In fundraising rounds, there is a sense of urgency, almost like a race. It seems that the first person to sign the term sheet wins the investment, and once it is signed, everything is practically closed. But this rush, combined with the need for an agreement to be made quickly, often results in entrepreneurs overlooking important details that could affect them in the long term, leading to costly mistakes.
Another problem is that many entrepreneurs arrive at these rounds without having built a solid legal foundation. They don’t have lawyers at the start, have not prepared the key documents, and they only start doing due diligence when investors begin asking questions. , the company often seems less structured than it actually is. The same way the good idea is: if the papers look like they were written with pins, the investor will notice. And this is where a lot of mistakes begin in the negotiation process. Because, at this point, the balance is not yet balanced, and you miss the perfect opportunity to impose better conditions.
So, this blog post will explain what clauses you should avoid in your term sheet, Also, it is important to prepare the key legal documents so that, when the time comes to negotiate, your company doesn’t appear as improvisation, but rather as a serious project that deserves to be taken seriously. Because, in the end, the difference between a well-closed round and an error cost is not only in the conditions you negotiate but also in how much power and control you gain.
To start, let’s talk about the clauses that are often used as a double-edged sword, like the liquidation preference. , For example, this is one of the most important clauses. In theory, it protects the investor by ensuring that they recover their investment before the founders in case the company is sold. However, if it is not well negotiated, it can make the company seem less valuable when sold for millions, but you see nothing in return. So, it often leads to searching for a 1x non-participating return. , This means that the investor recovers their initial investment first, and then the rest is split proportionally. If you start at terms like 2x, 3x, or participating, it means you could lose a few rounds before you get anything, which is not favorable for the founders.
Another critical point is vesting and reverse vesting. Many entrepreneurs are surprised to discover that, even though they are the founders, they can lose their shares if they don’t remain in the company for a set period. This might be reasonable to avoid someone leaving too soon, but the problem is that these terms are often too strict and leave founders with little flexibility. A scheme that lasts for four years could mean giving up shares for one year (for example, if they are required to acquire actions after completing a year in the company). However, reviewing these clauses carefully, especially in unusual cases, is important to avoid signing terms that practically tie you to the company, even if the business isn’t going well.
Also, attention should be paid to the protective provisionshay que prestar atención a las protective provisions, That is, the veto rights that investors may have over certain decisions. It’s normal that they want to protect their investment, but the problem arises when each investor has their own veto and any decision requiring approval needs their consent. In these cases, it can be difficult to negotiate a deal with a divided group, causing considerable movement of strategic decisions to convince several people with different interests. The ideal is to negotiate veto rights collectively and not individually, to avoid unnecessary blockages.
On the other hand, anti-dilution is another clause that seems harmless until it activates. Its function is to protect investors, and if the company later raises capital at a lower valuation, there are different types, with the most dangerous being full ratchet, which adjusts the investor’s shares as if they had always been valued at the lowest possible price, drastically diluting the founders. It’s advisable to seek a more balanced formula such as weighted average. , Which adjusts the investor’s shares as if they had always invested at the lowest possible price, drastically diluting the founders. It is advisable to seek a more balanced formula such as the weighted average. , It softens this effect and avoids extreme dilutions in future rounds.
Now, understanding which clauses to negotiate is only half the job. The other half is preparation by the company, which should begin at the moment of due diligence. Investors will see you as a solid, well-structured project. For this, certain documents must be ready, including what must be negotiated with the investors and the rules on founders’ relationships and clear property rules, which are fundamental. In addition, the company must have strong professional conduct and order, and you can avoid future problems if conflicts arise among founders.
It is also key to have defined agreements with employees and collaborators. If you have employees or partners, they must sign well-structured agreements, where investors are assured that the participation agreements are not structured in a way that could cause conflicts with employees or founders.
Additionally, it is essential to clearly define intellectual property conditions. If the company’s intellectual property is key, ensuring that it belongs to the company and not the employees or collaborators is crucial, especially in cases of founders or employees leaving the company, as this could generate legal problems.
Finally, something that makes a difference in a negotiation is the documentation from previous rounds. If you have received prior investments, it is crucial that the agreements are well-organized and easy to review. If an investor has to navigate through poorly drafted or contradictory documents, it will give them less confidence in the project’s stability.
In conclusion, negotiating a funding round is not just about raising capital, but ensuring that the agreement is fair and sustainable in the long term. Many startups lose more in the long run because they accept less money than they could have, since poor terms take away decision-making power and limit future growth.
Therefore, the key is not only how much money you raise, but how you structure the agreement and what preparation you put into the negotiation. If your company has a solid base, you’ll attract better investors, who will also have more room to defend their conditions and avoid falling into abusive terms. Ultimately, it’s about ensuring that the investor is betting on your company, but not in a way that they could take it lightly.
