All About Term Sheets: What Are “Dirty” Terms?
Last week in Part I of our series on term sheets, co-hosts Halle Tecco and Michael Esquivel delved into the intricacies of term sheets, particularly in the context of down rounds. If you haven’t caught that episode, be sure to rewind a bit and soak in the wisdom.
In Part II of our series on term sheets, we unpack "clean” and “dirty” terms in startup financing.
With the pressure to maintain high headline valuation numbers, investors often grant founders their desired valuations while sneaking in terms that our resident lawyer Michael does not like.
The episode breaks down the nuances of terms like liquidation preference, liquidation multiples, cumulative dividend structures, anti-dilution provisions—and the trade-offs founders must consider between valuation and terms.
In this episode, we cover:
Clean Terms vs. Dirty Terms:
Clean terms refer to straightforward investment agreements without complex structures. But sometimes while negotiating a higher “headline” valuation, founders and investors will include terms the industry refers to as “dirty terms” such as senior liquidation preference, multiple liquidation preference, cumulative dividend structure, mandatory redemption, and full ratchet dilution protection.
Liquidation Preferences:
Clean terms usually involve a 1X non-participating preferred security, providing flexibility for investors to choose between liquidation preference and conversion. Dirty terms may include seniority, multiple liquidation preferences, and participation features, impacting how proceeds are distributed in case of an exit.
Anti-Dilution Provisions:
Almost every preferred round includes anti-dilution protection, commonly using a weighted average mechanism to adjust conversion prices in case of a down round. Full ratchet anti-dilution protection can be more punitive, directly adjusting the conversion price to the lower price of the new round.
Most Favored Nation (MFN) Clause:
MFN clauses are not typically found in preferred stock rounds but are more common in convertible notes or SAFE agreements. They ensure that if a subsequent security is issued with better terms, the original investor gets the benefit.
Cumulative dividends:
Cumulative dividends act as a coupon, growing the liquidation preference over time. Mandatory redemption allows investors to force the company to buy back their preferred equity after a specified period, typically 5-7 years. Cumulative dividends, like a growing debt, increase the gravitational pull on the liquidation preference, making it harder for common stockholders to see returns in case of an exit.