M&A advisor Walker Deibel recently tweeted and highlighted a critical issue for startup founders: a lack of understanding of the complex clauses and terms within venture capital (VC) term sheets. Deibel emphasizes that these seemingly innocuous terms can significantly impact a founder’s equity, potentially leaving them with nothing despite a successful exit. Few documents are as critical to shaping your startup’s future as the term sheet for proposed financing. In just a few hundred words, a VC’s term sheet defines the financial terms of the investment, your startup’s valuation, who will hold control, and who stands to gain the most if the company is sold or goes public.

He cites the example of FanDuel, which sold for a substantial sum, yet its founders reportedly received no payout. Deibel’s research, spanning over 250 deals, revealed numerous “toxic terms” employed by investors that can effectively dilute or eliminate founder equity.

This underscores the importance of thorough due diligence and expert legal counsel when navigating the complexities of VC funding. Founders must carefully scrutinize term sheets to fully understand the implications of each clause and ensure their long-term interests are protected.    

Dirty Term Sheets: A Growing Concern for Founders

Venture capital term sheets often have clauses that favor investors over founders. These “dirty term sheets” include provisions designed to maximize investor upside while minimizing their downside risk. This article will explore the characteristics of these predatory terms, how to identify them, and strategies for navigating these challenging situations.    

A “dirty” term sheet isn’t defined by any single clause but rather by an accumulation of unfavorable provisions that heavily favor the investor. These provisions may include:

• High Liquidation Preferences: Prioritizing investor returns over founder equity, even in successful exits.
• Liquidation Multipliers: Further amplifying investor returns, potentially leaving little to no equity for founders.
• Pro-Rata Rights: Allowing investors to maintain their ownership percentage in future funding rounds, diluting founder equity.
• Full Rachet Anti-dilution Protection: Protecting investors from potential equity dilution in future funding rounds, often to the detriment of founders. 
• Board Flipping Rights: Investors can secure decisive board authority through voting rights, even with minimal equity ownership, effectively sidelining founders from critical decisions. 
• Investor Veto Power: Key decisions like acquisitions, executive hires, and major spending require investor approval, regardless of founder preferences.

Here’s what every founder needs to know:

Take FanDuel as an example. The founders built the company up into a business worth hundreds of millions of dollars.

Yet, the founders walked away with nothing when the company was sold.

This wasn’t due to bad luck or poor timing. It resulted from meticulously structured terms crafted to prioritize investor protection—often at the founders’ expense.

These terms are financial landmines that can obliterate founder equity in an instant.

Here’s the reality:

When you raise funding, you’re playing two distinct games.

The first is the game of business—running and growing your company. The second is the game of money—safeguarding your equity.

Most founders focus solely on the first and overlook the critical importance of the second.

1 Liquidation Preferences

The unseen threat to founder equity:

When investors put money in, they often secure terms ensuring they’re paid back first—sometimes 2-3x their initial investment.

This type of clause isn’t uncommon. It was even present in The Honest Company, founded by Jessica Alba.

2 Board Flipping Rights

However, some will likely stipulate that they receive board representation in exchange for funding when seeking investors. These clauses allow investors to gain control of the board, even with a minority stake.

One missed milestone or a disagreement on strategy, and you could find yourself sidelined—relegated to “Director of Marketing” at the company you founded. The VC strategy is brutally efficient: First, they oust the founder from the CEO role. Then, they bring in “professional management.” Next, they dilute the founder’s ownership stake.
Finally, they push for a rapid exit.  This is perfectly legal—and meticulously hidden in the fine print.   

3 Drag-Along Rights: Losing Control of Your Exit

Drag-along rights force you to sell your shares alongside the majority investor, even if you disagree with the timing, price, or buyer. This can significantly impact your equity and leave you with little to no return on your investment.

Key Takeaways:

• Limited Control: Drag-along rights significantly diminish your control over the sale of your company.
• Potential for Unfavorable Outcomes: You may be forced to sell at an inopportune time or for an inadequate price.
• Impact on Equity: These rights can significantly erode your equity stake, potentially leaving you with little to no return on your investment.

It’s crucial to consider the implications of drag-along rights and negotiate these terms to protect your interests.

