2. Where can you get funding for your startup?

Now that we have an idea of how much funding we need, we need to find the right source.

In Part Two of our Masterclass, we have identified and discussed 9 Startup Funding Sources:

1. Personal savings
2. The business itself
3. Friends and family
4. Government subsidies and grants
5. Incubators and accelerators
6. Bank loans
7. Convertible notes
8. Venture equity
9. Venture debt

Making the right decision for your business starts by understanding the options, but if you are looking for a guide through the different options, we have you covered here.

A. Funding sources quick guide

Use these questions to find a potentially great funding source fit for your startup.

Do the words early stage, idea phase, or pre-revenue come to mind when talking about your startup?

• Are you considering to invest your own savings or talking to friends and family?
• And/Or are you looking for a small outside investment and access to an ecosystem and advice by joining an accelerator or incubator?
• And/Or would you like to get an experienced investor as a shareholder?
• Perhaps, while doing so, you would like to consider one of the common instruments used in seed investing, the convertible bond?

Are you developing a new technology or thinking about launching a new innovative project?

• Have you considered applying for a government grant as a cheap source of funds to support your plans?

Did you hustle your way out of the pre-revenue stage and are you looking for cash to scale your business?

• Have you considered keeping all the equity and bootstrapping your way to the top?
• Or are you ready to take an outside investor into your shareholder structure?

Is being cash flow positive around the corner, do you need any investments in equipment, or are you looking for ways to fund your working capital?

• Have you already spoken to any of your local banks? Did you know that there are government programs supporting banks to lend to startups?

Or did you just raise a venture round and are you looking for some extra cash until you go into your next fundraising?

• Why don’t you consider what Uber, Airbnb and many others have done before you, and take on venture debt as the bridge between your funding rounds?

Read on about all the details in Part Two of our Masterclass about funding sources.

B. When to raise VC money

As you go through the above questions, it might be that you end up looking for a VC investment.

VCs are a very important part of the startup ecosystem, as they provide a large part of the invested capital, but they are also often misunderstood.

In order to understand if this is the right route for your startup, read up on Venture Capital in Part Three of our Masterclass “When to Raise VC Money (and when not to)”.

In summary, the most important thing to understand about VCs is how they are incentivized when making a decision.

VCs manage outside capital and depend greatly on their ability to source new capital. The key drivers in sourcing capital are the overall fund performance and the ability to source high-level deals.

Now research shows that in order to achieve good returns as a VC, you are highly dependent on a few big home runs. Often referred to as the Power Law in VC investing, this effectively means that the performance of the fund is dictated by a small number of investments with amazing returns.

What does this mean for you as a startup looking for funding? It means that you now have an idea what a VC investor is looking for and that you can see if you are a fit.

Here are some questions to guide you to assess how your startup would fit in a VC portfolio.

Does your startup classify as a “potential big win”?

• Do you have a $10bn potentially addressable market?
• Could your business reach +$100m in annual revenue within a 7-8 year time frame?
• And if so, what would it take to get there (geographies, verticals, markets)?

Is your business insanely scalable?

• Does adding new clients hardly increase the complexity of your business?
• Do you have a relatively low additional cost to deliver to additional clients?
• Do you have a product that is pretty much “plug and play” across markets?
• Do you have a product that is ready, and is money the main blocker from getting market share?

Does your business require scale to be successful?

• Are you running a marketplace, a micro-mobility provider, or any other business that benefits greatly from the additional scale?
• Are your unit economics highly reliant on getting the right scale?
• Or do you need a big investment up front with the promise of great scalability in the future?

Do you mind giving away control?

• Do you believe that having 10% of the business with VC money is better than having 80% of the business without?
• Do you not mind dealing with and reporting to professional investors?

Are you ready to sell or go public in the next 5-10 years?

• Are you ready to start the clock and prepare your business for an exit within the VC timeframe?
• Would you mind running a public company with all the public scrutiny it entails?
• Or are you willing to sell to another industry player or a financial sponsor at some point?
• Do you mind having limited leverage in the exit decision?

In case your startup does not fit these criteria, don’t worry. There are other ways to create a great business. Have you ever heard about bootstrapping? If not, check out the last section of Part Three of our Masterclass.

C. How to split startup equity

Before you can go out there and raise funding for your startup, it is important to get your house in order.

One of the key parts is to make a decision on how you will split your equity among the founders, employees and advisors.

For a detailed view on how to split the equity the right way take a look at Part Four of our Masterclass “How to Split Startup Equity the Right Way”.

