Summarize the article  In 2 pages

5 VC Clauses

Entrepreneurs

Should Never Ever Accept

Goncalo de Vasconcelos

Contributor Entrepreneurs

Most venture capitalists love presenting astonishingly complex term sheets. They’re in the business of making money and negotiate term sheets for a living. They’re well versed with the potential outcomes of the entrepreneur–venture capitalist relationship and minimize their downside risk as much as they can. But this makes for a hugely unfair playing field; while venture capitalists know the details of their term sheets, most entrepreneurs will have to google a term or two to discern what they mean. On top of that, the company will probably be running out of cash; meanwhile, venture capitalists have time on their side and the longer the

funding round

takes to complete, the better their bargaining position becomes – the VC gets extra information about the company’s performance while the company becomes more and more desperate for capital.

There are always two sides to each coin and it’s essential that entrepreneurs understand that venture capitalists are in the business of making money – out of your own business. Understand and accept this, and the relationship is far less likely to go sour. Venture capitalists need to protect themselves against entrepreneurs creating lifestyle businesses or refusing to sell the business at some point. However, that doesn’t mean you should leave the ball entirely in their court. Here are a few clauses entrepreneurs should never ever accept.

Participating Liquidation Preferences

If you can, avoid liquidation preferences altogether. If you can’t, make sure you never ever sign up to participating liquidation preferences, and definitively not if there is a multiple attached to it. Why? Because it will really hurt you.

Say that you raised $10m from a venture capitalist at a 2x participating liquidation preference at a $30m post-money valuation (and therefore for one-third of your company). Now let’s picture three scenarios:

1. Things don’t go according to plan and the company is bought out cheaply.  In this example the venture capitalist will take everything up to $20m, so whether you sell the company for $1m or for $20m, it all goes to the venture capitalist while founders, employees and other 

investors

 receive zero money from the sale.

2. The company does well enough but never becomes a unicorn.  Say the company is bought out for $50m. In this case the venture capitalist takes the first $20m and the remaining proceeds are split amongst all shareholders (yes, you guessed it – that includes the venture capitalist once again!). Of the remaining $30m, the venture capitalist takes one-third ($10m), making their total return $30m or 60% of the entire proceeds. Founders and the remaining shareholders get $20m in total, which is likely to mean about $5m to $7m to each founder.

3. The company becomes a success and is bought out for $120m. The impact of the participating liquidation preferences becomes less important in this example, but still feels wrong in principle. Out of the $120m, the venture capitalist takes $20m first and then the remaining $100m is distributed amongst all shareholders and therefore the venture capitalist will take a further $33m, making their total $53m.

Regardless of which scenario your company ends up in, you, as a founder, are unlikely to be over the moon at the result.

Reverse vesting without good leaver clauses nor regular vesting

Reverse vesting makes sense for both founders and investors. Usually effective for a set period of time post funding round, reverse vesting stops the founders from leaving the company  while keeping his or her entire share in the business, meaning they can’t simply walk out and ride the wave of the other co-founders’ hard work. Sounds fair, right? But again, be wary and never ever accept reverse vesting without regular vesting periods (quarterly or annually) and good leaver clauses.

· Regular vesting periods – usually quarterly or yearly. This means a portion of your shares will vest at regular intervals rather than only vesting at the end of an extensive period (say 4 years). If you leave before that period is up, you lose all your shares. This can be a very dangerous and abusive clause as there is a financial incentive for the company to fire you towards, but before, the end of your long vesting period and lapse all your shares in an incredibly unfair but perfectly legal manner.

·

Good leaver clauses.  Without good leaver clauses, reverse vesting could mean that if the company decides it doesn’t need you around anymore, you lose all your options. This is rather unfair and again gives a perverted incentive for the company to fire you. Instead, if you are a good leaver (for example, if the company decides it doesn’t need you anymore, or you step aside to allow somebody else to drive the company forward) you should keep some or all of your options.

Full Ratchet Anti-Dilution

This is an aggressive clause that protects the venture capitalist from the effect of a down round at a later stage to the detriment of all other existing share and option holders – founders, employees and, most likely, early investors.

A full ratchet anti-dilution clause basically says that if your company ever issues shares at a lower cost than the venture capitalist invested at, the company will automatically issue more shares to the venture capitalist to bring their investment to the share price of the down round.

Let’s use the same example as earlier: the venture capitalist invests $10m for one-third of the company at a $30m post-money valuation (say $10/share and therefore 1m shares). Now imagine that the company doesn’t hit its targets and raises money at $5/share instead. In this case, the venture capitalist would double the number of shares as a further 1m shares would automatically be issued to the venture capitalist at the new 

funding round for no extra capital. The 3m shares before the funding round would become 4m shares, with the venture capitalist now owning 2m shares, or 50% of the company instead of the 33% it owned before. For no extra capital. This means the share of the founders and remaining shareholders would go from 66% down to 50% just before the funding round and then get diluted once again with the new funding round. In practice this means that the valuation of the first funding round (in this example $30m post-money) was completely artificial and the real valuation is effectively set by any down round further down the line. It shifts the risk from the venture capitalist to all other shareholders as there is little risk for the venture capitalist to accept a high valuation at the funding round, and an incentive to push for a low valuation in future funding rounds and invest heavily then, taking a large chunk of the company in the process. This isn’t fair and can result in founders ending up with very little of their business.

Conclusion

If you are an entrepreneur and some of the above clauses are part of your term sheet, make sure you talk to a good lawyer and plenty of other entrepreneurs that may have had experience with these types of clauses. Ensure you understand everything in the contract you are signing – after all, if you accept any overly aggressive clauses and sign the document, you’ll only have yourself to blame if it goes wrong. However, hopefully the above will help you avoid potentially unfair and abusive clauses that could become any entrepreneur’s worst nightmare – to end up with very little or nothing of the company you fought so hard to build.