Red Flags that Investors Need to Look out for in Term Sheet

First-time investors are quite anxious to raise funding for their projects. The fact that professional investors are looking to invest in their projects can be quite overwhelming for some founders. As a result, it is common for these founders to believe that the investors are acting in good faith. Often, this means that the investors end up signing agreements without having access to proper legal counsel. This is not advisable since it is a known fact that many investors create term sheets and agreements which are completely skewed in their favor.

These one-sided term sheets are so common in the marketplace that there is a specific term for them. They are commonly referred to as “dirty term sheets”. It is important for the founders to be aware of the common pitfalls which need to be taken into account while signing term sheets.

Some of the common red flags that investors need to look out for have been explained in this article:

1. May be Binding: It is commonly believed that the terms set out in the term sheet may not be binding on both parties. It is commonly viewed as an expression of intent and a precursor to the actual agreement. This is the reason that many founders do not hesitate to sign this agreement even without proper consultation with their legal counsel. However, depending upon how the document has been worded, it is quite possible that the terms and conditions set out in the term sheet may be fully or partially binding to both parties.

   It is important for the founders to ensure that their lawyers have access to the agreement so that they can fully understand the implications of what they sign.

2. Exclusivity: The term sheet can have certain restrictive provisions which grant the investor the exclusive right to invest in a product. Normally, this would be acceptable to the founders. However, the cash flow scheduled promised by the investors should be carefully taken into account.

   It may be possible that the investors might obtain exclusive access to a deal by paying a small amount even though they do not have the full amount required by the startup. They may then start approaching bigger investors in order to sell this stake at a premium. It is also possible that the investor is not able to raise further funds. In such cases, the startup would be stuck without funds during their growth stage since they cannot seek external funding.

3. Termination: It is very important that the term sheet does not have any termination clauses. A termination clause is put in to deter the founder from backing out of the deal before it is actually materialized with proper legal documents. Hence, if the founders accept a certain sum of money as an expression of interest from investors, they may not be able to walk away from the deal by simply refunding that amount.

   There may be clauses in the agreement which stipulate that a certain amount of penalty needs to be paid. Investors acting in good faith do not include such clauses in the term sheets. This is because they do not expect the founders to cancel the term sheet before the agreement. Investors who use dirty term sheets know that at some point in time, the founders may want to bail out. This is the reason that they are ensuring that the terms are skewed in their favor if the founder wants to exit the arrangement.

4. Vesting Schedule: It is common for entrepreneurs to have a fixed vesting schedule. This means that the number of shares available to founders does not become available all at once. It is common for these shares to be allotted to the founders in installments over the course of four or five years. This is done in order to ensure that the investor will stick around for at least four to five years. Now, most entrepreneurs already have a vesting schedule worked out. If the investors want the vesting schedule to be modified as per their demands, it can be considered to be a red flag. They are basically trying to trap the entrepreneur by limiting their exit options.

5. Loss of Control: Founders must also be wary of investors who try to gain excessive control when the startup is at an early stage. It is important for founders to realize that control is a powerful bargaining tool.

   Entrepreneurs can raise more funds at later stages if they are willing to cede control to other investors as well. However, if early-stage investors have taken up excessive control, obtaining funding at later stages can be quite difficult. It is unusual for investors to ask for a lot of seats on the board of directors particularly when investing in early-stage startups. The founders should consider this to be a red flag.

6. Endless Loop of Negotiations: Another important point to notice is whether the investors are continuously bringing up points for renegotiations. Entrepreneurs are often swamped with other tasks and may not have the time to repeatedly renegotiate the same terms and conditions. This should be considered as being a red flag and investors must take action accordingly.

7. Liquidation Multiplier: A liquidation multiplier is a provision that is used by investors in order to protect the value of their investment. However, it can be aggressively used in order by investors in order to obtain more than their fair share. Let us understand this with the help of an example.

   Let’s say that an investor buys a 50% stake in a company for $50 million. This means that the entire company is valued at $100 million. Now, if the company is sold for $75 million and the investor has a 1× liquidation multiplier, then the calculation will be as follows:

   • The $50 million paid by the investors will first be returned to them as part of the multiplier

   • The balance of $25 million of sale proceeds will be divided into two halves. One half will be given to the investors and the other half will be given to the other shareholders

   Hence, in effect, the investors will get $62.5 million and the rest will get $12.5 million. To some extent, this is necessary to provide downside protection to the investors. A liquidation multiplier of 1× is considered to be fair in the investing community.

   However, if this liquidation multiplier is set at 2× or 3×, it becomes predatory. Let’s have a look at how the calculation will work in the case of a 2× multiplier.

   • If the same investor buys $50 million worth of stock in the company and the company is sold at $110 million, then 2× of the investors' investment will be set aside i.e. $100 million will be set aside.

   • The balance of $10 million will be split into two halves. Hence, investors will get $105 million and other shareholders will get only $5 million!

   Entrepreneurs should not sign deals where the liquidation multiplier is more than 1×. This is because in such cases, there is a high probability that they will end up losing money.

8. Participating Common Stock: Participating common stock is a special type of stock that may be issued to investors based on the conditions of the term sheet. This type of stock allows the investors to obtain certain extra dividends over and above the regular dividends which are offered to the common stockholders.

   Preferred shareholders have a higher claim on the cash flow of the firm. They receive the dividends first before any other shareholders are paid. Then, they also receive the dividend which is paid to common stockholders.

   Since participating common stocks receive twice the dividend, they have a higher valuation as compared to other stocks. Once again entrepreneurs must refrain from issuing participating common stock since it reduces the valuation of the other common stock.

9. Full Ratchet and Partial Ratchet: Full ratchet is another clause that is used by investors to protect their interests at the cost of other stakeholders. A full ratchet protects early-stage investors against possible dilution of shares when later-stage investors come into the picture. For instance, if an investor owns a 25% stake in a company and if that company raises more money later, the stake of the earlier investors should not be diluted.

   A partial ratchet is similar to a full ratchet. However, in this case, the stake of the investor can be partially diluted based on a certain pre-decided formula. Additional shares will automatically be issued to the earlier investors in order for them to maintain their original investment percentage. These additional shares are issued free of cost.

   Needless to say that if the investor is not paying for these shares, they are coming out of the pocket of the entrepreneur and other stakeholders. The full ratchet can create a lot of problems for the company in later stages. This is because every time the entrepreneur raises money a part of that ends up flowing to the original investor. It also acts as a deterrent for newer investors to invest in the company.

   A full ratchet is often used by predatory investors to scare away potential investors. This means that the company will have to use the same investors for later rounds of funding. This will provide the investor with an opportunity to undervalue the firm since there will not be any competition to challenge its valuation. Entrepreneurs typically refrain from signing any term sheets where either a full ratchet or a partial ratchet has been mentioned.

The above-mentioned types of clauses are considered to be predatory under the normal course of business. However, they can be considered to be fair if the business is very risky and both parties agree to it, they can be used to make the investors feel safe. It is imperative that the entrepreneur be aware of the types of risks that they may end up facing in the future.

The bottom line is that entrepreneurs should not be overwhelmed if they receive interest from investors. They must carefully evaluate the term sheet in order to understand the various scenarios mentioned in the agreement and be on the lookout for commonly mentioned red flags.