“I’ve Got an Investor Who Is Ready to Write Me a Check. What Do I Need to Know to Handle It Right?”

how to avoid risks when taking investment

After you’ve received that long-awaited “yes” from an investor, it’s time to put all the deal’s details in a document called a term sheet. Although not legally binding, a term sheet outlines the main details of your future relationship with the investor.

Don’t just agree to everything. Instead, examine and negotiate the details in the term sheet. To make the most of these negotiations, you must understand how each term plays out. This way, you can spot less favorable conditions and propose alternatives.

Here’s a list of the clauses that can confuse first-time founders. We’ll explain where the potential challenges may lie and offer alternative clauses to create a more balanced term sheet.

1. Pay Attention to What You Use as Valuation When Making Calculations

One of the trickiest topics you’ll see in a term sheet is how to calculate debt. Let’s break it down step by step.

Debt calculation depends on your startup’s valuation. There are two types:

  • Pre-money valuation. This is how much your startup is worth before you get a single dollar of investment.
  • Post-money valuation. This is the value after you’ve raised funding. Think pre-money plus all incoming cash.

So why does this part get tough during negotiations with investors? By the time you enter a priced round, chances are you already owe some people—employees, convertible note holders, or anyone else. You need to settle up with them, and this is where the two valuations matter. They decide if investors share in paying the debt or whether it’s your responsibility alone.

Let’s explore an example to better understand this concept. We’ll focus on ESOP, one of the toughest negotiation points. ESOP is an employee benefit plan. Cash might be tight in the initial stages, but retaining top talent is crucial. That’s why startup founders often turn to ESOP. It lets employees have company shares, keeping them motivated without extra cash. When they excel and remain with the company, their share value goes up.

But things get interesting when it’s time to issue ESOP shares. Of course, new shares reduce the current stockholders’ ownership. But, during negotiations, the question arises: Will ESOP shares only impact the founder’s ownership or that of the new investors, too? 

Let’s explore two scenarios.

  • Pre-money ESOP. In this scenario, ESOP is issued in the pre-money stage. Founders handle their obligations, including ESOP, before investors step in. This way, ESOP only reduces the founder’s ownership (and that of any current shareholders).
  • Post-money ESOP. ESOP is issued in the post-money stage. Now, it affects every shareholder—existing and new. In this scenario, the founder isn’t the only one taking a hit when they issue ESOP shares. This means they lose less ownership than in the first scenario.

Getting commitments like ESOP into post-money terms is quite rare, so they are often tough to negotiate. However, negotiating these commitments post-money is still worthwhile, as it’s important to advocate for your interests whenever possible. Getting to grips with pre-money/post-money dynamics is a good way to start. By the way, we explained valuation when we discussed the risks of a convertible note. Check out the article for an even better idea of how valuation works.

Our tip: Of course, negotiating the post-money valuation of your debt is a big win for your startup. It enables you to share dilution with investors. We suggest trying to push for this clause whenever possible. It might not always work with obligations like ESOP, but it will work with other types of debt.

2. Beware of Inadequate Liquidation Preferences

In the term sheet, there’s a lot about what happens to your startup’s assets and money if things go wrong. That’s absolutely normal. After all, investors don’t only want to make gains when everything goes well; they want to safeguard their investment if things don’t go to plan. That’s why the terms about liquidation often take center stage during negotiations. They provide the answer to the big question: “Who gets what if the startup shuts down for any reason?”

There is such a thing as preferred stock. We’ve already discussed the primary value of preferred stock for investors. In a nutshell, preferred shares provide financial guarantees. Investors with preferred shares get their money back before others when things get tough. Typically, their money is returned at a 1x rate, meaning they get no more or less than the dollars they put into the startup. In the worst case, they’ll simply receive what they initially invested.

But sometimes an investor asks for more guarantees, negotiating a 1.5x rate, a 2x rate, or even more. As a founder, you may find this unfair. After all, you’ve been putting a lot of effort into the startup and wouldn’t want to be left with nothing in your pockets once you pay back your investors.

Our tip: Aim for a 1x multiplier. It’s the golden standard, widely accepted across the board. This practice not only safeguards your interests but also ensures a fair deal for both parties involved.

3. Make the Investor Choose One of the Liquidation Preferences—Not Both

When we talk about liquidation, we need to keep in mind that it may take different forms. Perhaps you don’t raise the investment you need and the company goes bankrupt. Or maybe you exit via an acquisition. In the first scenario, there’s little left for shareholders. But, in the second scenario, you have earned quite a lot and now need to share it among shareholders. No matter how the story plays out, preferred stock owners cash in first.

An investor with preferred shares has two options when it comes to payback time. It’s regular practice to offer this choice. 

  • Option one. The investor goes straight for the money they initially invested. This means they get their cash and interest on top before anyone else. This option is common when the startup has limited or no profits.
  • Option two. The investor chooses to get some of the remaining money, just like common shareholders. They do this by converting their preferred shares into common shares. This way, they become regular shareholders. Now, they receive an amount linked to their share count. This choice is typical when the startup has earned some money. With this option, getting a proportionate share can lead to a bigger payout than just the initial investment return.

