Term Sheet Red Flags: What Is A Dirty Term Sheet?

What is a dirty term sheet? That’s a question many founders have been asking in the last couple of years. You’re likely familiar with the term sheet, a non-legally binding agreement that outlines the core components of an investment.

A term sheet is essentially an offer to invest in your company and is open for negotiation. It presents the investor’s terms and conditions and their expectations from the deal. You are free to study the terms, discuss the provisions, and accept them or request changes.

In recent years, a new concept has emerged–”dirty term sheets” that founders need to be wary of. The lower availability of dry powder in the market has triggered more down rounds. This occurs when a company raises funding at a valuation lower than the one achieved in a preceding funding round.

Typically, founders are wary of down rounds and the stigma attached to lower valuations. However, the general perception is that lower valuations represent a correction of the mispricing that occurred at the peak of 2021’s investment frenzy. Industries recognize that it is not a reflection of performance.

What is a Dirty Term Sheet?

To avoid a down round and the associated risks and loss of reputation, founders seek alternative solutions. It is understandable that you may consider accepting more structured financing that will allow you to maintain the current valuation. However, be wary of dirty term sheets.

You should look out for predatory provisions that maximize investor upside potential and improve the returns they will earn. At the same time, the term sheet will include provisions that minimize their risks and downsides while offering additional protection.

With the assistance of your expert fundraising consultant, you’ll scrutinize the term sheet to identify complicated and non-standard components. Remember that a clean term sheet is straightforward, easy to understand, and includes typical clauses.

You’ll also look out for potential deal “sweeteners” embedded in complex and onerous terminology. However, you have the advantage of negotiation. Once the founder and investors have signed the term sheet, they can initiate detailed discussions.

Before creating the final, legally binding definitive agreement, the parties negotiate the clauses and make changes to the term sheet. Understand that since the term sheet is not legally binding, it allows for higher flexibility and modifications.

You can ensure that the terms are balanced and equitable, and most importantly, beneficial for the startup and the investors.

How to Identify a Dirty Term Sheet?

Before diving into the typical “dirty” provisions, you should know how to identify typical term sheet red flags. For instance, the most significant red flag in a term sheet is complex terminology that you cannot understand.

At this time, you’ll rely on the assistance of your fundraising consultant to help with, say, “liquidation preference.” If you were to accept this condition, you’d have to accept a smaller number of shares in an exit. This provision is applicable even if the company sale is successful and highly profitable.

Educating yourself on industry standards places you in a favorable position and allows you to make informed decisions. For instance, including anti-dilution provisions in the term sheet can be standard practice. Many founders may offer this provision to attract funding.

However, you’ll structure provisions carefully to balance the interests of the company and ensure that its investors are aligned. Also, examine the framework for returns that investors are proposing. A clean term sheet should include dividends, distributed return of capital, and stock buybacks.

Investors also make money by selling their stock and receiving liquidation payouts and guaranteed multiples. However, if they request a high Internal Rate of Return (IRR) or any returns not necessarily sourced from headline valuation, consider them red flags.

A “dirty term sheet” aside, be wary if the investors are unwilling to clarify the conditions and terms. A lack of transparency is a major red flag, as is the urgency to close the funding round. If the investor is unwilling to allow you time and pushes for a quick decision, rethink the investment offer.

Typical Dirty Term Sheet Provisions

When understanding dirty term sheet provisions, it is essential to recognize that dirty or toxic terms are not singular. A dirty term sheet is a combination of several provisions that heavily favor the interests of the investor.

Your focus should not just be on running and growing the company, but also on securing your equity stake. You’ll also ensure control over decision-making rights and a profitable exit or initial public offering (IPO). Here’s what to look for:

Liquidation Preference

The liquidation preference clause determines how the investor receives their share of the proceeds when the company is liquidated (sold). Investors may require priority in being repaid their capital before other shareholders or the company owner.

Typically, investors should claim 1x the capital they invested in the company. However, a dirty term sheet will include 2x or 3x the investment amount along with a share in the remaining proceeds. They may also have a say in the liquidating decisions regarding the order of payouts you want to make.

Then again, there’s the “cap,” which specifies the maximum total payout investors can claim. Also, look out for non-participating liquidation preference in the dirty term sheet.

This condition allows investors to receive a payout according to their choice or their percentage holdings, whichever is higher. Essentially, it enables double-dipping, allowing them to recover their money along with a pro-rata share.

Anti-Dilution Protection

Founders often offer anti-dilution protection to investors to protect their equity from dilution when they raise subsequent funding rounds. This protection can take the form of a full-ratchet anti-dilution provision or a weighted average anti-dilution provision.

These provisions enable existing investors to purchase or convert their preferred shares into equity at a price lower than their initial investment. In this way, they can own more shares and maintain their ownership percentage in the company.

Remember that full-ratchet provisions are typically more aggressive than weighted average and primarily benefit investors. Their equity stake remains stable, while the founder’s stake takes a hit, significantly diluting their ownership.

