A Founders Guide To VC Term Sheets Pt. 2

Our Strategic Guide for Founders entering Venture Capital negotiations: Pt. 2 - Anti-dilution & No-Shop agreements

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Ok, so before we get into our terms for this week, I thought I’d take the chance to address something I neglected to mention in my previous post.

The most important part of the fundraising process is that you close your deal.

Fundraising will prove to be an intense, time-consuming period that will distract you from the day-to-day of running your business, so your end goal should always be clear.

Get the deal you want, close it, raise the money and get back to running your business.

So let’s start with a strategic negotiating technique to help you close your deal.

time

Push your VC by adhering to a strict time frame

VCs have a tendency to drag founders along, without ever making an actual offer, in an attempt to keep their options open.

But, they also never want to miss out on a deal.

You’ll need to push your VCs along because as a founder your time is one of your most valuable resources. Protect it by adhering to a strict time frame.

It’s important that during preliminary discussions with VCs you clearly define your fundraising period. If you notify all interested parties that you are entering negotiations for 4-6 weeks and closing the funding round by a certain date you already have the upper hand in the negotiations by creating a sense of urgency.

It’s also important that you understand the role your VC contact has at their firm.

Odds are if they reached out to you via email or you met them at a VC networking event that they’re an associate. Associates roles require them to scour the startup world discovering new investment opportunities but they generally have little say in closing a deal.

To do that you’ll want to push to get in front of a general partner or managing director.

Meet with the associate as they will usually be your initial connection to a VC firm. But, over time, if you don’t find a general partner or managing director paying attention to you or spending real time with you then it might mean they’re just dragging you along and you would be better off exploring other options.

Anti dilution provisions
What will the ownership of your company look like after the inevitable happens and you experience a down round?

Anti-dilution protection

An anti-dilution provision is a form of price protection that negates the dilutive effect issuing new, cheaper shares have upon a VCs investment. Simply put, it allows VCs the right to maintain their percentage ownership in your company.

Anti-dilution protection, together with the liquidation preference are two of the fundamental features that signify preferred shares over common shares

The provision protects their investor equity in the event your company requires additional financing and issues new shares at a lower price than in a previous financing rounds (AKA ‘a down round’).

Anti-dilution provisions involve the adjustment of previously allocated share prices so original investors can maintain their equity in the company. There are two main varieties for anti-dilution provisions: weighted average anti-dilution and ratchet-based anti-dilution.

Hand With Banknote Business Trap

Ratchet Based anti-dilution

Ratchet based anti-dilution is an extreme example of an anti-dilution provision that early investors can include and does not dilute their shares regardless of any shares added down the line.

If new shares are issued at a lower price than previous shares, then the old share price is reduced to match the new price.

This point is probably best illustrated using an example

  • Investor A is issued 10 000 shares at $1.00 each. If no anti-dilution provision is in place and the company decides to sell more shares to Investor B in a later round of financing then A’s equity is effectively reduced.
  • A’s equity in the company before B came on board, was 20% and the founder owned the remaining 80% (40 000) of the company. After B invests, they are allocated 20 000 new shares, taking the overall ownership for A to roughly 15% while B owns 28% and the founder owns 57%.

However, if there is an anti-dilution provision in place and the company sells more shares to Investor B at a lower price (let’s say $0.50 a share)

  • Investor A gets to remind them that they have to treat their shares as equal to the new price. So, as the $10 000 dollars Investor A spent on their shares at $1.00 a share would have bought them 20 000 shares at $0.50 a share, they are awarded another 10 000 shares.
  • With a full ratchet in place suddenly the founder is in the position where A owns 28.5%, B owns 28.5% and the founder has their equity diluted to around 43%.

weightedWeighted Average anti-dilution

A weighted average is far more common and takes into account the amount of the lower-priced shares issued, not just the actual valuation.

In a weighted average scenario, the number of shares issued at the reduced price is considered in the repricing of the previous round. This essentially means finding the dollar amount the company has received in all of its investments, dividing that by the number of shares it issued in all those investments, and coming out with the average price for those shares.

