How to Avoid Bad Terms that Kill Startups
Bad investors can do untold damage to a company and they only show themselves at the worst times. It’s hard to know in advance how an investor will behave in tough situations, so it’s best to protect your company by ensuring you have the right terms. You’ll need to ask for these terms when an investor agrees to invest. Although they may not be significant until later, when you’re raising more money or selling the company.
Only Accept Standard Investment Terms
When you’re excited about closing a round, it’s easy to get caught accepting non-standard terms. An investor may provide their own unique documents, containing unusual terms; or an investor’s lawyer may have significant changes to your documents, which make the terms non-standard.
How it Hurts: Non-standard terms will be untested and new to many lawyers, so they’ll require longer review. Outside of the their unpredictability, these documents increase legal costs for both your company and any future investors. In the worst cases, non-standard terms can prevent an investor moving forward and require you to go back and renegotiate the problematic terms.
How to Avoid Issues: For convertible notes, be sure to use a popular template, with standard terms, that investors are known to accept, e.g. YCombinator’s SAFE note, this will keep legal costs down. For priced rounds (Series A, B etc), make sure you use a lawyer with plenty of successful startup experience, ideally in Silicon Valley, and excellent references. Your existing investors and lawyers can help you understand potential pitfalls and make sure you understand the documents before you sign. Priced rounds cost tens of thousands in legal fees, so be diligent even though it’s not interesting work.
Confirm Future Participation in Advance
An investor that usually participates in later-stage priced rounds, invests earlier in your seed round, to get the first option on the later round.
How it Hurts: If this investor doesn’t want to lead your next round, that’s a strong negative sign often called “Signalling”. Even worse, if this late stage investor refuses to participate in the round and maintain their stake, pro-rata, it can destroy your fundraising prospects completely.
How to Avoid Issues: Ideally, don’t take money from the late stage investor, instead take money from genuine seed investors. Seek out the seed investors that tend to co-invest with your preferred later stage investors. If that isn’t possible, get the late stage investor to verbally confirm they will maintain their ownership in future rounds. You should also get them to discuss this with another one of your investors, to further ensure they don’t go back on their word.
Include Drag-Along Rights
You have a significant number of small investors and the documents for your priced round do not include Drag-Along rights — where a large majority of stockholders can force a minority to agree to your company’s sale.
How it Hurts: A relatively small investor decides to “dissent” (contest) an acquisition as a way to bargain for a larger payout for themselves. This can slow kill the acquisition as the buyer may have to deal with a potential lawsuit immediately after the sale.
How to Avoid Issues: Whenever you issue stock to investors be sure to include Drag-Along rights in the terms, with a standard threshold of 80–90% agreement. If it’s already too late and you’re in an acquisition process, then make sure you’ve spent plenty of time discussing the sales with each investor. Although drudgery now, it’s a better option than having to go nuclear and get each of your investors to call a dissenter with reputational threats.
It’s not easy to make these requests of an investor, when it may delay closing a round. However, the cost of not protecting the company may be felt later at critical stages. Have the courage to ask the right questions early and secure your startup for the tough times.
This article is part of a series on Seed Fundraising.
1. When to Raise Money
2. How to Build a Deck
3. VCs vs. Seed Funds vs. Angels
4. How to Get a Meeting
5. How to Request an Introduction
6. How to Get Early Momentum
7. How to make a Good Pitch Great
8. The 5 Most Common Pitch Mistakes
9. Meeting Requirements
10. The Basics of Meetings
11. How to Handle an Angel Investor Meeting
12. Know these Numbers for your VC Meeting
13. 4 Investor Gotcha Questions
14. How to Follow-Up After an Investor Meeting
15. How to Close the Lead Investor
16. The 4 Stages of a VC Process
17. How to Raise a $2 Million Seed Round
18. Go from Investor YES to Cash in Hand
19. When Investors Say Yes but Mean No
20. When and When Not to Use an Investors Name
21. Stop Making These Common Fundraising Mistakes
22. How to Avoid Bad Terms that Kill Startups
23. What to do After Receiving a Term Sheet
24. Term Sheet Problems Part 1 — Money Talks
25. Term Sheet Problems Part 2 — Boardroom Blues
26. Term Sheet Problems Part 3 — Side Letters
27. 10 Traits of Successful Founders
Sterling Road invests in pre-seed B2B startups based in North America. Full process here: sterlingroad.com/process.
You can reach me here: email@example.com
Thanks to Duncan Davidson and Kaego Rust for reading drafts of this.