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Don’t Get Trapped: Spotting Red Flags in Your Start-up Term Sheet

Don’t Get Trapped: Spotting Red Flags in Your Start-up Term Sheet

Posted on by Alyson Perry 4 min read

As a founder, securing investment is exhilarating. But amidst the excitement, the term sheet – that seemingly non-binding “blueprint” for your deal – can contain clauses that silently undermine your control, dilute your equity, and even jeopardise your ultimate exit.

At Stewart & Smith Advisory, we’ve seen countless term sheets. Our mission is to empower founders to understand and navigate these complexities. Here are some “predatory” or overly founder-unfriendly terms you must be aware of:

1. Excessive Liquidation Preferences (Beyond 1x Non-Participating)

  • What it is: This clause dictates who gets paid first and how much, when your company sells. A 1x non-participating preference means investors get their original investment back before anyone else. This is standard.
  • The Red Flag: Watch out for anything more than 1x (e.g., 2x, 3x) or “participating preferred” shares (where investors get their money back and then share in the remaining proceeds as if they were common shareholders).
  • Founder Impact: In a modest exit, or even a decent one, these can mean founders and employees get little to nothing, even if the company “succeeds.” Investors could double or triple their money before you see a cent from your common shares.

2. “Full Ratchet” Anti-Dilution Provisions

  • What it is: Anti-dilution protects investors if a subsequent funding round happens at a lower valuation (a “down round”).
  • The Red Flag: A “Full Ratchet” provision is the most punitive. If you raise money at a lower share price in a future round, this clause effectively resets the conversion price of the original investor’s shares to that new, lower price.
  • Founder Impact: This drastically increases the number of shares the original investor gets for free, causing massive dilution for founders and common shareholders, potentially making future fundraising very difficult. A “weighted average” anti-dilution is a far fairer, more common alternative.

3. Founder Vesting Reset or Unfair Vesting Terms

  • What it is: Founder vesting ties your equity ownership to your continued service, typically over 3-4 years with a 1-year cliff. It aligns incentives for the long haul.
  • The Red Flag: If an investor insists on restarting your vesting schedule from scratch after their investment, even if you’ve already put in years of work. Or, if “bad leaver” provisions are excessively harsh (e.g., losing all vested equity for minor infractions).
  • Founder Impact: Forces you to re-earn equity you’ve already worked for, reducing your economic stake and flexibility. It signals a lack of trust and can be a significant de-motivator.

4. Excessive Investor Control & Veto Rights

  • What it is: Investors gain certain rights to protect their investment, including board seats and requiring consent for major decisions (protective provisions).
  • The Red Flag: Investor demand for a majority of board seats, or super-majority voting rights that effectively give them veto power over everyday operational decisions (e.g., hiring/firing key executives, budgets, product roadmap changes, minor capital expenditures).
  • Founder Impact: Strips founders of control over their own company, leading to micromanagement, slowed decision-making, and potential misalignment with the long-term vision. You lose agility and autonomy.

5. Redemption Rights

  • What it is: A provision that allows investors to force the company to buy back their shares after a certain period (e.g., 5-7 years) if there hasn’t been an IPO or acquisition.
  • The Red Flag: This creates a mandatory cash outflow obligation for your company, regardless of its financial health or readiness for such a redemption.
  • Founder Impact: Can severely cripple your company’s cash flow, especially if you’re still in growth mode and not profitable. It essentially turns equity into a debt-like obligation, potentially forcing a sale or winding down the company prematurely just to satisfy the investor.

Don’t Go It Alone: Seek Expert Counsel

A term sheet is complex. Understanding these clauses isn’t just about protecting your current investment; it’s about safeguarding your company’s future, your control, and your ultimate financial outcome.

Before you sign anything, always engage experienced legal counsel and a strategic financial advisor like Stewart & Smith Advisory. We help founders dissect these terms, understand their true implications, and negotiate a deal that’s fair, balanced, and sets your business up for long-term success.

Facing a term sheet? Let’s talk strategy before you sign.