Common Pitfalls In Venture Capital Term Sheets

While VC firms can seem like friendlier negotiating partners than, say, private equity funds, it’s nevertheless imperative to bear in mind that these are professional investors, and that the purpose of venture capital term sheets is to get the best deal possible for the firm (and not necessarily you). The thing about common pitfalls in term sheets, though, is that they’re not always obvious, and it’s recommended that concerned parties engage competent legal counsel to assist on these issues. Nevertheless, knowledge and experience are invaluable in this context, and this Insight is designed to help shed light on some frequently seen issues for founders and startups in something of a “what to look out for in venture capital term sheets.”

1. Shop Where You Want

The single biggest red flag in any venture capital term sheet is a “no shop” (or “no-shop”) clause. A no-shop is another way of describing an exclusivity covenant, basically stating that the startup cannot seek out or connect with other potential investors for a set period of time. The point of a no-shop is to provide the parties with a window of time in which to finalize their agreement. What this really means is that it provides protection to a venture capital firm or other investor from having their investment “scooped” by a competitor. It’s a power play, made by a player who thinks the company they’re negotiating with needs their investment more than they need to make it. In some cases, that is the dynamic. But in many cases, particularly those in “hot” deal markets, competition is a startup’s best friend, and a long no-shop period could allow the “heat” of the market to dissipate while the startup’s options are still under restriction. In our view, a no-shop is an immediate red flag, and startups or other companies presented with one should consult competent legal counsel in order to formulate a strategy in response.

2. Seats Not For Sale

Venture capital term sheets very often contain a requirement that the investor gets a board seat. Board seat requirements have become so common that they’re almost a templated term in various VCs’ model term sheets. (That was a joke, but…was it?) But realistically, startups and other companies shouldn’t be of the mindset that their first, second, or other early stage investment round should require giving away one or more board seats. Investors will argue that a board seat is necessary in order to secure their investment. However, at a minority position on the board, does it actually accomplish anything, beyond perhaps setting the stage for other eventual board seats forming a bloc of investor-directors who can wrest control away from the founders? True concerns of investors around investment protection can often be resolved in the Stockholders’ Agreement, particularly if the investor is purchasing a class of equity other than common (e.g., a series of preferred). 

3.  The Option Pool Shuffle

As much as we’d like to, we can’t claim credit for inventing the term “Option Pool Shuffle,” as typically seen on venture capital term sheets. The term was invented, as far as we know, by the co-founders of AngelList on their blog, Venture Hacks, though the first use of the clause is probably way further back in corporate law history than that. The term refers to a bit of a valuation trick that’s become something of a standard when negotiating with prospective investors over startup valuation. So, what it is, and how does it work? So, part of what a venture investment will be used for, in many cases, will be increasing the company’s headcount. These new hires will very likely require equity in addition to salary and bonus compensation, and so it follows that the company will need to create a new or expand an existing option pool. The “option pool shuffle” applies these options as issued and outstanding (and thus counts them as part of the company’s fully diluted capitalization) on a pre-money basis! So, it’s not: pre-money valuation + new cash = post-money valuation; instead, it’s pre-money valuation + new cash + new options = post-money valuation, effectively applying a discount to the pre-money valuation. And how’s this all justified? The new hiring.

In most cases, new hiring is going to be a part of financing-fueled expansion, so a response of “we’re not going to hire” doesn’t typically work (though, in a post-AI world, maybe it can?). What startups and their founders can do is push back to make the new options pool more realistic (i.e., reduced), by putting realistic goals and hard numbers towards the question of “how big does the new option pool need to be?” Not surprisingly, this typically results in lower figures than what was initially counted in the investor’s calculation, and it’s through negotiation on this basis that this “discount” for the investor can often be pared back. A wholly separate tack to take is to reject the premise of including the new option pool on a pre-money basis, as its inclusion on a post-money basis would have the effect of diluting both the existing stockholders and the new investors proportionally. The important things to note here are: a) to be aware of this pitfall; and b) to engage a competent legal advisor to assist with understanding market trends and feeling out the correct amount of pushback in the context of a venture capital term sheet and subsequent financing deal.

4. Double Dippers

Investors and financing providers typically invest for preferred, not common shares. These preferred shares are so-called because they typically come with a liquidation preference. Simply put, a liquidation preference is the right, in a liquidation scenario, to receive a payout up to a certain amount (typically 1x or another multiple of their initial investment) prior to the common stockholders receiving a payout. In the event of multiple classes of preferred shares, the liquidation preferences of each class will likely be pre-determined as to preferences vis-a-vis each other in a Stockholders’ Agreement or similar document. “Double dip” participation (also known as “participating preferred”) means that a preferred stockholder has a liquidation preference, and then takes a portion of (or, “participates” in) the distribution of the net proceeds left for other stockholders. For example, if a company with only 2 classes of stock (common and preferred) has a preferred stockholder who’s invested $1 million on a 2x liquidation preference and 10% participation (i.e., the “double dip”), if the company were to sell for $3 million in proceeds, the preferred investor gets $2 million back (the liquidation preference) plus another $100k (10% of the remaining $1 million in net proceeds).

It’s vital for founders and their counsel to set limits around double dip participation, such as caps on total return for preferred stockholders. While it’s important for investors to be compensated for their investment (why else would they invest?), it’s important to ensure that the returns match the risk, and furthermore, that the deal is in line with prevailing market terms. Professional advisors, such as startup lawyers, typically have broader vision into current market trends, and founders and startups are encouraged to seek competent legal counsel to advise on how to approach double dip participation and other items pertaining to distributions of proceeds which may exist in venture capital term sheets.