Navigating the risks of “dirty” term sheets

"Startup X raised € Y million investment, valued at € Z million." 

This is a familiar headline in the tech media landscape – and perhaps the future funding triumph of your company. Yet, hidden behind these eye-catching figures are critical provisions that will profoundly impact the path of your startup and determine the financial outcomes for you and your team in the event of a successful exit. These vital details are typically laid out in a term sheet. 

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What is a term sheet?

Think of a term sheet as your investment blueprint, outlining key terms agreed upon in principle by parties. Although the term sheet itself is not generally legally binding, it can include certain legally binding provisions, like confidentiality or exclusivity. However, given that the final investment agreements – usually encompassing an investment agreement (IA) and a shareholders’ agreement (SHA) – typically follow the roadmap laid out by the term sheet, it is essential that you understand its provisions and their implications before you seal the deal.

Let’s take a deeper dive.
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Don’t solely fixate on valuation

While a term sheet primarily focuses on financial matters, it also outlines the dynamics and balance of power between you and your investors. Founders sometimes obsess on valuation while overlooking other critical provisions in the term sheet. Investment money and valuation hold immense importance – but so are many other term sheet terms.

In the wake of the tech investment frenzy reaching its peak in 2021 (as depicted above), the funding landscape has undergone a remarkable shift where capital is now more expensive and valuations are down. 

With valuations on the decline and founders striving to avoid raising at a lower valuation than a previous round – a so-called “downround”, which dilutes existing shareholders' stakes – a wave of creative solutions has surfaced. These include:    

• the introduction of “extensions” – raising additional funds at the same terms as last time, 
• raising capital through convertible notes, i.e. raising debt that converts to equity at a discounted valuation to be determined later, and 
• the implementation of “tranches”, where investors release funds based on performance milestones.

And, in the midst of this creative landscape emerges the intriguing player: 

The Dirty Term Sheet.
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What makes a term sheet “dirty”? And why is it problematic? 

Provisions that boost potential gains, ensure minimum returns, or provide protection against downsides are sometimes labeled as "dirty" due to their inclusion of non-standard or highly complicated features, differing from the straightforward "clean" term sheets featuring standard clauses. Put differently, “dirty” terms are proposed investments where the majority of the economic gains for the investor do not necessarily come from the headline valuation, but rather through a series of dirty terms that are hidden deeper in the document. 

Dirty term sheets pose significant challenges for two key reasons: 

Firstly, they tend to “explode” at some point in the future. You can no longer simply look at the cap table and estimate your return. Once you have accepted a dirty offering, the calculation of payouts for potential future valuations becomes intricate. This involves a complex analysis, where the investor's return is computed as a priority, leaving the remaining proceeds to be distributed among other stakeholders.

The second significant problem stems from how complex these dirty term sheets are. This could make it really tough to find funding in the future. If a potential investor is faced with a dirty offering, they'll closely study the complicated details of the previous deal. They might even decide not to invest. This raises the chances that you'll either run out of money or need a major recapitalization that wipes out the ownership of past shareholders. So, even though taking such a round might seem harmless and temporarily relieve your worries, it could unknowingly expose your entire company to significantly higher risks.
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Identifying red flags - let’s look at three examples

So what does a dirty term look like? Let's delve into some common examples.
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‍🚩 Aggressive liquidation preferences 

Beyond fundraising, there is another important milestone for companies – an exit, more commonly known as a liquidity event. These events can range from sales, mergers and acquisitions, IPOs, to even the company’s insolvency. When a liquidity event occurs, the company is obligated to pay out its shareholders. Liquidation preference clauses outline how investors receive returns in liquidity events. 

The choice of liquidation preferences can significantly alter the payout waterfall for both investors and founders alike. In the longer term, the choice of liquidation preferences will also determine how much of an administrative hassle the founders will need to deal with when paying out its investors.  

From the investor's standpoint, a liquidation preference acts as a safeguard in case the company exits at a lower valuation than initially anticipated.