Beyond deciding on how much to allocate to whom, it is also very important that you do it in the right way, protecting yourself and your business for when it does not work out as expected.

This is also very important to the investor, who will become a co-owner of your business. Not protecting your business thus also means not protecting your investor.

Here are some tips to work with before going into an investor meeting.

Think before you allocate

Are you convinced that the advisor/employee/co-founder can deliver on the promises?

• Have you spoken to previous employers/employees/partners?
• Did you see any previous projects?
• Did you have enough time to truly assess the ability to deliver?

Do you have a similar view on future cooperation?

• Do you share similar priorities and goals?
• What will happen in the medium term, do you see a role for both?

Work with reverse vesting

Founders often receive their equity in the beginning, but what happens if it does not work out and one of your co-founders leaves?

You are still at the beginning of the road and now you have this founder with a piece of control over your business.

This is where reverse vesting comes in, by making the equity gift conditional on the founder staying in place. If not, part of the equity is returned to the company.

Set up good corporate governance

What happens if you and a co-founder disagree?

Who comes in as the tie break? Or do you just have more voting rights? These are questions to consider.

One of the ways to tackle these issues is by having a good board of directors which will be part of the most important decisions.

Keep control over who owns the shares

One of the key risks of giving away a lot of equity is that it might fall in the wrong hands.

You can protect yourself by using either a Right of First Refusal or a Blanket Transfer Restriction which allows you to buy the shares first or limits the selling altogether.

Set up the right equity incentive program for employees

Startups are a risky business and they attract a certain form of employee. One of the key methods to reward this employee is through equity incentive programs.

Investors will ask you to reserve enough equity (probably out of your ownership) to reward and attract the necessary talent to build your business.

Read up on the differences between shares and options and take into account the local habits.

When setting up an equity incentive scheme take with you the following tips:

• Understand your employee’s needs: Not all markets nor employees have the same appetite for equity. Understand the needs and adjust.
• Employees talk: Never forget that employees across firms and industries talk about their compensation. Try to stay close to market standards.
• Be transparent: Equity is not always as simple as it seems. Make sure that you are transparent to employees so they understand the real value and downsides where needed.

D. Understanding the different startup funding rounds

Another important aspect of getting investment in your startup is understanding in what funding stage you currently are. Because one does not simply fuel up once.

With each stage come different challenges and needs, but also different requirements in terms of progress.

Read up on all the different stages in Part Five of our Masterclass “Startup Funding Rounds: The Ultimate Guide from Pre-Seed to IPO”.

In order to have an idea of where you are, you can ask yourself the following questions:

• Did you just create a business plan or technical idea and are looking for funding to build an MVP?

-> Pre-seed / Seed

• Did you just launch your MVP and are you seeing the first customers appear? Are you now looking for funding for your first key hires to truly develop your initial product and prove your product market fit?

-> Seed

• Did you just figure out your product market fit, develop a scalable and repeatable product, and lay the foundation to create scale in your sales? Then it is time to super-fuel your growth.

-> Series A

• Are you in the midst of crazy growth and can’t keep up with the generated demand?

-> Series B

• Are you running a startup valued at $100m or more with several years of strong growth behind you? But you are not ready to go public and need a bit more time to finetune your business?

-> Series C or more

• Are you and your investors ready to sell some shares? Does the company have the reporting and management structure in place to go through life as a public company?

-> IPO

E. Last but not least: selecting the right investors

Now that you have a good idea of how much funding you need for your startup, know what sources you would like to use, and understand what round you are looking for, it is time to discuss how to find these elusive investors. And how to find the right ones.

For a detailed and practical overview of how to find and select the right investors, take a look at Part Six of our Masterclass “How to Find the Right Investors”.

First of all, there are two different stages when it comes to raising capital. A networking mode and a fundraising mode.

Why this distinction?

Well if you have ever engaged in fundraising you will be able to attest to this: it dominates everything. From the moment you wake up to the moment you go to bed, it will always be top of mind. It is hopelessly distracting and that is why you should limit it to the shortest period of time possible. Get in, get your cash, get out.

That does not mean however that you should stop talking to new people and meeting investors in a very informal setting. Hence, the networking mode. But the moment that you get into a room to pitch your startup, you are in fundraising mode. Be careful, investors love to drag you into fundraising mode, as it provides them with an opportunity to invest in you before anyone else.

Once you have decided that it is fundraising mode it is essential to do your research and be structured.

To us, there are two key steps.

