Dirty Term Sheets

With startup funding drying up in early 2023, dirty term sheets are becoming an increasingly common problem for founders. These ‘dirty term sheets’ are filled with predatory provisions that are in the best interests of venture capitalists and other investors, such as angel groups and angel syndicates to maximize their upside potential while simultaneously minimizing their downside risk. In this guide, we cover what makes a term sheet ‘dirty’, how you can spot one and what to do if you receive one, and much more—let’s dive in!

What is a dirty term sheet?

Dirty term sheets are just regular terms, except that they are loaded with so many onerous terms and conditions that are skewed in favor of the investor that they can be considered predatory. Investors who use these dirty term sheets typically have sweeping powers over the startup, from hiring decisions to vetoing future acquisitions. They also usually have protective provisions that can prevent the startup from raising additional funds, making a strategic hire, or issuing new stock to employees. Founders often don't realize the full implications of the provisions outlined in a dirty term sheet until it's too late. And unfortunately, even if founders do take the necessary steps to protect themselves from one, they may still be taken advantage of.

What makes a term sheet “dirty”?

There’s not a singular item that inherently makes a term sheet “dirty”, rather it's the combination of all of the provisions and conditions inside a term sheet that make it “dirty”. These may include things like liquidation preferences, liquidation multipliers, pro-rata rights, antidilution protection, and more, which are unfavorable to the startup. There are typically a couple of these provisions present in a term sheet, and when this is the case, it's fine, it only becomes problematic when investors tack on all of these and more.

What’s the difference between clean and dirty term sheets?

The difference between “clean” and “dirty” term sheets is the number and complexity of the provisions included. “Clean” term sheets are those that are fair and balanced, with terms that are beneficial to both the investor and the startup. “Dirty” term sheets, on the other hand, are those that are loaded with onerous provisions that heavily favor the investor. These may include things like 2-3x liquidation multipliers, “full-ratchet” anti-dilution protection, redemption rights with a 2-3x multiple, participating preferred stock with 5-10x voting rights, and ‘demand’ registration rights.

Why are dirty term sheets dangerous?

Dirty term sheets can be dangerous because they can give the investor too much power and control over the startup. The investor may be able to exercise their redemption rights and demand repayment at any time, they may use their participating preferred stock to veto key decisions and they may leverage their ‘demand’ registration rights to force a company to go public (or seek an acquirer) even if they’re not planning to do so shortly. This can lead to the startup founders losing control of the company.

In addition, dirty term sheets can make it difficult for the startup to raise additional capital. Investors may be less likely to invest in a company with “dirty” terms, as they may view it as a risky investment, which can limit the startup’s ability to scale and grow.

Liquidation preferences and dirty term sheets?

Liquidation preferences are a common example of a “dirty” term. Investors with a liquidation preference are given the right to receive their investment back first before any other investors in the event of a liquidation, which isn’t problematic on its own. But now let's say it's combined with a liquidation multiplier and redemption rights, the investor would be entitled to receive a multiple of their investment back at any time, even if the startup isn’t prepared and doesn’t have the funds to fulfill the request—which may put the startup at risk of insolvency.

What happens if you have a dirty term sheet and experience a down round?

If you have signed a dirty term sheet and experienced a down round it may be detrimental to your startup. Depending on the provisions outlined in the agreement, your investors may be able to vote you (and your executive) out of the company, they may trigger their redemption rights and force you to repay them, causing a cash crunch or they may trigger their anti-dilution protection so their investment doesn’t go underwater. In any of the above scenarios, the outcome is not a positive one for you, your founding team, or your employees.

How to avoid dirty term sheets?

The best way to avoid “dirty” term sheets is to work with experienced legal counsel who can review the provisions of any term sheets you receive, explain the implications of said terms to you, and negotiate them on your behalf. Ultimately, no term sheet will be completely “clean”, or free of provisions, because investors want to protect their investment and the provisions help them do just that. So, your best bet is to understand what each of the provisions means, negotiate the terms that you care about, and compromise on the ones that you don’t.

Final thoughts on dirty term sheets?

Dirty term sheets can be dangerous for startups, as they can give the investor too much power and control. These term sheets are often loaded with onerous terms and conditions that favor the investor, and as such should be avoided if possible. Before signing any term sheets, make sure to review them with legal council, so you understand precisely what may happen if the rights are exercised. Negotiate the terms you care about and compromise on the ones you don’t. By doing so, you can ensure that your interests and those of your startup are as protected as they can be and that you are receiving fair terms for both you and your investors.

If you think that you've received a dirty term sheet, feel free to reach out! We'll take a look and let you know our thoughts!