There are typically four primary features of a liquidation preference:

• The multiple – this specifies how much preference shareholders, specifically those first in line to be paid out by the company, must be paid out minimally before the other shareholders receive any payout. Typically, the liquidation multiple is with reference to the total invested amount for each investor. Higher multiples (anything above a 1x liquidation multiplier) can be particularly painful for founders who can be left with nothing or next to nothing in a liquidity event.
• Participating vs. non-participating – a “non-participating” liquidation preference means that preferred shareholders have the option to (a) receive a payout in accordance with their specified liquidation preference, OR (b) receive a payout based on their percentage shareholdings, whichever is higher. Think “participation” liquidation preference on the other hand as the investor double-dips by getting its money back PLUS its pro rata.
• The cap – the cap specifies the maximum total payout that the investor can receive, with respect to their liquidation preference.  
• Seniority structures – dictates the order of payouts.

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‍Recommendation: When accepting investments into your company, you need to carefully consider what each type of proposed liquidation preference would entail. Also, you need to balance the interests of the new investors, the ones who invested earlier, and your own interests. Take the time to analyze and model various projected exit values to fully grasp the actual monetary differences that arise from different options for liquidation preferences. 

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‍🚩 Unfair leaver clauses 

Leaver clauses are provisions that outline the repercussions when an entrepreneur or key employee departs from the company, and are a form of “vesting mechanism”. These clauses can be triggered by various circumstances such as resignation, termination, or unfortunate events like death. They can be broadly categorized as either good leaver clauses or bad leaver clauses.

A good leaver clause typically offers favorable treatment to an entrepreneur who leaves the company due to circumstances beyond their control, such as health issues or family emergencies. A good leaver clause would be unfair if it so narrowly defined that it is impossible to qualify for it, leaving the founder with little to no protection even if they leave for a valid reason.

 A "dirty" way to draft a bad leaver clause would be to make it excessively punitive or unfair, e.g. the founder forfeits all equity in the company if they leave, even if they have vested shares or have contributed significantly to the company's growth.

Both scenarios are problematic as they create an imbalance of power between the entrepreneur and the investor, potentially straining their relationship and ultimately hampering the company's success.

‍Recommendation: Key considerations include: i) When does the vesting period commence? ii) Does vesting accelerate upon termination without cause? iii) Does vesting accelerate (either entirely or partially) in the event of a change of control?
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‍🚩 Overly broad or vague veto rights 

A common way to downside risks when making an investment is by inclusion of veto rights over certain major company actions. Veto rights give a party the ability to block or veto certain decisions and thereby provide control over the direction of the company.

Veto rights are referring to the “reserved matters” list, namely stuff that relates to the company’s business affairs such as future shares issuances, amendments to the company’s constitution, declaration of dividends or the sale or buyout of any new business or formation of a new subsidiary. In practice, the company (i.e. the management team) will have to seek the investor’s approval before taking any of these actions.

These clauses are common to include in a shareholders’ agreement, but can become problematic if they are too broad or vague. For instance, a clause that states "the investor will have the right to veto any major decisions" without defining what constitutes a major decision can leave room for disagreements and disputes.

‍Recommendation: You need to carefully review the proposed veto catalog, and consider what each type of matter subject to veto right would entail. Key considerations include: i) ensure that the matters subject to veto rights are defined with clarity and specificity and ii) reflect on the long-term impact of veto rights on the company's management and growth.
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How to get a fair VC term sheet

We aren’t here to tell founders what the right terms are for their business. Instead, we strive to empower founders with an understanding of the implications and potential trade-offs involved when bringing in external investors. Sometimes, opting for a downround – entailing a lower valuation – might be more favorable than embracing investments which could entail significant control concessions to new investors.

Here are essential steps to be better equipped to negotiate a term sheet that reflects the best interests of your business and its future:

• Always ask why certain clauses are included if you’re uncertain about their meaning or if they raise concerns. Investors should be able to provide logical reasons. Responses such as “we always do it like this’’ do not count.
• When reviewing a term sheet, it's essential to have a clear understanding of what could happen in the best-case scenario as well as the worst-case scenario. Only then can you make informed decisions that align with your long-term goals.
• Never sign a deal that you don't fully comprehend.
• Seek legal advice from experts in the field.
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‍Our commitment

As early-stage investors, we're the first institutional backer behind many amazing founders. At Wellstreet, we have therefore committed to pave the way for a just and transparent deal, setting the benchmark for others to follow. 

We believe that a fair term sheet is good for everyone.

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Eager for more? Stay tuned as we're preparing to launch a digital course on this very topic soon!

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Disclaimer: This content is provided for informational purposes only. This is not legal advice. Always consult with a legal expert.