First, create a list

Start out by collecting a list from the following resources:

• Network: Ask fellow entrepreneurs and people in the scene (they might have a list).
• Incubators and Accelerators: If you are part of one, don’t forget to leverage your participation. If not, asking never hurts.
• Government agencies: In a lot of countries, the government has set up agencies specifically to help out starting entrepreneurs. They typically have this kind of information.
• Universities: Contact alumni networks, entrepreneurship support groups and university staff for leads.
• Directories: Big directories like CrunchBase and AngelList can be a great resource.
• LinkedIn: Identify and connect with high net worth individuals and investors. Don’t forget to search for keywords like “investor”, “venture capital”, “angel”, “member of board”.

When creating this list try to be as complete as possible, while also not creating needless work. If a name does not make any sense right from the beginning, then just leave it out.

Tip: Do not underestimate what you can get by leveraging your network.

Now filter your list

Now that you have this huge list, you need to narrow it down to those investors with the highest probability of success.

To do this there are three key criteria:

• Is the investor interested in your company?
• Can the investor invest in your company?
• Is your company interested in the investor?

Read up on Part Six of our Startup Funding Masterclass for a step by step approach and practical tips on how to judge each of these three very important questions.

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3. How to deliver a successful investment pitch?

Once you have locked down the investors that you would like to invest in your startup, it is time to convince them.

It all starts with creating the right pitch.

In Part Seven of our Masterclass “How to Make the Perfect Pitch Deck” we discuss at length how to create the perfect pitch following the Airbnb example.

In summary, we would give the following tips.

A. Understand your audience

You are speaking to a very specific audience and you should know its characteristics:

• They have limited time for your pitch
• They are looking at several pitches every day
• They are looking for opportunities by finding clues of successful businesses (investor mindset)

In order to be successful, you need to offer those clues in a clear and concise fashion.

B. Understand the purpose of the pitch

When creating your pitch, never lose sight of what you are trying to do. You are trying to convince an investor to invest in your business.

Investing in startups is a very risky business and most investors are heavily reliant on a limited amount of big wins. A big win, that is what the investor is looking for. You need to show how you can be that next 10x investment.

The pitch deck is one of the most important documents you will use to convince investors, but it is also not the sole document. Refrain from including every possible detail and metric. It is all about getting the investors excited and setting yourself up for more detailed discussions.

C. Key items to include

In order to convince investors, you need to convince them of the following key items:

• Market opportunity
• Ability to execute
• Scalability
• Competitive advantage
• Positive momentum

Market opportunity

Any company’s upper limit is its addressable market. So in order to convince an investor of the potential of your business, you first need to convince them of the market for your product.

A good market opportunity is typically a combination of the following factors:

• A relevant problem that needs to be solved
• Existing products/companies that do not provide the right solution
• A timing component that enables a new solution (regulation, customer behavior, etc.)

Ability to execute

Once you have established that there is an attractive market opportunity, the question arises if you are the right team for the job.

Investors are looking for teams that are able to execute.

In fact, a lot of investors would rather invest in an A team executing a B product than the other way around (trusting an A team to eventually move to the right product).

Scalability

If the market opportunity exists, you also need to be able to serve it.

The ability to acquire, grow and serve customers in a scalable manner is critical.

Therefore your pitch should provide as much evidence as possible that your business is scalable. Be it in your product or in your business model.

Competitive advantage

Any good market comes with a number of competitors. That is why investors are looking for startups that can compete in the long term.

Highlight your unique competitive advantage; whether it is a network effect, hard-to-replicate technology, or the ability to out-execute everyone else.

Positive momentum

Finally, investors want to see that the market and customers agree with you. That in fact, you are building a business that can win.

Try to show your positive momentum by delivering on your business plan, showing positive developments in your product and of course customer traction and growth.

To learn how to take these tips and build your own perfect pitch deck, take a look at Part Seven of our Masterclass “How to Make the Perfect Pitch Deck”.

D. Nail your investor pitch

When pitching to an investor a good pitch deck is important, but so is the way you deliver the pitch.

People are simply not good at giving attention nor remembering.

Learn how to use storytelling to grab the investor’s attention and make your pitch stick in Part Eight of our Masterclass “How to Nail Your Investor Pitch and Get Funded?”.

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4. What to look out for when negotiating with an investor?

You have pitched to investors and some of them are interested.

Now it is time to start discussing the term sheet, one of the most important documents you will ever sign.

What is a term sheet?

A term sheet is a non-binding written document that includes all the important terms and conditions of a deal. It summarizes the key points of the agreement set by both parties before executing the legal agreements and starting off with time-consuming due diligence.

Why is it so important?

