For those times business growth goes beyond your credit limit, American Express business funding is here to help. Learn more.

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Follow your passion and we'll follow your lead, with Cards and funding to help you grow your business and your rewards. Terms Apply.

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Nitin Gupta is the co-founder of LawPivot, an online market for legal services. He previously provided answers to the 10 most common questions of entrepreneurs. In this posting he explains the 10 biggest booby traps in term sheets from venture capitalists.

Although receiving a venture term sheet to fund your company is a cause for celebration, please consider the various booby traps that it may contain before you break out the party hats. This is a top 10 list of things an entrepreneur should understand about term sheets:

1. Valuation. Valuation. Valuation. Valuation is perhaps one of the biggest traps in a term sheet. Valuation means what you value your company before you go out to seek investment (for example, if you value your company at $2 million, and a new investor provides a $1 million investment, then the investor would have 33 percent of the company). A valuation that is too low is one an entrepreneur will soon regret. Essentially, you have given too much of the company to the investors relative to their investment. On the other hand, a valuation that is too high may cause you difficulties in a future round of investment if investors in those rounds think the deal is too pricey. The solution is to do your homework and study similar deals and consult folks in the industry given that valuation is a “black art” in private companies.

2. Resetting vesting. Look out for the fist in the velvet glove. Investors have a strong interest in keeping incentives for entrepreneurs to stay fully committed, i.e., to stay real hungry while the investors eat veal. One dial that they love to turn back is your vesting schedule. A typical vesting schedule will be based on a four year time period, in which your shares vest monthly in 1/48 increments of total shares (vesting means gaining control of your stock, such that it cannot be taken away). Oftentimes entrepreneurs are well into their vesting by the time money is within sight. Investors, however, want to make sure there is enough runway to keep the founders motivated all the way through an exit. This is a delicate negotiation where both sides have valid concerns. Be prepared to be flexible, but keep what you have earned in terms of equity. If investors are too brutal here in resetting vesting terms when you have worked full time for a known period, this may be real red flag.

3. Milestone-based financing. Sometimes investors want to break up the investment amounts over time and condition them on the achievement of milestones (for example, product development). However, as an entrepreneur, this reduces the certainty that you will receive the future financing amounts. Even if you are going to accept such milestone-based financing, make sure that you tightly define the milestones and limit the conditions that allow the Investor discretion on whether to do the financing. If you miss the milestone, you have the double whammy of losing the investment tranche and having to look for money from a new source (assuming that you can without restriction).

Want more on venture capital? Check these out:

4. Liquidation preferences. Ignore this at your peril! The liquidation preference is the part of the exit consideration that the preferred holders get in preference to the common holders (that is you!). A high liquidation preference (for example, receiving a high multiple of their investment first before common holders receive money upon an exit) can leave entrepreneurs out in the cold or greatly reduce what they receive upon exit of the company. Liquidation preference provisions come in many flavors and seemingly slight differences in the wording can have a huge impact. Beware of this one. The best one to hope for is a non-participating 1x preference, which means an investor receives an amount equal to the initial investment plus accrued and unpaid dividends upon an exit.

5. Anti-dilution trap, aka the “full ratchet.” Investors will almost always request an adjustment to their equity holdings in the event that you later raise money at a lower price per share. This is called an anti-dilution adjustment, and some version of it is a market norm (called the broad-based weighted average formula). However, there is a killer strain of this one known as the “full ratchet” anti-dilution mechanism. This anti-dilution protection “ratchets” down the price of all prior investor shares to the lowest amount paid for any single subsequent preferred share regardless of how much is raised. This can cause a disastrous “meltdown” in your capitalization table and badly hurt the holdings of the entrepreneur. Steer clear of a “full ratchet”!

6. Protective provisions. What are protective provisions? They are a series of promises about things that a company will not do without the consent of their investors. They can include things like controls on issuing a future financing round, on changing the bylaws or certificate of incorporation and on a sale of the company. These protective covenants are considered “negative” controls because they prevent the company from doing something but cannot be used to force the company to do something. Yet, you ignore these at your peril. Investors love to load up these provisions with all kinds of goodies. If there are too many conditions that are too restrictive, the company can find its ability to make decisions to be hamstrung. Review these provisions with an expert or an entrepreneur who has been around the block numerous times.

7. Expanding the option pool. This can be a backdoor attempt to lower valuation. Investors will oftentimes insist that a company greatly expand the size of its stock option pool on a pre-investment basis. While this is to be expected, make sure that your option pool does not get too far above norms (20 percent or lower of the fully-diluted capitalization is a normal range). Many times an investor will crank this number of shares up in a backdoor attempt to lower valuation. How does it lower valuation? It lowers valuation because the pool is typically increased before the financing thereby diluting the entrepreneurs and not the investors. In other words, it comes out of your hide. Practically speaking, the size of the option pool should be no greater than the amount of equity incentives that are needed to get to the next round.

8. Drag-along provisions. Investors will sometimes ask for a “drag along” provision, that is, a provision which forces entrepreneurs and others to vote in favor of the sale of the company if a certain number of investors want to sell. Entrepreneurs and investors may not see eye to eye in a sale of the company context. For entrepreneurs their life, livelihood and dreams are tied up in their company whereas investors may view the situation as a pure financial decision. Investors could throw in the towel early based on a tough period for the company and sell the company short. If they try to implement a drag along, be sure to push back.

9. Dividend provisions. Don’t spend what you don’t have. Dividends entitle your stockholders to be paid a percentage of an amount (such as a percentage of an original purchase price per annum). For early stage companies, it is unusual to have more money that you can spend on company necessities. The typical scenario is that you are living on a tight budget, so don’t agree to pay cumulative dividends which accrue automatically whether you pay them or not. Such obligations are generally not consistent with the cash needs of a high-growth company.

10. “No Shop” booby trap. Term sheets for investments are often not binding on either side, with one exception. Many times an investor will ask that, as a condition of signing the term sheet, you sign up to a “No Shop.” This is an agreement not to shop the deal to any other investor for a period of time. Although there is a degree of fairness here to the investor because of the time, effort and resources they are planning to deploy, it can handcuff the entrepreneur from raising money during a critical period. What if the investor moves too slowly and you are running out of money? What if you cannot get a better deal because you can’t create a market for the deal by talking to others? What if the investor does not close at all and you are forty-five days down the road? If you can get away with it, just say “no” to the “No Shop.”

For those times business growth goes beyond your credit limit, American Express business funding is here to help. Learn more.

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Follow your passion and we'll follow your lead, with Cards and funding to help you grow your business and your rewards. Terms Apply.

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Want more on venture capital? Check these out:

For answers to these types of questions and more, take a look at LawPivot. At Nitin’s site you submit questions, and it helps you to identify the right lawyers. Then you send your question to these lawyers, and you confidentially receive answers. 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