A VC in Vacationland

Investor-Relations-auf-Facebook (Photo credit: koesteran)

Here are sixteen soft (or not
so soft) terms for entrepreneurs to watch out for in term sheets form investors (In no particular
order):

1.            BOD composition— Generally, a five
person BOD, with two inside members, one investor and two outsiders is an
optimal one. Investors often want two seats, with one outsider, making
independence difficult. Keep to a two independent board member model.

2.            Voting rights—you want all shares to
vote equally. Some investors insist on preferential voting, like 2 votes per
preferred share, or other like nonsense. One share; one vote is the rule.

3.            Redemption Rights—avoid adverse change
redemption clauses at all costs. ACRC’s are nasty stuff. Regular redemption
rights are a necessary evil as VC’s love downside protections and this gives
them some. Let it go.

4.            Pro Rata Rights (aka Right of First Refusal)—gives
the investors a right to invest in future rounds at generally favorable terms.
Most times, VC’s don’t care unless the terms are overly generous (like 30+%
discounts to the new share price) and then they will make the founders eat the
difference out of their equity.

5.            Sales Restrictions—prohibits sales of
common shares to outsiders. Generally a good idea as it allows you to control
who owns your company.

6.            Debt Covenants—these clauses prohibit
you from borrowing money without shareholder approval. If you want a line of
credit, then you must get approval, for example. Not a terrible clause, but
avoid if possible.

7.            Indemnification –all investors want to
see this clause as protection against lawsuits. Buy Directors and Officers
(D&O) insurance to protect board members and yourself.

8.            Assignment—generally OK, but do not
accept any “assignment without transfer of the obligation” clauses slip in
here. This would allow a new entity who received the equity make up new rules
you need to abide to.

9.            Co-Sale Agreements—try and keep this
clause under control, although VC’s generally will not negotiate this one. Set
a cap of say $500K on your sale rights without VC participation, rather than a
total exclusion. It will let you buy that Testerossa you dream of.

10.          Anti-dilution—be sure and work with your
lawyer on crafting this one. There are many pitfalls and only experienced
professionals can figure them out.

11.          Protective Provisions—another VC
protection clause that gives VC’s veto rights on certain company actions. It
will stay in the term sheet, but try and limit its reach to major
recapitalizations, not borrowing money to buy technology

12.          Drag-Along—this is one of those good
guy/bad guy clauses that can help or hurt you. The hurt comes if it is easy for
investors to force a sale at a price that leaves you with nothing.  It’s a clause that will stay; your best bet
is not to create the environment where it happens

13.          Conversions—try and get an automatic conversion
clause, which has a number of negotiable terms, especially the threshold (most
likely IPO offering) at which the conversion takes place

14.          IP & Inventions—the clause is fine
since it will force you to get all employees to sign an agreement to protect
proprietary information and intellectual property

15.          IPO Share Purchases—this is a “friends
& family” purchase clause that allows early investors a chance to get extra
shares in an IPO at issue price. It’s a nice for early investors.

16.        No-Shop Clause—avoid at all costs. The
clause says you cannot use the issued term sheet to shop for a better deal.
Perhaps the best you can do is to require that the clause expire when the VC in
question decides not to go ahead with the deal. Also, allowing acquisitions
during the term is important.