This document can dictate how much you will enjoy seeing your startup grow, as it outlines the key terms of your deal with investors.

As an entrepreneur, you are looking to build a business, not negotiate a term sheet.

But you also want to raise capital at the best conditions possible. You don’t want to lose upside and control or take on inappropriate downside risk.

The term sheet is the place to make sure this doesn’t happen as it is all about dividing this upside, control and risk between you and the investors.

Go beyond discussions and learn all about the various terms and clauses, as for a term sheet the devil is in the details.

To make matters worse, you will probably negotiate a term sheet for the very first time while the party on the other side has already done 100s. So you have to be prepared.

Start off by understanding all the building blocks in Part Nine of our Masterclass “The Ultimate Term Sheet Guide – all terms and clauses explained”.

Tips and Tricks

Term sheet negotiations are going to be a stressful time and, depending on the success of your business, you might have more or less leverage.

Before you commit, realize that the negotiations are a great way to see how the VC truly operates. If you really don’t like the process, then you should take this in consideration before committing long term to this investor.

Follow these tips when negotiating a term sheet:

• Hire a good lawyer: Raise enough money to cover the legal fees and hire a solid firm with experience in your local VC ecosystem.
• Know what to fight on: After years of negotiating contracts between VCs and companies a number of clauses have become standard practice. A good lawyer will redirect your focus to the clauses that are worth fighting over.
• Keep it simple: A good contract is a contract for which both sides fully understand the impact at all times. Push back on clauses or on a deal that is hopelessly complex.

Clauses that are worth fighting over are the following:

• Investment size: One of the important drivers of the deal and your future growth possibilities is the investment size.
• Valuation: The valuation has a direct impact on your future upside. Don’t go overboard on trading valuation for a complex deal structure. You need to make sure that you and the investor remain fully aligned in the future.
• Liquidation preference: In a non-seed deal, a liquidation preference of 1x non-participating should be achievable. This clause has a massive impact on your and your employees’ upside.
• Founder vesting: There are multiple ways for VCs to protect themselves from a founder leaving. One of them is a buyback, which is certainly more attractive for you than reverse vesting.
• Anti-dilution: A form of anti-dilution will certainly be included, but there is a big difference between full-ratchet or weighted-average. Push back on full-ratchet or limit the amount of the investment that is protected. Anti-dilution is directly linked to valuation. The harder you push on valuation, the harder the investor will push on anti-dilution.
• Redemption rights: Fight back hard, as they can be a ticking time bomb for your business. If you do need to let them in, make sure the conditions give you enough time and try to restrict the amount.

The clauses that are probably non-negotiable are the following:

• Right-of-first-refusal & Co-sale Rights: Make sure that the rights are drafted in a form that is aligned with the standard practices.
• Pre-emptive rights & pro-rata rights: These rights might limit your ability to bring in other investors down the line.
• Board governance: A good board is more than a fight for control between you and the investor. Structure your board well, get quality experience on board, and your board might become a valuable source of advice.
• Voting rights: Understand the real impact of voting rights and why the investor wants to include them. Check with other portfolio companies to see what is included and how they are used. Here, an experienced lawyer can really add value.

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BOOM! 💥 You’re ready to raise funding like a pro.

To go into more detail on one of the topics, check out the corresponding topic below:

1. How Long Should Your Startup Runway Be?
2. 9 Startup Funding Sources: Where and How to Get Funding for Your Startup?
3. When to Raise VC Money (and when not to)
4. How to Split Startup Equity the Right Way
5. Startup Funding Rounds: The Ultimate Guide from Pre-Seed to IPO
6. How to Find the Right Investors
7. How to Make the Perfect Pitch Deck
8. How to Nail Your Investor Pitch and Get Funded?
9. The Ultimate Term Sheet Guide – all terms and clauses explained

Good luck! 👊

We’ve highlighted the term sheet’s importance, refreshed its definition, and zoomed in on the goal of the term sheet negotiation. Now let’s explore the different concepts, terms and clauses. 🧐

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Understand the different types of shares

By the time you are letting investors into your company, you have already set up the company and thus created common shares.

In order to facilitate investment, you will issue additional shares. While doing so, you might want to add specific clauses which could justify creating a new share class.

An example would be that a B class share is created with which holders have less voting rights than A class shareholders (original shares).

Another and related instrument are preferred shares. This is commonly used in the startup world, as it allows to set different types of rules.

It is by definition more senior than regular equity. This means that preferred shares have more claim to the company’s assets than regular shareholders. In the event of liquidation, this can be of great importance. 😅

Venture investments are typically issued in preferred shares, therefore, we will continue this article assuming that we are negotiating a preferred shares term sheet.

