Last week Aaron Harris over at Y Combinator wrote about bad terms and the types of things to look out for when you don’t always know what you’re getting into. We wanted to reference that post from our blog because we thought it was an important topic for the entrepreneurs that utilize our platform and reference our site. In a perfect world the investors would want an agreement to be fair in order to produce not only a friendly relationship, but also a fruitful one. Sometimes the terms can create situations that make it difficult for the entrepreneur to remain agile as they grow their business and since growing their business is beneficial for the investor, the terms should keep that as the primary target.
Aaron talked about some real stinker terms to be on the lookout for like Anti-dilution, Super pro-rata, 1x+ liquidation preferences, etc. But as he noted, the list can go on and on. The best bet is to find a lawyer that can guide you through these and how they may impact the company now and down the road. If anything, you just want to understand them.
“Get a lawyer that understands startups. It’s important to find someone with experience. Not only can a good lawyer explain what’s going on with terms of your agreement, he/she can tell you if those terms are standard. Lawyers can also help you negotiate, though this is usually more relevant in priced rounds.”
In many cases, the investors themselves may not even need those particular terms. They may have been advised to include them but if you were to discuss it with them as to the impact to the company, an investor may see the folly if such structure is built into the deal.
Aaron also pointed out that an investor who habitually inserts bad terms can find themselves ignored by the community on future opportunities because of the negative outcome that results from continually forcing such constraints on companies. Other investors in the same deal may even pressure that investor to drop the term because of it’s detriment to everyone involved.
Overall, Aaron’s piece gives great perspective and guidance on how to assess and move forward with caution. Which can be in short supply in a lot of deals these days.
Some of the terms that Aaron recommends to look out for but not limited to are…
- Liquidation preferences greater than 1x (http://www.learnvc.com/2008/07/liquidation-preference/)
- Super pro-rata (http://www.bothsidesofthetable.com/2011/09/25/why-super-pro-rata-rights-are-not-a-good-deal-for-entrepreneurs/)
- Cramming down the pro rata of earlier angels/investors
- Asking for extra advisory shares on top of an investment.
Jump to Aaron Harris’s full post here to get a much more in-depth analysis. And if you are an entreprenuer looking to interface with your investors and potentially find new ones, sign up for a free company profile here at Venture360.