Again, an example may be helpful in illustrating this point

Using the above scenario a weighted average would involve:

  • Investor A saying “I bought 10 000 shares at $1.00 per share, but now the weighted average formula average price is $0.75/share” With the weighted average this would have bought Investor A 13,333 shares, so he is awarded 3 333 new shares.
weighted average formula
The Weighted Average Formula: Your lawyer’s weapon of choice

These are the broad strokes for a weighted average anti-dilution, at this point, we’re usually happy for the lawyer to take over and start referring to their formulas and spreadsheets.

Without getting into all the spreadsheets and financial details of anti-dilution provisions the gist of all this is, that investors will insist upon anti-dilution protection as it protects their investment.

A full ratchet means that the investor’s ownership does not dilute at all.

A weighted average is more founder friendly.

Although it still dilutes a founders ownership it also slightly dilutes an investors ownership (still not as much as the founder) based on the amount of money raised in the past and being raised currently.

Full ratchet anti-dilution protection is very harsh on the founder and should be avoided at all costs, whereas a weighted average is more founder friendly and thankfully the industry standard.

If you’re entering into negotiations and feel as if an investor is trying to full ratchet you, rethink your options.

Keep in Mind

A term sheet in your hand is valuable, use it to shop around (providing you don’t break any no-shop term sheet provisions) and as leverage against other investors to try and get the terms you want.

While you probably won’t be able to eliminate anti-dilution provisions you should focus on minimising their impact

Restrictive Covenants (No-shop clauses)

handshake
As a Founder, this term may seem restrictive and anti-competitive to you.

A no-shop clause is a term that VCs are likely to initiate and agrees that the two parties will work in good faith towards the closing of a financing deal.

The founder is essentially agreeing that they will not initiate or engage new proposals from any other VCs than the one they currently have a letter of intent or ‘handshake agreement’ with.

For a VC, a no-shop clause allows them to focus on closing their current deal rather than continuing to compete with other VCs in their current financing round.

As a founder, this term may seem restrictive and anti-competitive to you.

Getting the best deal for around of financing comes from having multiple options. Also, a no-shop clause makes no guarantee that a VC will actually follow through with funding. However, it is possible for you to put a no-shop agreement to good use by negotiating a time-frame for the agreement.

A no shop agreement should be seen as an opportunity to hold your VC to a timeframe (usually around 40-60 days) in an attempt to hurry the closure of a deal.

As I mentioned earlier, founders need to push VCs and as your time is one of your most valuable resources you should protect it by adhering to a strict time frame. A no-shop clause can offer you this definite time frame when trying to close your round of financing.

Keep in Mind

Acquisitions often follow investment, it’s also prudent that you keep the door open for acquisitions when agreeing to a no-shop clause during financing.

If you can negotiate a carve-out for acquisitions this turns the VC no-shop agreement into a useful term used to cover yourself on two fronts.

As I said, VCs have a tendency to drag founders along, without ever making an actual offer. But they also never want to miss out on a deal. By strategically negotiating a no-shop clause, you’ve taken a clause intended to kill your competition and instead used it to force the process of financing while leaving the door open for acquisitions.

That’s all for now

As always.

We suggest that you always consult a lawyer experienced in structuring VC deals when entering into negotiations.

However, it doesn’t hurt to be just as smart, if not smarter, than your lawyer.

Make sure you’re not attempting to negotiate against a VCs principles. Sometimes no means no. VCs might flat out disagree with a provision because they’ve been burned before, so do yourself a favour and negotiate the terms you can.

Practice your due-diligence and talk to past companies your interested VC has invested in, both successfully and unsuccessfully. Learn from their mistakes, learn what was negotiable, what wasn’t and try to gauge how the VC was as a business partner.

Next week we’ll be getting into investor pay-to-play agreements, equity vesting schedules and how founders can use these provisions to their advantage.

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