A "bad" term sheet could leave an entrepreneur without control of their company at the earliest stages of starting up, forcing them into losing major chunks of their equity, and even blowing up future deals with new investors. So, it's important to get this right.

When it comes to term sheets, founders are often at a disadvantage during negotiation compared to their investor counterparts because investors, who are often dealing with term sheets on a monthly basis, have access to seasoned lawyers and a CFO ensuring they get the best deal possible. At Contrary, we believe it's in everyone's best long-term interest to get a fair deal that benefits all parties, and as a founder, you'll often need to be willing to negotiate to get to that point.

The question isn't whether or not to negotiate, but what is truly worth negotiating over? Contrary sees countless term sheets, both our own and those of our co-investors, and with that we've compiled a list of 8 significant red flags that you, as a founder, will want to avoid:

Losing Company Control at an Early Stage

Especially at the Pre-seed to Series A stages, any term sheet that would allow investors to theoretically fire you (or your cofounders) from your own company should be a no-go. Generally speaking, this would take the form of investors having more board seats than the founders.

At the Pre-seed stage, it's uncommon to give away any board seats. Keep in mind that you'll slowly cede control in each of your future rounds unless you manage to end up with significant leverage, and specifically structure deals such that you and your cofounders centralize or maintain power. To be clear, having one trusted investor (typically the lead investor) as a board member at the Seed stage can be an asset. Just avoid a pre-Series A term sheet that would give investors more board seats than the founders.

Greater than 1x Liquidation Preferences

The best way to illustrate this scenario is with an example. Let's say your investors, with a 2x Liquidation Preference, invested $10M in your company at a $20M valuation, and for simplicity's sake, all shares are split 50/50 between the founders (you) and the investors.

Note: if not for this example, this split would be a red flag.

Then let's say you sell the company for $22M. Because the investors have a 2x Liquidation Preference, they get to double their money before anyone else can take any money off the table. In this case they would get $20M (2 x $10M), and the remaining $2M is left over for the founders and any other shareholders to split accordingly. In this example scenario, there's at least $2M left over to be split up, but Liquidation Preferences can get messy if you don't raise enough or don't sell for a large enough amount. Some Liquidation Preferences are so predatory that founders and their employees (and even some of their early investors) can be left with nothing.

Having a liquidation preference greater than 1x is uncommon for good reason. It's the investor signaling a lack of confidence in the founding team, a lack of up-to-date investing knowledge or worse, a really bad legal team. 1x preference is standard.

Re-vest Over 4 Years

Founders should generally be on a 4 year vesting schedule with a one year cliff. This way a founder earns their equity over time. This is done for a few reasons, but most notably it's a precaution and motivating factor for the founders to stick around for at least the first four years of the business. This is important because otherwise a founder could leave after a year with a massive chunk of the equity.

That being said, investors should not force the founders to restart their vesting schedule or alter it after their investment. This is not standard, and can signal a serious lack of trust between your team and the investor.

Super Pro-Rata Rights

"Pro-Rata Rights" allow an investor to participate in future rounds of funding to retain the same percentage stake they already have in the startup. So, if the investor owns 10% at the Seed and has Pro-Rata Rights, then they have the right to invest enough in your Series A to retain their 10% without dilution. This is standard, and considered fair.

"Super Pro-Rata Rights", however, give your investor the opportunity to increase their percentage. This can be a signal of strong support, but it can make it very difficult to add new investors in future rounds.

Investors have certain "ownership targets" when investing, meaning a certain percentage of ownership they're aiming for in each company they invest in. Early investors with Super Pro-Rata Rights can make it more difficult for future investors to hit their targets, forcing you to chose between losing the deal or taking more dilution than you want or frankly, should.

Another notable aspect of Pro-Rata Rights: they shouldn't last in perpetuity. If your investor doesn't exercise their Pro-Rata Rights in a round, they shouldn't keep the rights for future rounds. It's also worth noting, most Angel investors won't have Pro-Rata Rights.

LP Right to Invest

This is rare, but some firms may give their Limited Partners, aka the institutions and people who invested in the fund that invested in you, the right to invest alongside the fund itself. The primary downside of this rare arrangement is that it crowds out space on the cap table for better/more trusted investors in favor of people you may have never worked with. This also complicates the cap table for future investment, making it more difficult to raise capital in future rounds. This arrangement, and any other arrangement where additional sources of investment can be added that you don't control, should be avoided. Just don't do it.

"MFN" Clauses on Uncapped Notes

"Most Favored Nation" clauses will sometimes appear on a convertible note term sheet at the early stage, and should be negotiated out. An MFN clause means that an investor receives the benefit of more favorable terms offered to a subsequent investor. This is often misunderstood by first-time founders and can end up being costly.

Essentially, it can force you to offer additional "perks" to an investor you might not want to partner with on a continued basis. For example, you could have an early angel investor with an MFN clause that doesn't add much value to your venture. Now let's say in your next round you raise from a great firm that wants pro-rata rights. In this scenario, because the early angel has an MFN clause, they get those pro-rata rights as well, giving them the ability to invest again in your company, further crowding your cap table from other sources of financing.

That said, an MFN clause is not always unreasonable, especially in small amounts. MFN is a useful tool for investors who might want to get involved and help but are less experienced on valuation/term negotiation, so they're trusting future investors to handle that. Just be aware of how it works, and don't let too much capital stack up under MFN terms.

"Full Ratchet" Anti-Dilution Protections

The Anti-Dilution Clause protects an investor in the event that a future round of financing is done at a lower price than the price they paid. If anti-dilution is in place, the investor's "conversion price" is adjusted (down) such that they are issued more shares for the capital they already invested. Some anti-dilution protections (often referred to as "weighted average") is standard. However, "Full Ratchet" anti-dilution protections could allow an investor to increase their stake in your company without any additional investment, which is notably not ideal in the event of a down round.

Extremely Low Valuation

Let's be realistic. Even if you think your company will one day be worth $10B dollars, it's not going to be valued that way at the seed stage. It's worth understanding what comparable companies (at your stage and in your sector) are priced at and comparing your valuation to those. Before accepting a term sheet, think about how much of your company you're willing to give away and how much you need to raise, and use that as a benchmark. Talk to trusted founder/investor friends to spot-check your offers.

If you're given an offer that feels too low, the best way (by far) to gain leverage is to have multiple offers from competing VCs. You can also reference the valuations of other companies in your sector, or conversations you've had with other founders to build your case,

Receiving a term sheet is a pivotal moment in building your venture-backed business. It can mean the start of a years-long "marriage" with an investor or a number of them. Everyone benefits by getting that relationship off on the right foot, but a bad term sheet with unfavorable clauses that hurt the founders is likely to leave all parties worse off in the long run. That's why it's important to get it right from the first term sheet on. Term sheets are meant to be respectfully negotiated, so if you spot one of these red flags, don't be afraid to fight to change it.

Additional Resources

Introducing The Term Sheet Grader — TechCrunch created a simple excel table that shows, defines and scores the key provisions in the average term sheet. Friendly provisions get additional points, industry standard provisions get 0 points, and unfriendly provisions lose points.

Term Sheet Negotiation: How to Avoid Common Mistakes — Niko Bonatsos, an MD at General Catalyst, explains how to skillfully negotiate a term sheet, and how to not get caught up on provisions that don't matter.

Term Sheet and Closing — A Y-Combinator post that tells you what specifically you should do after receiving a term sheet you're interested in.

Our Top Ten Term Sheet Hacks — A slideshow with transcribed notes from investor Naval Ravikant on how to ensure you have a fair term sheet.