Top 5 Worst Seed Round Terms For Startups

Here’s a list of the top 5 worst seed round terms that cause harm to startups at the seed financing stage and therefore should be avoided:

5. Control

“Control” of a startup can manifest itself in various forms such as equal (or investor-favorable) representation on the board of directors or a requirement of obtaining seed investor approval for new hires and/or budget matters. Whatever the form of control, seed investment is way too early to be even thinking about losing any amount of control of your startup. You need to figure out why your potential angel investor wants to control your startup.

4. Dividend (that pays out)

By paying your investor a dividend (rather than having dividends accrue and be paid out at acquisition or other typical payable events), you are simply paying back the investor with his own money. What a deal — for the investor. This is something you might see in a late stage private equity financing with a company that has a history of generating revenue. It does not belong in any early stage deal. If your potential angel investor insists on getting dividends paid out quarterly, the angel investor should invest in dividend aristocrats or MLPs, rather than your startup.

3. Tranched Investment

Don’t agree to a tranched seed investment based on milestones. I don’t like tranched investments for 3 reasons. First, the benchmarks are typically difficult to come up with and negotiate and are often imperfect indicators of performance. Second, startups will tend to focus towards hitting these (imperfect) milestones and possibly ignore other projects or natural off-shoots that may pan out huge. Third, some angel investors like to make the additional investment at their option once your startup hits the milestone. Therefore, if you do agree on tranched investments, make sure they are at least automatic — if you hit, they wire. But even better for the startup would be to negotiate a tranched investment that was at the startup’s option upon hitting the milestone.

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2. Non-Dilution

The investor wants non-dilution rights because they are either really greedy or they don’t trust you to issue additional equity. The angel investor’s best protection against “wasted dilution” is the fact that the founders are being diluted pro rata along with the angel investor — you have to get the angel investor to wrap their brain around this. Unfortunately, for some angel investors having the co-founders sit “side by side” with them is not enough protection.

1. Personal Guaranty

If the shit hits the fan and the company has to shut down, co-founders should only be out time…not additional cash to their investors. If your co-founders didn’t already have ulcers from taking the startup leap, they will soon after signing the personal guaranty. Thus, this is the worst seed round term of them all, as it involves potential physical harm.

Conclusion

While this list of the top 5 worst seed round terms are pretty horrible, there are several honorable mentions that fought hard to make this list.  Hopefully when your startup goes to raise a seed round, it does not have to deal with any of these worst seed round terms…and certainly not more than one.  (Hint, if you get more than one of the worst seed terms thrown at you by a potential investor, it’s probably a sign not to take his or her money).

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4 thoughts on “Top 5 Worst Seed Round Terms For Startups

  1. Ryan says, “The angel investor’s best protection against “wasted dilution” is the fact that the founders are being diluted pro rata along with the angel investor — you have to get the angel investor to wrap their brain around this.”

    Then how does the angel protect against the founders issuing themselves more stock? Without a non-dilution clause, can’t the founders look for ways to effectively dilute the angel while not pro rata diluting themselves through “value-added” issuance to themselves or other offerings that won’t be available to the angel?

  2. Wannabe Angel is right. The investor in a seed round (given the lack of control in #1) is basically giving the entrepreneurs a huge leeway, as well as a specific agreed-upon option pool to allocate as they see fit. Requiring investor approval for further dilution is normal given the complete freedom in all other areas. I’ve usually seen this in the form of “here’s an agreed upon option pool you can allocate, and here’s another 5% to cover loan warrants and other ‘course of business’ issues, you only need my approval if there’s anything beyond those.”

    Let me pose this the other way around: what is a legitimate dilutive issuance of shares that goes above those two items that shouldn’t require investor approval? I can’t think of any – anything else would be giant and company changing.

  3. Curious to get your input on what alternatives might be to the tranched investment scenario? I have a potential investor who is proposing this in order to reduce their upfront risk. I understand their concerns from their point of view but it seems other things like preferred stock, liquidation preference (1x), etc also help reduce their risks. I’m afraid this just gets very complicated. What about the tax ramifications? Think founder’s stock vesting, options, 83b, etc. Whatever happened to KISS – keep it simple? Thanks for any input.

  4. I am a bankruptcy lawyer, not qualified to comment on items 2-5. But number one is completely undervalued advice by so many business owners. Never sign the P.G.

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