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Understand the capitalization table

A cap table is, in essence, an overview of the total capitalization of the company.

Typically created and stored in a spreadsheet, the cap table is one of the most critical documents for a company, as it tracks the equity ownership of all the company’s shareholders and security holders, as well as the value assigned to this equity.

Cap tables need to be comprehensive and accurate. They also need to include all elements of company stakeholders such as convertible debt, stock options and warrants in addition to common and preferred stock. See below for what a basic cap table looks like.

The table highlights the most basic information such as the holding of the founders and key investors.

Key terms regarding the cap table

Like with anything in finance, the capitalization table uses a specific language. 🤔

Valuation

The key terms related to valuation are:

• Pre-Money Valuation – Valuation of the company before the investment (more on this later)
• Post-Money Valuation – Valuation of the company after the investment (more on this later)
• Price per Share – This is calculated by taking the post-money valuation and dividing it by the fully diluted number of shares (see below)

Security types

As highlighted in the previous section, it is not uncommon to create a different kind of security type for an investment.

Now, as the cap table needs to be comprehensive and complete, we will list the most common security types with links to their definitions. For the rest of the article, it is more than adequate if you remember common stock, preferred stock and stock options.

• Common Stock
• Preferred Stock
• Stock Options
• Warrants
• Restricted Stock

Share counts

Share counts are important as they are the denominator for various aspects of the cap table analysis.

• Authorized Shares – Before issuing any shares, they need to be authorized by the company’s board. Authorized shares refer to the number of shares that is authorized for current and future issuance (this amount should be adequate for future issuances; for example for issuance of options).
• Outstanding Shares – This is the total number of shares that have been issued (thus a subset of authorized shares). It does not include options that have not been granted, nor does it include options that have not been exercized, as the shares are only issued when exercized (hence there need to be enough authorized shares).
• Fully Diluted Shares – This is a calculation which models all the granted options, restricted stock, warrants, and the remainder of the option pool itself, into a number of shares that represents a theoretical count, as if all of these outstanding items were granted and exercized.

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Understand the key term sheet clauses

Most people will tell you that an investment is dictated by two key terms: valuation and investment.

But as investors are trying to minimize their risk while setting themselves up for the best return, a number of additional clauses will be added. These have a huge impact on the deal.

A deal with a lower valuation but with better terms can often be the better deal. 👈

The key clauses of a term sheet can be grouped into four categories; deal economics, investor rights and protection, governance management and control, and exits and liquidity.

1. Deal economics: who gets what?

The logic behind taking outside investment is often that you would rather have a smaller part of a bigger pie, instead of a big part of a small pie.

Now, in order to protect this piece of the potentially big pie, you need to watch the deal economics closely. 🧐

Beyond valuation, conversion, and option pool, investors also use special clauses to limit their downside and guarantee a certain return, such as a liquidation preference, participating preferred, and dividends.

Be careful with these types of terms and don’t forget that your latest term sheet will also be driving your next round of financing.

a. Total size of the round

One of the first and most important items on the term sheet is the investment amount.

Typically the term sheet specifies the amounts per investor (lead, non-lead).

b. Valuation

The next item on the list is the valuation.

The start of any negotiation is making sure that you are both talking about the same thing. This is not always as straightforward when it comes to pre- and post-money.

Pre-money and post-money valuation

The key difference between pre and post is timing.

Pre-money refers to the value of your company excluding the funding that you are raising.

Post-money refers to the value of your company directly after you receive the investment.

Now, let’s say you are looking for a $500,000 investment in your company and decide that your company is worth $1,000,000. If this $1,000,000 refers to the pre-money valuation, it means you will hold two thirds of shares after the investment. If it, however, refers to the post-money valuation, you will only hold half of the shares post-investment.

In the below table, the pre-money and post-money valuations are indicated in bold.

c. Conversion

Preferred stock is more valuable than common stock as it grants certain rights. One of which is a conversion right.

A conversion right is the right to convert shares of preferred stock into shares of common stock.

The rate at which this happens is the conversion rate (e.g. 2:1).

There are two types of conversion rights: optional and mandatory.

Optional conversion

Optional conversion rights allow the holder to convert her shares of preferred stock into shares of common stock (initially on a one-to-one basis).

Let’s assume that an investor has a $1 million non-participating 2x liquidation preference representing 25% of the outstanding shares of your company. If the company gets sold for $50 million, the investor would be entitled to the first $2 million due to its liquidation preference.

