These non-standard terms can be detrimental to founders, especially first-time founders who encounter such terms often without realising their long-term implications.
This article explores several non-standard terms we’ve encountered in our past experience and explains why they should be approached with caution.
Excessive liquidation preference
Liquidation preferences are usually anticipated in a term sheet, designed to protect investors holding preference shares in the event of a startup’s sale or liquidation.
The usual practice is to have a 1x liquidation preference (i.e. the investor gets back the 1x amount they originally invested) before any proceeds are distributed to other shareholders.
Be wary of non-standard term sheets that allow for liquidation preferences of higher multiples 2x or 3x, which entitles investors to two or three times their initial investment before the rest of the shareholders will receive any return of capital.
Additionally, a liquidation preference may also be a non-participating or participating liquidation preference. Participating liquidation preference provides more protection for investors since they can get both their original investment back as well as a portion of any remaining proceeds from the sale or dissolution pro rata with the remaining shareholders.
Why it’s non-standard
Excessive liquidation preferences are particularly problematic because they can leave present shareholders including founders and employees with little to no payout, even in a successful exit.
For example, if a startup is sold for US$10 million but a VC has a 3x liquidation preference on a US$3 million investment, the VC will receive US$9 million, leaving just US$1 million for distributing pro rata between all shareholders (including the investors if there is participating liquidation preference).
Full ratchet anti-dilution protection
An anti-dilution clause serves to protect investors in the event of a “down round” (i.e. a future funding round where your startup’s valuation is lower than in the previous round).
A full ratchet anti-dilution protection allows investors to reset the price of their shares as if they had invested at the new, lower valuation.
This form of anti-dilution clause can lead to severe dilution for founders and early shareholders.
For example, if an investor originally invested at US$5 per share, but the startup later raises money at US$2 per share, full ratchet anti-dilution would allow the investor to convert their shares as if they had invested at US$2 per share. This dramatically increases their ownership stake at the expense of the founders.
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Why it’s non-standard
Full ratchet anti-dilution is considered an aggressive protection for investors. As a founder, you may wish to propose a more common and balanced approach which is to use a “weighted average” anti-dilution, which adjusts the share price based on the overall effect of the new round but does not reset it entirely.
Excessive investor control over daily operations
The founders and the management team are responsible for the daily operations of the startup, while investors usually serve more of an advisory role. Non-standard term sheets may include provisions that give investors disproportionate control over daily operations. This could include the ability to veto hiring decisions, control budgeting, or even approve product launches.
Why it’s non-standard
Investors generally reserve veto rights for significant matters like acquisitions, raising new rounds of funding, or changing the startup’s business model, but not routine business decisions. As a founder, granting excessive levels of controls can slow down decision-making in a startup.
Excessively long “no-shop” or exclusivity clause
A “no-shop” or exclusivity clause, limits your startup from negotiating with other potential investors for a specific period, usually 30 to 60 days.
However, excessively long no-shop periods for 60 days or more, should be resisted as this may stop you from seeking alternative funding if the deal falls through.
Why it’s non-standard
While exclusivity may be expected, anything beyond 60 days may be considered as non-standard. You should negotiate for a shorter no-shop period as a long no-shop period may leave your startup vulnerable and may even lead to missed opportunities (particularly if the round fails).
Mandatory redemption rights
In simple terms, redemption rights allow investors to demand that your startup “buys back” their shares after a certain period (usually between five to seven years depending on the VC fund’s life).
While redemption rights should be anticipated, non-standard term sheets may include mandatory redemption clauses that force the startup to repurchase shares at a high price, regardless of you startup’s financial condition. Standard redemption rights are typically discretionary, meaning investors can request redemption but are not guaranteed it.
Why it’s non-standard
Compulsory redemption can create significant financial strain on your startup, especially if your startup does not have the necessary liquidity i.e. profitability to complete the buy back upon issuance of the redemption notice. In extreme cases, mandatory redemption rights can drive your startup into insolvency as the condition can lead to extreme financial burden on your startup.
Unrestricted Right of First Refusal (ROFR)
A right of first refusal (ROFR) clause allows a shareholder in a startup the right but not the obligation to purchase shares from the other existing shareholders before the shares may be sold to any third party.
While this is a common term, non-standard term sheets may involve unrestricted ROFRs, allowing an investor to block any sale of shares, even nominal or small transactions between other shareholders i.e. angels or employees, limiting liquidity among the present shareholders.
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Why it’s non-standard
Most term sheets may anticipate a ROFR with reasonable limits, such as the ability to buy shares only above a certain threshold or for strategic reasons. An unrestricted ROFR may be considered restrictive and should be resisted as it may be uncommon in a VC funding.
Cumulative dividend
A dividend is usually a cash distribution of a startup’s profit to its shareholders.
As a preference shareholder, dividends may be cumulative or non-cumulative at a certain rate (eg, six per cent to eight per cent annual dividend preference of the original invested sum).
If the dividend is cumulative, if your startup is unable to pay the dividends in a given year, they will accrue and must be paid before any dividends are paid to ordinary shareholders. If dividends are non-cumulative, unpaid dividends do not accrue, and there is no obligation to pay them in the future.
The rate will be a fixed return the VC expects to receive, but it can accumulate over time until a liquidity event i.e. an acquisition or IPO, triggering the payout.
Why it’s non standard
Startups rarely pay dividends because they generally prefer to reinvest their profits into expanding the business.
Agreeing on cumulative dividend terms can be detrimental, although it may be generally more common in later-stage financing rounds, where the startup is more mature and may likely be already profitable. Even in these cases, dividends are still relatively rare compared to the primary focus on capital appreciation.
Investor rights to force an IPO or a trade sale
Non-standard term sheets may give investors the right to force the startup into an initial public offering (IPO) or sale within a certain timeframe, regardless of whether the startup is ready or not. This can be harmful if your startup is not financially ready or even the market conditions are not unfavourable. This may force a premature exit.
Why it’s non-standard
Forcing an IPO or sale within a specific time frame may not be typical in early stage venture deals. Founders should be wary of this term, as it can push your startup into a premature exit (usually at a lower valuation than you may likely with more time to grow).
Final thoughts
Signing a bad term sheet can be detrimental down the line when you plan to raise further rounds from other investors. As a first time founder, it may be hard to distinguish between a standard or a non-standard term. Engaging a startup lawyer before signing a term sheet can help you pinpoint the red flags in a term sheet to avoid friction or even likely dispute in the future.
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