A drag-along provision requires minority shareholders to participate in the sale of a company if the majority shareholder decides to sell. This ensures that minority shareholders are “dragged along” under the same terms, conditions, and price as other sellers.

Drag-along rights simplify transactions by streamlining processes like share offerings, mergers, acquisitions, or takeovers and give the majority shareholder greater control. Ultimately, this clause prevents minority shareholders from obstructing a sale arranged by the majority.   

4 Anti-Dilution Protection: Safeguarding Investor Interests (at Your Expense)  

Anti-dilution provisions protect investors from equity dilution in subsequent funding rounds where shares are issued at a lower price than in their initial investment.

• How it Works: When the company raises money at a lower valuation, these provisions adjust the conversion price of the investor’s preferred shares, effectively granting them more shares to maintain their ownership percentage.
• Impact on Founders: This mechanism primarily benefits investors, as their ownership remains relatively stable while the founders’ equity stake is diluted.
• Unfair Advantage: It’s akin to a game where only the founders can lose chips, while investors are shielded from the consequences of a lower valuation.

Understanding the implications of anti-dilution provisions is crucial for founders to negotiate fair and equitable terms in their funding rounds.  

Compounding Danger of “Dirty” Terms

Mr. Deibel highlights the compounding danger of these unfavorable terms. As funding rounds progress (Series A, Series B, Series C, etc.), the cap table becomes increasingly complex:

• Multiple Layers of Preferences: Investors from earlier rounds may have different and potentially conflicting preferences, creating a complex hierarchy of returns.
• Board Control Provisions: Investors gain more board seats, further diluting founder control.
• Anti-Dilution Clauses: These clauses compound, further eroding founder equity with each successive funding round.

Investor Sophistication:

Professional investors are highly skilled negotiators. They meticulously analyze each term, spend significant time on deal structure, and often devote relatively less time to valuation itself. This deliberate approach reflects their understanding of how these terms can significantly impact founder equity and ultimately shape the company’s trajectory.

Key Takeaway: Founders must approach term sheet negotiations with the same level of rigor and due diligence as their investors.

Protecting Yourself Against “Dirty” Term Sheets

• Plan Your Capital Needs: Carefully map out your total capital requirements upfront.
• Prioritize Early Funding: Aim to raise a larger initial round with favorable (“clean”) terms, minimizing the need for multiple funding rounds, each potentially introducing more unfavorable clauses.
• Seek Expert Legal Counsel: Consult with experienced legal counsel specializing in venture capital to thoroughly review and negotiate term sheets.

By carefully considering these factors, founders can navigate the fundraising process more effectively and protect their equity while securing the necessary capital for their business.

Building Leverage Before Raising Capital

The most effective defense against “dirty” term sheets is to build a strong foundation for your company before seeking investment. This includes:

• Demonstrating Revenue Growth: Achieve significant and sustainable revenue growth to demonstrate market traction and validate your business model.
• Optimizing Unit Economics: Ensure your company operates with strong unit economics, demonstrating profitability potential.
• Defining a Clear Path to Profitability: Outline a roadmap for achieving and maintaining profitability, showcasing your long-term viability.

The Importance of Leverage:

When a company is desperate for cash, founders are more likely to accept unfavorable terms. By building a strong foundation and achieving key milestones, you gain negotiation leverage and can demand more favorable terms from investors.

Conclusion 

When navigating the venture capital landscape, it’s essential to partner with an attorney experienced in venture financing. Begin by ensuring the investor is the right fit for your business, and then evaluate all the terms — not just the valuation. Please pay close attention to key elements like liquidation preferences, the options pool, and board seats to understand their implications fully.

An experienced attorney with a deep understanding of current market standards and the intricacies of venture deals can:

• Identify and Negotiate Unfavorable Terms: Spot “toxic” terms within term sheets and advise on effective negotiation strategies to protect your interests.
• Provide Strategic Guidance: Offer valuable insights on deal structure, valuation, and other critical aspects of the fundraising process.

By partnering with an experienced attorney, founders can navigate the complexities of VC funding with greater confidence and increase their chances of securing favorable terms. If your startup plans a fundraising round in 2025, it’s crucial to begin preparing your tax and financial due diligence materials now. This will ensure a smoother and more efficient fundraising process.