“Dirty” Term Sheets: Is it Worth Accepting One Over a Down Round?

Down rounds have long been a sensitive topic within the startup community, and the current environment (mid-2023) makes them even harder to stomach due to the anchor of sky-high valuations from 2020-2021. However, there seems to be a shifting perception towards down rounds, recognizing them as necessary corrections to past mispricing rather than reflections of poor business performance.

Nevertheless, to avoid down rounds, some founders may resort to structured financing through what is known as “dirty” term sheets. These term sheets include deal sweeteners that improve investor economics, providing guarantees for minimum returns or downside protection. This approach allows investors to meet a specific valuation ask and avoid the stigma associated with down rounds.

The use of “dirty” term sheets may not be the silver bullet some founders hope for. Taking a “dirty deal” can jeopardize the future of a company, and often, a “clean deal” at a down-round valuation is preferable. Dirty deals can significantly complicate things, including provisions such as multiple liquidation preferences, warrant coverages, or aggressive ratchet protections to veto rights. Although accepting a “dirty” term sheet might seem like a good solution to increase runway without accepting a lower valuation, there are potential drawbacks to consider:

1. Implications of Asymmetric Risk Allocation: The use of complex provisions to sweeten deals may create misaligned incentives between investors and early shareholders. Conflicting risk perceptions could lead to decision-making challenges during difficult times, potentially causing investors to push for actions that don’t benefit all stakeholders.
2. Complications for Future Financings: Embracing structured financing could set a precedent for future rounds, making it difficult to attract new investors who are unwilling to accept similar privileges. Unwinding complex terms might also be especially complex, causing friction during future fundraising efforts.
3. Fleeting Valuation Appearances from Structure: The market is becoming increasingly aware that structured provisions might mask a startup’s true fair valuation. This awareness is particularly relevant during IPOs, where mispricing and stakeholder misalignment could occur, leading to potential reputation issues.

Let’s examine each one in more detail.

1. Implications of Asymmetric Risk Allocation

When investors demand “sweeteners” through structured term sheets, it reveals their perception of risks and how they allocate them. These “sweeteners” can generate returns for investors through aggressive legal clauses rather than genuine valuation growth. However, this can lead to a misalignment of incentives and stakeholder interests. Investors who resort to such tactics may be signalling their fear of losing money, which can potentially affect decisions during difficult times. For instance, they may push for a premature sale or reduce risk when it’s necessary to take it. Good investors prioritize negotiating fair valuation and opt for standard terms, recognizing that long-term value is built through strategic growth.

2. Complications to Future Financings

Accepting a certain financing structure can have lasting effects on future rounds:

1. Subsequent investors may demand similar structured privileges as previous investors, potentially complicating negotiations and diluting early shareholders’ interests.
2. Existing investors may be reluctant to unwind burdensome terms, dissuading potential new investors from participating in future rounds.
3. Complex capitalization tables and non-standard terms take time to unpack during diligence and closing processes, leading to added friction in raising funds.
4. Over time, the structure could compound, leading to increasingly onerous terms and making future financings challenging.

Accepting a “dirty” term sheet could render future financings nearly impossible. Investors asked to follow a previously structured offering might opt out, increasing the risk of running out of money or a complete recapitalization that could wipe out previous shareholders.

3. Valuation Appearances from Structure Could Be Fleeting

Market participants are becoming more aware that structured provisions could hide a startup’s true fair valuation. This could become evident during IPOs when private startups go public. Investors might be guaranteed a minimum return based on the price of their final equity round, creating a moral hazard problem. This could encourage mispricing in IPOs, leading some to overpay in the final private round in the hope of inflating the IPO price and diluting IPO investors’ risk. Such discrepancies in valuations have raised questions about IPO mispricing and stakeholder misalignment.

In Conclusion

Although every startup situation is unique, founders should exercise caution when considering “dirty” term sheets that may inflate headline valuations. Prioritizing transparency, stakeholder alignment, and long-term value creation can lead to better outcomes. Ultimately, founders who make informed decisions based on a comprehensive understanding of the trade-offs will be better equipped to navigate the funding landscape and guide their companies to success.