Naturally, when exiting the startup, the investor chooses the option that brings them more money. But some investors aim for a double win by trying to include participating liquidation preferences in the term sheet and investment deal. Another name for this is the right to double dip.

If the investor gets participating liquidation preferences, it’s like a two-step money return. First, they get back their investment, then they participate in pro-rata (“in proportion”) sharing of any remaining money. Of course, that would be a big win for the investor. In fact, they’ll receive a larger economic return than their ownership suggests.

But for you, the founder, it leans the other way. When the investor double dips, you and other regular stockholders are left with less money.

Our tip: Don’t hesitate to stand firm for a 1x liquidation preference without any participation. This is a reasonable request, especially in the early stages of financing. It means that if things don’t go as planned, the investor just gets back their initial investment. They don’t then get an extra dip into the remaining funds. Their interests are still protected but they don’t gain extra funds at your expense.

4. Avoid Disproportionate Top-ups in the Case of a Down Round 

After a successful first round, a startup can have a down round where its shares cost less than before.

An investor might look at this situation and say: “Hey, I bought the stock at a price that was too high and I received too little. That’s unfair! These shares don’t seem worth the money I paid for them. We should reconsider their price.” With this reasoning in mind, they may push for a so-called anti-dilution clause.

An anti-dilution clause means that if the startup doesn’t achieve the promised growth at some point, the investor has the right to convert their stock into a new number of shares at a lower price. This way, they can top up their shares.

An anti-dilution clause comes in many forms. Each enables the investor to adjust the conversion price of their shares. The worst type for you is full ratchet. Here’s how it works. When the share price drops and new shares are issued at a lower rate, the investor recalculates their shares as if they bought them at a lower price. They then request an increased number of shares and receive a larger percentage of shares than they did initially.

Why is a full ratchet bad for you? Because you end up sharing more stock with the investor without getting any extra cash from them. That makes it harder to bounce back after a down round as you have no money and less control over your startup.

Thankfully, there’s another type of anti-dilution clause called the weighted average. This rule looks at two prices: the higher price before the drop and the lower price after. To find the weighted average, check how many shares were given at each price. Then, you change the new share price based on the weighted average. If there were more shares given out at the higher price before the drop, the new share price won’t reduce significantly. It will still reduce from what it was before, but not as much as it would have with the full ratchet clause.

Our tip: Anti-dilution clauses are common. While the full ratchet is the most aggressive, the weighted average method is more founder-friendly. If you include an anti-dilution clause in your investment deal, the investor’s shares will be topped up to somewhere between the old and new valuations.

5. Insist on Pro Rata Instead of Super Pro Rata Rights

You have probably come across the pro rata clause in your term sheet. This is a very typical issue that is widely accepted by VCs. It gives the investor the right to take care of their shares, meaning the investor can (they are not obliged to) participate in the next financing round if they want to maintain (and not increase) their percentage ownership in the next round. It’s entirely up to them whether they want to maintain their ownership or not. If investors decide to exercise this right, they will be able to buy shares before new investors. It’s as if they have a VIP pass to the front of the line.

Super pro rata is what you should be concerned about. This clause allows investors to increase their percentage ownership in the next financing rounds. This is a problem because the investor with super pro rata may get too much stock and too much power. In practice, this can potentially limit the freedom and decision-making authority of the founder. They may find themselves taking a backseat in the company’s development.

Another issue is that, as the first investor buys shares before others, there may not be enough equity left for subsequent investors. The first investor takes it all.

Our tip: To avoid super pro rata, you need to insist on pro rata rights. They are very common in the startup world and more beneficial for you as they don’t harm your investors.

If the investor is pushing for more than pro rata, think about setting a cap on the total amount of shares that any single investor can hold. This way, you’ll maintain control over who holds a critical mass of shares. 

6. Avoid the No-Shop Clause if You Expect a String of Investors

As we’ve mentioned before, a term sheet is a non-binding agreement. But here’s the catch: if some investors see your startup as a juicy opportunity, they might want to avoid competing with others to get a slice of the pie. They could demand exclusivity through a no-shop clause in their term sheet.

The no-shop clause means there will be a period during the fundraising process when you can’t talk to other investors. Brace yourself for a financial penalty if you break the clause.

Our tip: If you believe that you can attract more investors and get better terms, insist on deleting the no-shop clause. This way, you can get two or more term sheets, allowing you to get a better view of how investors are evaluating your startup.

Here’s one more thing to keep in mind: if you agree to include the no-shop clause, it may send the wrong message to the investor. They might interpret it as a sign of desperation and try to take advantage of it, pushing harder during the negotiations.

Bottom Line

Before you jump into negotiations, it’s essential to understand what is and isn’t founder-friendly. Take the time to learn the ins and outs and the do’s and don’ts of the terms in your term sheet. This knowledge will help you navigate your negotiations more successfully.

In the Softeq Venture Studio accelerator program, we make sure you stay informed about potential legal risks. That’s why special master classes are part of the program. We also connect participants with experienced mentors who can offer valuable advice and strategies for your case. At the end of the program, you’ll be well-equipped to navigate the legal challenges that may come your way.