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3 Term Sheet Terms to Avoid in Your Next Funding Round

When it comes to a Term Sheet, the devil is always in the details.

A t erm s heet is a short document – usually between one and six pages long – that covers the headline conditions by which an investor is willing to invest in your company. The term sheet is often the conclusion to weeks or months of pitching and diligence. But make sure to r ead your term sheet carefully before you get too excited.

While there will be further negotiation as your lawyers draft and execute the full documents around the investment in the following weeks, a term sheet is important because it sets the overall direction and balance of power between you and the investor . It’s worth spending time getting those details ironed out before you start working on the deal. Otherwise, you could end up with an expensive misunderstanding and a legal process that doesn’t go anywhere.

A lot of people focus on the headline terms – the valuation at which the investment will take place, the nature of the investment (debt or equity) and the size of the investment and round. These points are undeniably important. However, it’s crucial to read the fine print.

In times of capital availability (2009 through 2015), this fine print got progressively entrepreneur-friendly. Great entrepreneurs running promising companies were in high-demand and investors were willing to be very flexible on their conditions in order to ensure they could get their foot in the door.

While it’s still too early to say if we’ve had a seismic shift in the investor market, there has clearly been a dip in venture investment in the last quarter or two, and that has had an effect on term sheets too. Slowly, but surely, the conditions they contain are being tightened. In most cases this is a good thing. We want a marketplace where there is tension on both sides and where the terms oscillate between the two protagonists. Capital that is too easy to come by creates bad habits and sloppily run companies.

But we’re also getting to the point where some of the terms are over-reaching. An entrepreneur desperate to keep her company fueled may overlook some of these changing terms, but she would do so at her peril. Every situation is different and you need to think through your options, but I would advise every entrepreneur I know to be extremely careful of any of the following terms.

“Redemption rights”

This sounds as bad as you might guess. It's an investment in the company but with a clause that allows your investor to ask for their money back – while maintaining their stake. If your company does well after the investment, then you won’t care. It may never be called and, even if it does, you won't care – all those profits from your thriving business will allow you to easily afford it. At the opposite end of the spectrum, if the company fails, then you still won’t care. You won’t have any money anyway, so there’s nothing left for the investor to sue or try to grab hold of, so everyone loses equally. No, redemption really hurts when you go through a particularly tough phase. In this case, you may believe you can make it through, but a disbelieving investor with redemption rights may suddenly panic and redeem their investment. Depending on how much you have to pay, it could wipe out your reserves and slow the growth of your business.

Related: 5 Ways To Scale After Closing Your Series A

Board fees,” “Monitoring fees,” and other sneaky fees

I include this one because I saw it recently, and it really incenses me. More common (and more defensible) in private equity, this is where your VC invests in you, but charges you a “board fee” for turning up to board meetings. Others might even charge you a “monitoring fee” that can be charged for handling or monitoring the investment . It’s bad for the company and annoying for other investors who see some portion of their investment dollars go to another firm.

“Full ratchet anti-dilution”

And I saved the best for last. When someone invests in your company they will sometimes require anti-dilution rights. This protects their stake if future rounds in the company are priced lower than when they invested. In practice, the way this is usually achieved is that the pricing of the shares acquired in the original round are decreased to account for the down round. Anti-dilution clauses are usually governed by a weighted average approach. In this case, the new, lower price for the original shares is calculated by looking at how much was actually invested in this new, lower-priced round. If the new round was small, the new price is only a little lower; if it is a large round, the price lowers more dramatically. This pro-rating of the new price makes sense, ensuring that a smaller top-up or extension round at a lower price doesn't dramatically change things. In its worst form, however, you can end up with what is known as “the full ratchet.” It is pretty much as painful as it sounds. In this case, regardless of how large or small the new round is, the entire previous round is re-priced at the new, lower price. The new investors obviously don't lose the portion of the company they are buying so guess who gets completely squashed out? That's right – it's you.

– Suranga Chandratillake is a general partner at Balderton Capital and a Techstars mentor.

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