rights:
- Limit the percentage of shares that can trigger the drag-along. A supermajority, like 75-80% is better than a simple majority of 50-60%. This makes it harder for a small group of investors to force a sale.
- Negotiate a floor price below which shares cannot be dragged and sold. This protects all shareholders from being forced to sell at a price that undervalues the company.
- Consider carve-outs that prevent the drag-along from being exercised in certain situations, e.g. if the company is close to reaching an important milestone. This gives you more flexibility and control.
- Negotiate tag-along rights, which allow minority shareholders to join in and sell their shares on the same terms as the majority if they choose. This can provide more opportunities and benefits for smaller shareholders.
- Carefully review all details of how the drag-along provision can be exercised to understand the level of control investors have to sell the company without your agreement. Question anything that is unclear and push back on terms that give away too much power.
Broad drag-along rights are a sign investors want a lot of control over the ability to sell the company when they want and how they want. Make sure you fully understand any drag-along provisions before signing the term sheet to avoid losing control of your startup's destiny.
Restrictive ‘Right of First Refusal’
A ‘right of first refusal’ gives investors the right to participate in future funding rounds before outside investors. However, an overly restrictive right of first refusal can be a red flag.
If the term sheet gives investors an indefinite or very long right of first refusal—like over 5 years—it could deter other investors from participating in future rounds. They may not want to go through the process of conducting due diligence and term sheet negotiation if the existing investors are guaranteed participation and can block the round.
A right of first refusal should be limited to the company’s next equity financing round. It should not apply to debt financings, convertible notes, or non-equity fundraisings. The company needs flexibility to raise capital as needed to fund operations and growth.
The right of first refusal should also specify a reasonable time period for investors to exercise their rights, such as 15 to 30 days after receiving notice of a new funding round. An open-ended or lengthy decision-making period creates uncertainty for the company and can slow down or jeopardize a funding round.
Rights of first refusal are meant to give investors some protection and allow participation in future growth. However, an overly restrictive right can backfire by deterring new investment and limiting a company’s access to capital. As with all terms, the right of first refusal needs to strike a balance between investors’ rights and the company’s need for flexibility and control over financing decisions.
When reviewing a term sheet, look for a narrowly tailored right of first refusal that applies specifically to the next equity round and provides a reasonable decision-making window. If the terms seem too restrictive, you’ll want to negotiate improvements to ensure your company’s ability to raise funds on acceptable terms.
Aggressive ‘Liquidation Preference’ Terms
Liquidation preference terms refer to how much equity investors get paid first in a liquidation event like an acquisition. Aggressive terms heavily favor investors over founders and employees.
For example, a 2x liquidation preference means investors get paid double their investment amount before anyone else gets paid. A 3x or higher preference is a major red flag. At that point, founders and employees are working mostly for the benefit of investors.
Another concerning term is ‘participating preferred’ stock which allows investors to get their preference amount and then share in remaining proceeds alongside common stockholders. This reduces the amount left for founders and employees.
It’s understandable that investors want to minimize risk, but overly harsh liquidation preferences make it almost impossible for founders and employees to earn a reasonable return. Such terms suggest the investors don’t fully believe in the startup’s potential and are just trying to guarantee themselves a large payout.
Rather than accepting unfair terms out of desperation, founders should push back on aggressive liquidation preferences during negotiations. A 1x preference is standard and fair. Higher preferences should come with additional benefits like a higher valuation or more investment. If investors won’t compromise, it may be better to walk away and find new investors who believe in the vision.
The liquidation preference signals how much investors trust and value the founders and their company. Make sure the terms are fair before moving forward, or you may end up with no ownership in your own startup! Discuss concerns with a lawyer to understand your rights and set reasonable limits on what you’re willing to give away to secure funding. Your startup’s future depends on maintaining a fair balance of control between founders and investors.
So there you have it, five major red flags to watch out for in term sheets that could signal trouble down the road. Negotiate the best deal you can, ask lots of questions, and don't feel pressured into signing anything you're not comfortable with. Your startup is your baby, and you want to make sure any new investors will treat it right. If something feels off, it probably is. Trust your instincts on this one. The last thing you want is to end up in a bad partnership that sours what should be an exciting new chapter. Do your due diligence, get advice from experienced founders and industry experts like WOWS Global, and make the choice that lets you sleep well at night knowing you've set your startup up for success. You've got this! Now go out there and build something great.