The single most important and intimate relationship a founder needs to cultivate is with her investors. This relationship is akin to a marriage and, similarly, the term sheet — a contract outlining the terms of the investment — is akin to a prenup. In this series of posts I’ll explore how the term sheet becomes a crucial predictor of the fate of this relationship, beginning with the caveat referred to as a “clawback”.
A clawback is a provision that essentially says, “Founder, if you don’t achieve X milestones by Y timeframe, we have the right to adjust your business’s valuation and take a larger share of your company.” In a marriage, a clawback allows a soon-to-be spouse to say something like, “I’d like to marry you but, if you don’t produce a baby by our first anniversary, I have the right to trade in your wedding ring for something cheaper.” The truth is that, while rare, a clawback is not an unheard of provision today. Investors use them for a variety of reasons, mainly as a precaution to protect their investments.
Timing is Everything
The key issue with a clawback is its timing. At the early stages of a new business, both partners would be wise to expect the unexpected. A startup’s ability to pivot in response to market conditions and changing consumer behaviors, especially in a rapidly evolving tech landscape, is its lifeline. When expectations are defined in a manner that is too confining (without consideration for the real-life ebb and flow of a burgeoning business), it can hinder both parties’ ability to reach and possibly exceed their collective goals. Such conditions can signal mistrust and even worse, apply undue pressure that is counterproductive and even destructive to shared goals. This is not an ideal way to begin a relationship.
Don’t Fall in Love Too Soon
While founders are sometimes overly eager to go with the most immediate funding opportunity, and getting a term sheet can be a dream come true, it’s wise not to fall in love at first sight and lose your objectivity about what makes or breaks a lasting relationship. Do not be so enamored with having someone willing to “put a ring on it” that you become disempowered in the process. Negotiating terms is best done with discernment and a sense of assuredness that the terms and conditions of your relationship don’t compromise what’s in the best interest of your business.
It’s Okay to Question Motives
Understand your investor’s motives and the underlying reason for including any terms that are not standard. First, you’ll want to know if this is standard for all their investments and, if so, why? Then, determine if you can meet those motivations with less restrictive terms. Have a conversation, a negotiation. If you still aren’t satisfied, then it may be wise to walk away. Do your due diligence, talk to other portfolio companies and investors, negotiate wisely, and don’t neglect to question clauses that are nonstandard and potentially harmful to your business interests.
Know When to Say ‘No’
Remember that negotiating investment terms involves clarity, confidence and the art of finesse — this is especially important for minority-owned businesses. While gratitude and humility are honorable traits, never let a sense of indebtedness dictate business decisions or impact how you relate to investors. Remember that they have a choice to invest in you or go elsewhere, but they chose you. Conversely, you are also in the process of choosing them, or not. This is business, not charity, and you don’t have to say “yes” if/when the wisest decision is to say “no”.
Keep in mind that the presence or absence of a clawback in isolation doesn’t give a complete picture of the viability of the relationship. So, while I wouldn’t advise a founder to sign a term sheet with a clawback, I would encourage that you speak with an attorney and weigh all the pros and cons. What else might your potential investor have to offer that could make the relationship worthwhile?