Understand these term sheet clauses before taking VC money

I used to think I was reasonably familiar with how startup investments were structured and what deal terms were common, thanks to my experience starting two companies in the US and investing in a few dozen more.

That changed in 2018, when I moved back to Southeast Asia and co-founded Iterative, a startup accelerator. I began seeing deal terms I had never encountered before or that had mostly disappeared in the US.

In most cases, these terms are designed to provide downside protection, decrease risk, or grant rights typically reserved for larger investors in later rounds.

Great for investors, not for founders.

I was shocked at how often founders accepted these terms, simply because they didn’t know how doing so could affect their startup in the long run.

This article will explain a few deal terms whose full implications founders often don’t understand. While agreeing to some may make sense in certain situations, founders need to know how these terms work and push back when they don’t serve their company’s best interests.

What to watch out for

Anti-dilution clauses

These provide downside protection to investors and shield them from losing too much ownership if the company raises a future round at a lower valuation. In a down round, the clause adjusts investors’ ownership to mitigate the impact of the lower valuation.

Weighted average anti-dilution is the more common, founder-friendly version of this clause. It adjusts the share price of investors down a bit, depending on how many new shares are issued and at what price.

See also: Founders fume over Malaysian VC’s term sheet

Full ratchet anti-dilution is more aggressive. If a down round happens, investors’ original shares get repriced as if they had paid the new lower price, regardless of how many new shares are issued.

This is challenging for founders: They’ll be diluted more to compensate, as dilution has to occur somewhere to bring in new capital. In the event of a down round, the more aggressive the anti-dilution clause, the more diluted founders and shareholding employees get.

Nobody wants to see a down round. But when it happens, anti-dilution clauses become important. If founders own too little of their company early on, this might drive away future investors as they fear founders may not be motivated enough. Potential backers could be concerned that founders might have to be given a lot more shares later, which would dilute the shares of early investors.

Steps to take

Your responsibility