If the investor, however, chooses to convert its shares using her optional conversion rights, it would receive $12.5 million. 😯

Optional conversion rights are typically non-negotiable.

Mandatory conversion

Mandatory conversion rights oblige the holder to convert her shares into shares of common stock at pre-defined events, such as an IPO. This happens automatically, that is why it is sometimes referred to as “automatic conversion”.

d. Option pool

Up next is the option pool size, as it is directly linked to the valuation.

A key tool to attract talent in the startup world is by sharing equity with your employees. Investors know this and often ask you to organize a pretty sizeable option pool before their investment.

By forcing you to do this prior to investment, it will not be dilutive to the investors.

In fact, as it is coming out of the pre-investment cap table, it will have a dilutive effect on your shareholding as a founder, similar to a price change.

In this example, we show the difference between a $1m investment at a $3m pre-money valuation and no option pool and the same investment with a 15% option pool established pre-money.

As you can see, by establishing the option pool pre-money, it comes directly out of the share of the founders.

e. Liquidation Preference

The liquidation preference sets out who gets paid first and how much they get in the event of a liquidation, a bankruptcy or a sale.

By including liquidation preferences, venture firms try to protect their investments from downside risks, by making sure that they get their investment back before any other shareholders.

Now imagine that an investor invests $500,000 in preferred shares with a liquidation preference of 2x in the company.

Now if the company gets sold for $2,000,000 the investor will receive $1,000,000 (2x $500,000) and the regular shareholders (common share) will divide the remaining $1,000,000 amongst themselves.

If the investor had, for example, invested $500,000 as a preferred (2x) and additionally invested $500,000 in regular stock representing 50% of the common shares. The investor would have received $1,000,000 due to the liquidation preference and 50% of the remaining $1,000,000 due to her ownership of the common shares. Thus at the sale there only remains $500,000 for the other shareholders despite selling at $2,000,000. 😖

This shows the impact of a liquidation preference on the preferred.

f. Participating preferred

With regular preferred equity, the preferred holder gets paid out first. Afterwards, the remainder of the sale price goes to the common shareholders.

If the preferred is a “participating” there will be a “double dipping” as the participating preferred also receives a pro-rata share of the remaining proceeds, as if it were holding an equal amount of common shares as well (like in the above example).

Say your company has $10m of preferred participating equity and $40m of common equity. In this example, 20% of the capital structure is preferred and 80% are common shares. If your company gets sold for $60m the participating preferred shareholders first receive $10m. Now of the remaining $50m they will also receive 20% of $50m, so in total $20m. This in comparison to just $10m if there was no “participating” clause.

In the case of common dividends, a participating preferred also receives a proportion following the same principle.

g. Dividends

One way to guarantee a certain return is by asking for a dividend (or an interest).

In the case of startups, this dividend is often not paid on a regular basis. Instead, the investor allows you to accumulate your dividends by growing the preferred in size over time. At the end of the investment (sale/IPO), the preferred will have grown and the investor will benefit from the fixed return.

Basically, the liquidation preference grows over time. 📈

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2. Investor rights and protection: protecting their investment

When discussing deal economics, we’ve already seen how investors optimise their upside in the deal. Now we will look into clauses that are used to protect their investment.

The most important clause of this category is the anti-dilution provision.

Dilution happens as a company issues more shares and the existing shareholders’ ownership decreases.

a. Anti-dilution rights

With an anti-dilution provision in place, the company is prevented from diluting investors by selling stock to someone else at a lower price than the initial investor paid.

There are two key varieties; weighted average anti-dilution and ratchet based anti-dilution.

Let’s assume for now that we are in a Series A round negotiation.

Full-ratchet anti-dilution

A full ratchet means that if a company issues new shares in the future at a price below the price of the Series A, the Series A price is reduced to the lower price.

This effectively means (for a full ratchet) that if the company issues one share at a price below the price of the Series A that all of the Series A gets reprised.

What does that mean? 🤔

If the Series A gets repriced, the ownership or the conversion rate will change.

Say you originally have a company with 100,000 shares and a share price of $10 per share. You now issue 100,000 shares in your Series A at the price of $10 per share representing an investment of $1,000,000. At the end of the Series A, you will hold 100,000 shares out of a total of 200,000 representing 50% of the company.

If the Series A price gets repriced to $9 per share, the investment remains $1,000,000 but they now represent 111,111 shares your ownership is decreased to 100,000 / 211,000 or 47%.

Weighted average anti-dilution

A more commonly used variety is the weighted average anti-dilution. Here the number of shares issued at the reduced price is considered in the calculation of the new price of the Series A.

