For any early-stage startup founder, there are several key moments that mark the trajectory of the company’s growth and serve as a testament to the founding team’s hard work. To name a few, there are the MPV launch, your first customer, and, of course, your first term sheet.
Raising money is a daunting and outright scary task for any first-time entrepreneur, and thus getting that first term sheet from a professional investor is an incredible validation of your vision, product quality, and persistence.
Sadly, not all term sheets are created equal and sometimes, as difficult as it is, it is better to walk away from a deal than to take it and jeopardize your company’s future. In this article, and the corresponding video, we discuss three situations which warrant you saying “No” to investors.
Situation # 1:Unfair valuation terms.
The unfair valuation terms are:
- The company valuation is too low (equity).
- The valuation cap is too low or the discount rate is too high (convertible debt and SAFE).
How do you know that the valuation is too low? You can value your company by:
- Creating a five-year financial forecast and applying one of the quantitative valuation models specifically designed to value early-stage ventures. We discuss how to create a model for an early-stage venture in Course # 4 and cover valuation models for early-stage companies in Course # 3;
- Using one of the scorecards, also described in Course # 3; or
- Looking at the market and getting the comparables data.
Situation # 2: Investors want too much control.
If your investors ask for too much control, you may have difficulties raising future rounds of financing and making decisions critical to the company’s future.
The unfavorable “control” terms are:
- Voting rights: investors ask for a special class of voting shares that have more voting power than others or for an (unreasonably) higher percentage of votes necessary for passing certain strategic or financing decisions.
- The Board of Directors: investors demand too many seats on the Board. There is a limited number of those seats and every seat represents power. The Board votes on all the important company decisions as well as has the right to fire any executive, including yourself.
Situation # 3: Disadvantageous anti-dilution rights.
Anti-dilution rights are designed to protect existing investors from being diluted too much in case of a down round, or when a company is struggling and has to raise capital at a very low valuation.
Offering an anti-dilution protection is sometimes appropriate and can be used to sweeten the deal, especially if you want to attract a certain investor.
The problem arises when non-biotech investors demand the maximum level of anti-dilution protection, called Full Ratchet, that is typically only used for biotech companies. Under that scenario, you determine the percentage of company ownership by only considering the dollar investment amount and disregarding the company’s valuation and share price of a given financing round.
Those three scenarios represent top three reasons why you should walk away from a deal. To learn more about how to raise capital in the U.S. as well as pros and cons of different financing vehicles and how to negotiate different clauses, check out Course # 5.
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