This provision has a more detrimental impact on the founder when they are raising a down round. This is why it’s one of the red flags in a dirty term sheet.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Peter Thiel, Silicon Valley legend (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

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Board Flipping Rights

Board representation and board seats are a common aspect of venture capitalist (VC) funding. Bringing on board a member who contributes valuable expertise and guidance can be a significant asset. But it can also be a liability if it assigns disproportionate control over decision-making.

A dirty team sheet will include clauses that allow investors to exert control over the company. That is, even though they hold only a minority stake. Founders often face situations where they are ousted from the CEO position and relegated to lower positions.

A single disagreement with the board regarding strategy or an unfortunate decision can move them to the “Director of Sales.” The first step typically involves hiring an external professional in a managerial position and then offering the founder an exit.

Diluting the founder’s ownership stake or constantly superseding their ideas is another brutal and effective strategy to wrest control. This is why you analyse the legal jargon behind the board-flipping rights clause. It is likely that the clause is legally binding and has no wiggle room for contesting.

Be cautious of veto rights that allow the investor-assigned board member to block or veto specific decisions. As a result, they may have control over the company’s growth, direction, and future.

If you see broad clauses like “the investor will have the right to veto any major decisions,” consider that a red flag. It is crucial to define what constitutes a “major decision” to prevent potential disputes and disagreements.

For instance, the company will need investors’ approval before issuing new shares or amending its business plan. They may also have a say in declaring dividends, buying or acquiring another company, or forming a subsidiary. You may want to restrict these decisions to the management team.

Vesting Schedules and Unfair Leaver Provisions

Vesting schedules are the timelines within which founders and team members fully own the equity allotted to them. Look out for dirty term sheet clauses that shorten this time frame for the founders, particularly as compared to investors.

You’ll also scrutinize the leaver provisions. Leaver provisions are clauses that determine the sequence of events involving the founder or key team members leaving the company. A dirty term sheet will include unfavorable repercussions or terms for founders or levy harsh penalties.

Founders and team members may want to leave the company for various reasons, such as health conditions or family situations. They may choose to resign or be terminated from their positions. Or, due to an unfortunate event, such as death.

A good leaver clause offers fair and equitable treatment to the founder, providing them with adequate protection. Particularly if they leave because of an unavoidable situation or a valid reason. A dirty term sheet will have bad leaver clauses, where the founder must forfeit all their shares upon exit.

This clause applies even if you have vested shares and made significant contributions to the company, essentially building it from the ground up. Your fundraising consultant will ensure that the schedules and provisions are not unfavorable for founders.

For instance, clauses that cut short the vesting schedule if the founder or a team member is fired. Or, if the vesting schedule accelerates partially or entirely when the founder loses control of the company. That is, in the event they are relegated to a lower position.

Are you looking for more information about what a term sheet is and how it works? Check out this video in which I have explained term sheets in detail.

Additional Protective Provisions

Protective provisions are designed to protect the interests of minority shareholders and minimize their risk. However, the scope and definition of this clause can work against your interests. For instance, they allow investors to prevent you from raising further funding rounds or hiring talent.

Protective provisions may also result in investors vetoing the decision to offer stock options to employees. Accepting certain protective clauses could become crucial if you wish to secure funding. Investors may consider it a prerequisite for backing the company.

With the assistance of your fundraising consultant, you can add restrictions to the clauses. For instance, you need not accept provisions that give investors controlling rights over hiring decisions.

Or the decision to change compensation structures for yourself, the founder, CEO, and other C-Suite executives. You can also restrict their rights to vote when entering into strategic partnerships, horizontal or vertical mergers, and acquisitions.

Let’s say, you opt to pivot the business plan or product portfolio to adapt to evolving market conditions or customer preferences. Or, when purchasing critical business assets and intellectual property (IP). In that case, investors should not have the right to prevent the move.

Keep in mind that it is absolutely crucial that you secure your ability to run and scale the company strategically.

Investor vetos and voting rights should not hamper growth, particularly since they are primarily concerned about maximizing returns. And, of course, a profitable exit that aligns with their fund lifecycle and investment horizon.

The Takeaway!!

Founders often make the mistake of accepting a dirty term sheet, particularly when they feel at a disadvantage. For instance, during a down round. However, it is preferable to run a down round instead of accepting toxic terms and conditions of investment.

Your focus should be on the long-term implications of the dirty clauses. Be very aware of the possibility of losing the company or being forced to liquidate it prematurely. Engage the services of an expert consultant and legal counsel who can thoroughly scrutinize the terms and identify any potential red flags.

Ensure that you clearly understand the meaning of the terms so you don’t accept clauses that aren’t in your best interests. Remember that you can always negotiate for favorable clauses and conditions since the term sheet is not legally binding. Negotiations and compromises are the key here.

In the worst case, you always have the option to walk away from the deal and continue pitching to other investors.

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