NCP = OCP * ( (CSO + CSP) / (CSO + CSAP))

• NCP = new conversion price
• OCP = old conversion price
• CSO = common shares outstanding immediately prior to the new issue
• CSP = common share purchased if the round was not a down round (at Series A pricing)
• CSAP = common shares actually purchased because the round is down

Weighted average anti-dilution is much more friendly to the founders than full-ratchet, as it takes into account the number of shares issued in the new round. 👈

Generally, it comes in two versions: broad-based and narrow-based. Broad-based weighted average anti-dilution counts the amount of share according to the fully diluted capitalization of the company. The narrow-based version only counts common stock. In-between options are often negotiated, where the broader the base the smaller the anti-dilution adjustment, hence the more founder friendly.

b. Pre-emptive or pro-rata rights

Pro-rata or pre-emptive rights give investors the right, but not the obligation, to maintain their level of ownership throughout subsequent financing rounds.

This by allowing the holder of the rights to participate proportionally (pro-rata) in any future issues of common stock prior to non-holders.

They are also called pre-emption rights, anti-dilution provisions or subscription rights.

Say you have 100 shares and you sell 10 shares to an investor with pre-emptive rights. If you now issue 500 additional shares, the investor will have the right to buy 50 shares (at the same pricing) before others.

The danger in granting them is that in later rounds you might find investors that are only willing to come into your company if they can acquire a sizeable portion of equity.

If at that time you have a lot of pro-rata and pre-emptive rights, you might not be able to offer this sizeable portion to the new investor.

Pro-rata rights are highly sought after in hot startups. This even leads to some investors selling those rights. As this might lead to you getting unwanted investors as shareholders, it is not uncommon to include language that prevents investors from doing so.

c. Right of first refusal (ROFR) and Co-sale rights

The pre-emptive rights and pro-rata rights protect the investor in the case of a primary offering (new stock issuance) by offering the right to buy more stock directly in the company.

The ROFR and co-sale rights protect investors in the case of a secondary offering. This refers to stock offerings where existing shares are sold.

In the event that an existing shareholder tries to sell her shares, the ROFR offers the investor the right to buy the stock before it can be sold to a third party.

Generally, the ROFR also states that, if the investor wants to sell the stock, the company has the right to buy the stock before it is offered to a third party.

With co-sale rights, the holder of the rights has the ability to join any secondary transaction, such as a sale of shares by other shareholders.

This means that if one of the larger shareholders has negotiated a sale of their shares at a certain price, the holder of the rights can opt in to add their stock to the package that is being sold, at exactly the same deal terms.

It is done in order to protect the smaller shareholders, as they often do not have the same ability to negotiate an attractive deal as the major shareholders.

d. No-shop clause

The no-shop clause included on the term sheet is there to prevent the company from asking investment proposals from other parties.

This gives the investor leverage, as it prevents you from shopping around for better terms.

The no-shop is pretty standard, but it is important to look out with the timing. 🕚 You don’t want to have a too long no-shop clause, as it could allow the investor to take a long time for her due diligence and to potentially drop out at the last moment (don’t forget that a term sheet is non-binding).

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3. Governance management and control: who’s in control

When setting the rules of the investment through the term sheet, one of the key aspects is who’s in control of the company.

The key terms to look out for are the voting rights, board rights, information rights and founder vesting.

a. Voting rights

Voting rights are the rights of a shareholder to vote on matters of corporate policy.

This clause of the term sheet points out how voting rights are divided across different instruments (A, B, Preferred). It also defines for which corporate action a voting majority is required.

This can amongst other items include:

• Changes to the share instrument
• Issuance of securities
• Redemption or repurchasing of shares
• Declaration or payout of dividends
• Change of the number of board directors
• Liquidation of the company including a sale
• Closing material contracts or leases
• Annual spending budgets and exceptions
• Changes to the bylaws or the charter

Depending on how the voting majority on this topic is defined, it allows the holder of the instrument to block any of the above actions.

Let’s clarify by an example. 🤓

Say that the term sheet for a preferred share deal stipulates that approval of a preferred majority is required for the above actions.

That would mean that your preferred shareholders have a veto on issuing new securities, changing the number of shares, paying out dividends, selling your company, etc.

The voting rights can also stipulate that a “common” majority is required, which puts the power to decide in the hands of the common shareholders (preferred shares often also have common voting rights).

b. Board rights

Another major potential loss of control is the composition and mandate of the board.

