Navigating dirty term sheets

Bill Gurley recently wrote about the growing trend and potential impact of dirty term sheets on entrepreneurs, employees, and investors. Bill defines dirty term sheets as “investments where the majority of the economic gains for the investor come not from the headline valuation, but rather through a series of dirty terms that are hidden deeper in the document”.

Examples of dirty terms include participating and/or multiple liquidation preferences, ratchets, payment-in-kind dividends, and series-based financing vetoes. Such terms let entrepreneurs achieve their headline valuation target while making it harder for shareholders of common stock and earlier series of preferred stock which don’t have these rights to get a return on their investment. If all goes well, these terms end up having no or only a small impact on the distribution of exit proceeds. However, if all doesn’t go well, which is most of the time, the dirty terms shift economic value from common stockholders and earlier series of preferred stockholders to the new investor.

Common stockholders generally include the founders and employees of the company, whereas preferred stockholders tend to be investors. In most instances, the founders still have a voting majority of the company and they are therefore the ones agreeing to the dirty terms. So even if the dirty terms end up hurting the founders down the road, they were the ones who accepted to take that risk.

But what about the employees and investors of the company? At best, employees and small early investors have no say in future financing discussions. At worst, they aren’t even aware of these discussions. And unfortunately, beyond originally partnering with a founder whose judgment they trust, there’s not much they can do about it.

As for larger early investors, although they’re aware of and have a say in the discussions, voting power usually resides with the founders. So, although large early investors may not agree with the dirty terms that the founders are accepting because it will make it more difficult for them to achieve a financial return in all but the best outcomes, they’re often unable to change these terms.

What is a large early investor to do in this case?┬áThere are two possible approaches that I’ve seen in practice.

One approach is to use hard power to block future dirty term sheets. For instance, an investor can take a series-based financing veto which gives them the right to prevent a future funding round from taking place. If used properly, this allows the early investor to veto financing rounds with dirty terms. This is equivalent to using a dirty term yourself in order to prevent future dirty term sheets.

The problem is that you can also use the dirty term to your advantage. For example, an early investor could use the veto to block an outside funding round without dirty terms so that they can secure better terms from the company by making it an offer when it has less runway remaining.

One idea is for the early investor to take a series-based financing veto which is valid only for dirty term sheets, where the potential components of a dirty term sheet are clearly stated. For example, the investor could only veto a future funding round if that round carries a participating or multiple liquidation preference. However, I haven’t seen this applied in practice yet.

Series-based financing vetoes are more common in developing startup ecosystems than they are in developed ecosystems. For example, they’re more common in Turkey than in Silicon Valley. There are two reasons for this.

The first is that investors in developed startup ecosystems prefer to prioritize their reputation over their one-off financial return. There are many successful companies being built so investors prefer to take the risk of a less than ideal return on one company while retaining their reputation so that they can continue to invest in other winning companies, rather than try to protect their interests in a single winner even if this comes at the cost of their reputation.

The second reason is that the investors in developed startup ecosystems have greater trust in the entrepreneur’s judgment. They find it less likely that the entrepreneur will accept a dirty term sheet which hurts not only the potential returns of investors, but also founders themselves.

And this leads to the second approach. The second approach consists of using soft power to try to influence the founders so that they don’t accept dirty term sheets. The investor’s reputation stays intact, but they lose some control over their eventual financial return.

What’s interesting is that the second approach is, in fact, at the essence of all startup investments. The very act of giving someone else money to build their company means that you’re ceding control over your eventual financial return to that person. You’re accepting to trust their judgment, and to use soft power to try to influence them when you believe it’s necessary.

And if that’s what you’re doing when you’re investing, I don’t think that your approach to navigating dirty term sheets should be any different.


Also published on Medium.

  • Saul_Lieberman

    A veto that can only be exercised by a director might protect against misuse.

  • Everyone can misuse. So better to specify dirty terms which can be vetoed rather than try to assign veto to someone unlikely to misuse it. Also early investor is unlikely to accept assigning veto to non-investor director.