☢️ Does This Term Sheet Look Toxic to You?

He offered us $10,000,000. And I told him:

“You’re batsh*t crazy if you think we’ll accept these terms.”

Ok, so maybe I didn’t tell him that OUT LOUD, per se…

…because I actually didn’t even understand what he was offering

I was just sitting on the couch of the musty one-bedroom basement flat we were borrowing from my cofounder’s mom, staring at the termsheet in my email like,

umm 🤔 Did he just offer us mafia terms?

​

Back then, I was young. I was green.

I didn’t know my a$$ from my elbow.

I had family and friends telling me “take the money!”

But I was pretty worried - I didn’t know what these terms meant, and this was a lot of money.

So I called a friend: “Hey, is this normal?”

And told him about the 3x liquidity preferred participating shares with 10% cumulative dividend & a nasty ratchet on a PIK note.

If that sounds like gibberish, don’t worry, it did to me too.

But my friend basically did a spit take through the phone.

—

These are called predatory terms, and today I’m going to show you how to handle them.

Unfortunately, most founders have no idea what they’re up against.

Like me, when I started.

Here’s the thing:

Dirty termsheets are how you lose the company.

Lawyers won’t save you here.

It’s up to you to:

• Know what’s dangerous, and be on the lookout
• Go for the wiggle room
• Counter effectively
• Be ready to torpedo it

Here's what to do:

Step 1: Look out for toxic terms

You gotta know what you’re looking for.

There’s a few predatory terms you need to keep your eye out for:

​

Just because a termsheet has one or two of these features doesn’t mean it’s toxic, though.

Here’s what each means, and some general levels to watch out for:

• Liquidation Preferences & Multipliers = If you go exit / go bankrupt or liquidate, we get X times our invested money paid out. Then other investors can share the rest. Watch out for >1x
• Participating Preferred = When you exit / IPO, our invested money gets paid out first. Then we share the rest with other investors. ⚠️ Caution in all circumstances, but especially toxic when Preferred shares carry 5-10x voting rights too
• Redemption Rights = You don’t perform, we send you our shares & you give us our money back. ⚠️ Caution in all circumstances, but especially toxic at 2-3x multiple
• Cumulative Dividends = We have a rolling dividend on our investment. You pay us first when you have a liquidity event (or in some cases, you pay us in more shares through a Payment-in-Kind / PIK note and we own more % of your company)
• Heavy Ratchet = If you have trouble raising / miss your targets, you take the pain. We keep our % (or end up with an even higher % ownership)
• Clawback = If you don't perform, I am forcibly taking my money back. ⚠️ Extreme caution!

Step 2: Ask if you can negotiate

Not every deal is going to have these features, but more will than you might think.

The chart below is misleading since it only captures deals that actually closed:

Never be afraid to ask your potential investor why they included certain terms.

Maybe they’re trying to cover for a specific risk.

Maybe they’re just trying to make more money.

Maybe it’s “just a try-on” and they’re happy to take it out.

Give them the benefit of the doubt, and just ask with an open mind.

It’s up to you to figure out their “why”

Then…

Step 3: Give a solid counter-offer

A first-offer term sheet is almost never a “take-it-or-leave-it” kind of thing.

There’s a few ways to counter a toxic termsheet:

• Take it out: Just delete the toxic paragraph, and see what happens. [warning: if you do this unilaterally without discussing it first, you’ll come off as aggressive]
• Swap it for something else: Take out a toxic term, but give up another term to fit that investor’s goals. Give a little, take a little
• Water it down: For example, instead of 3x liquidation preference, maybe you can get away with 1x. The term’s still there, but it’s less aggro. Expect to sweeten the deal another way.
• Give yourself a way out: Add in a buyback clause, which essentially says: “we can buy back the shares according to a set formula” If you really need the money but don’t want the investor / this deal long-term, then you need to have a way out. Not every investor will accept a buyback since it caps their upside - but I’ve found predatory investors are more likely to accept a concrete buyback option structure

…and of course, if you can’t negotiate to get a deal you really like, then your final step…

Step 4: Be ready to walk

It sucks leaving money on the table.

It’s painful. I know.

But some investors are simply predatory, and if you took a predatory deal, that scares off good investors later on.

Predatory investors aren’t really trying to help your company grow - taking their money would mean poisoning your own ability to grow.

You can’t let one deal ruin your whole company forever.

Summary

Remember the mafia money I got offered?

It was a $10,000,000 offer, and it was real. It would’ve changed our company’s life (and mine too).

But it was toxic - and my life would have become toxic as a result, so I walked and said “we’ll find it another way.”

In every case, keep your eyes open. Never be afraid to ask about an investor’s motivations in including certain terms, and try to find a way that works for you both.

But always have other options, and be ready to pursue them if the terms you got offered were just a bit too dirty.