A board of directors is a group of individuals chosen to represent the interests of the shareholders in the company. Its mandate is to establish policies for corporate management and oversight and make decisions on major corporate decisions.

The key corporate decisions that a board can decide on are:

• Hiring/firing senior executives
• Dividends and option policies
• Executive compensation
• Setting broad goals
• Assuring adequate resources are at its disposal

The structure of the board and the number of meetings can be set by the company in its bylaws. It is here that investors might choose to make adjustments in order to take a bit more control over the board.

An example of a founder-friendly board structure is 2-1 with two founders on the board and one investor. A riskier example would be 2-2-1 with two founders, two investors and one independent board member. Because if you lose control over the board, you effectively lose control over your company.

Other dangerous practices can be specific provisions that stipulate that the investor board member’s approval is required for an action. This can go from approving the annual budget to very operational items, such as opening business lines or markets.

Make sure that you fully understand the importance of the board’s decision making and the impact of the proposed structure and provisions.

This is also were investors show their trust in you and your senior team. The more control the investor is trying to gain through the board, the more they are trying to minimize the risk of mismanagement. And effectively putting you on a leash.

c. Information rights

Paired with board rights are so-called information rights. These require the company to share the company’s financial and business condition with its investors on a regular basis.

In most cases, the information rights will oblige you to provide quarterly management reports with some financial or management dashboard data. They can also oblige you to provide detailed annual financials, within a certain period after closing the fiscal year.

d. Founder vesting

Investors like to have certainty when investing. One of the potential risks is that you, as the founder, get fed up with the business and decide to walk away.

Therefore investors are constantly looking for mechanisms to minimize the risk of losing founders.

Founder share vesting does just that, by making it painful for a founder to leave the company by putting shares at risk.

Additionally, the returned shares allow the company to incentivize a fitting replacement for the departed founder.

While this seems logical, the devil is in the details. As a founder, you are obviously not to be treated the same way as an employee. Where an employee share option plan is in place to reward future work, you already have done a lot and should be rewarded for it.

Therefore negotiate a vesting program that works. It is not unreasonable to exclude part of your holding from this arrangement.

Single vs double trigger

An important detail to any vesting scheme is what happens at the moment of a sale. The easiest solution is that at the time of the sale all shares vest immediately. This is also called “single trigger”. 🔫

The other approach is that the founder’s shares vest after being a good leaver after a period of time (e.g. 12 months). This is called a “double trigger”.

While a single trigger is an attractive solution for a founder, there is merit in considering the double trigger. When a potential buyer is considering buying your company, they probably want to have a form of guarantee that you are staying for at least the integration of the company.

It is therefore not uncommon that, at the moment of the deal, founders still forego their single trigger in order to make a deal possible.

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4. Exits and liquidity: what happens when it’s cashing time

a. Drag-along and tag-along rights

In the event of a sale, the buying company typically wants to acquire all shares. While the majority shareholder can decide to sell her shares and the whole company, she can not force minority shareholders to do the same without a specific clause or a lengthy legal process.

Say now that you as a founder have 51% of the remaining shares following your Series A and would like to sell your company to SearchEngine Inc., but your minority VC shareholder would like to see more upside, blocking the sale.

That is where drag-along rights come in. They prevent any future situation in which a minority shareholder can block the sale of a company that was approved by the majority shareholder or by a collective representing a majority.

Drag-along rights are also good for the minority shareholder, as they ensure that the same deal is offered to all shareholders.

In order to protect the minority shareholder even further, there are also tag-along rights. These rights give the minority shareholder the right, but not the obligation, to join in any action with the majority shareholder. This because majority holders are often more capable of finding favourable deals from which the minority shareholder would be excluded without this provision.

Comment: Drag-along and tag-along rights typically end at an IPO, as they get replaced by security laws for public markets.

b. Redemption rights

A term with potentially devastating impact is the redemption clause.

With this clause, investors have a right to demand redemption of their stock within a specific window of time.

This is great for a structured venture fund, as they have a set time (10-12 years) at which they need to return the funds to their limited partners. This allows them to do so.

The way it is done however can create a time bomb that creates a liquidity crisis for a fast-growing company like a startup.

As management is forced to redeem the funds, it is either forced to sell the company in a rushed way, or get remaining shareholders to come across with the money in a hasty financing round.

Typically the company will pay the redeeming party the greater of fair market value and the original purchase price plus an interest rate (of around 5% – 10%).

The time window can be set to certain events or set to start x years out (typically 5 years). The clause also stipulates how much time the company has once the event has happened to complete the redemption and if it relates to a fraction or the complete investment.