One Clause That Could Kill Your Startup

You’ve probably heard stories of founders losing their startups to venture capital firms and other investors? Although not often, it does happen. And the mechanism that makes it happen might be sitting on your term sheet.

VCs often invest in early-stage, speculative startups with uncertain valuations. Sometimes their $200,000 for 10% of your company is intuition at best.

So what’s a poor VC to do? They typically want anti-dilution clauses to be installed into your legal structure.

Anti-dilution mechanisms allow an investor to demand that the startup issue it more shares in the event its valuation goes down to brings its prior investment in-line with the present valuation.

The most popular is a ratchet clause. Here’s how it works:

VC-1 invests $10 million for 25% of your company in July, setting a valuation of $40 million with a share price of $1 per share. The founders and early investors retain the other 75%.

In October, VC-2 invests $5 million for 25% of your company, setting a valuation of $20 million with a share price of 50 cents. Your company has lost a lot of value. VC-1 has lost half its initial $10 million investment. This is called a down-round, because your valuation has gone down.

If VC-1 had a ratchet clause, your startup would be legally required to issue VC-1 enough shares to brings the price it paid per share down to the $20 million October valuation or 50 cents per share. In this case, because your startup’s valuation dropped by 50% (from $40 million to $20 million), you would have to double VC-1’s shares to bring its price per share down to 50 cents.

In this situation, you would have given up 10% of your company to VC-2 for no present value. Replace the 10% figure with a 20%+ initial investment and you can see how a ratchet clause can quickly dilute the founders out. It gets even worse when multiple investors are exercising ratchet clauses at the same time. This is how founders end up having less than 5% equity in the company before even going public.

How Unicorns Use Ratchet Clauses in the Real World

It’s difficult to discuss private (pre-IPO) startups that have had investors exercise ratchet clauses on down rounds. Either because that information is not publicly available or because the people that know are bound my confidentiality agreements (such as myself).

However, several recent IPOs reveal how punitive ratchet clauses can be to founders and early-stage investors. For example, Chegg’s 2013 IPO revealed that if the go-public share price was not double what some late-stage investors had paid, Chegg would have to issue them the difference in shares. This is exactly what happened – to the detriment of the share price (which has never recovered) as well as the founders and early-investors positions in the company.

Everyone knows that equity financing is the most expensive form of funding—because you’re selling future performance. But when investors also demand that the other shareholders absorb their risk with ratchet clauses, it can be a dangerous game.

Adrian Camara is a cofounder of Paper.