3 traps in Term Sheet agreements from Q3 2024
In the third quarter of 2024, we analyzed 14 Term Sheet agreements signed in the Silesian and Lesser Poland regions. We see a clear shift in the approach of VC funds towards protecting their own capital at the expense of founder shares. Money likes silence, but hard facts about liquidation clauses require loud discussion before signing.
Participating Liquidation Preference
In documents from August and September 2024, the so-called participating liquidation preference appears more and more frequently. For a founder holding 43% of shares in an IT company, such a clause means that when the company is sold, the investor first takes their contribution (often with a 1.5x multiplier) and then participates once more in the division of the remaining cash. In one of the cases we examined, upon exiting the company for 12 million PLN, the founders received 840,000 PLN less than they originally assumed in their spreadsheet.
The principle is simple: the investor minimizes their risk by shifting it onto your capital. If your contract contains the word 'participating', you lose twice. According to our observations, 9 out of 14 funds tried to smuggle this clause in as a market standard, which is untrue in the current economic situation. The game for control over the final financial result starts right here, not when setting the valuation itself.
A participation clause can reduce your real profit when selling the company by over 12% at a standard valuation.
Veto on operational matters and IP transfer
The second trap concerns the investor's control rights. In Q3 2024 agreements, we noticed an expansion of the list of matters requiring fund approval to include purely technical issues, such as choosing a server provider or changing open-source libraries in the source code. Such a tight share structure is meant to protect IP, but in practice, it paralyzes the development team's work. In October 2024, we helped a software house that waited 23 days for supervisory board approval just to move code repositories.
Blocking the ability to freely manage intellectual property is a direct path to losing agility. If the fund has a right of veto for every change in the system architecture, you stop being the owner of the technology and become its tenant. At Alians Business Diplomacy, we recommend limiting the veto solely to key transactions exceeding 47,000 PLN, which allows for operational liquidity without annoying the investor.
Drag-Along clause and the 51 percent threshold
The 'drag-along' mechanism—the right to drag other shareholders into a sale—has become exceptionally aggressive in recent months. Funds are trying to lower the activation threshold for this clause to 51% of all votes. This means that if the investor reaches an agreement with one smaller shareholder, they can force you to sell your life's project at a moment that is extremely unfavorable for you in terms of taxes.
In November 2024, we analyzed a case where a founder lost control over the timing of the investment exit because they were 3% short of the votes needed to block a forced sale. We recommend setting the drag-along threshold at at least 72% or introducing a minimum price per share that must be reached for the clause to be triggered. Remember that in business diplomacy, numbers don't lie – either you control the sales threshold, or the market will do it for you.
Lowering the drag-along threshold to 51% is like handing over the keys to the company with no possibility of return.
Full-Ratchet Anti-dilution protection
The last element that dominated negotiations in Q3 2024 is the anti-dilution protection mechanism in subsequent funding rounds. Funds are pushing for 'full-ratchet' clauses, which are extremely unfavorable for founders in the event of a so-called down-round (issuing shares at a lower price than previously). If a new round values the company lower, the investor from the previous round receives free shares to compensate for their loss, and the entire dilution hits you exclusively.
A pragmatic solution that we managed to negotiate for 5 of our clients in the last six months is switching to a 'weighted average' mechanism. It is fairer because it distributes the burden of a lower valuation across all participants in the process, taking into account the actual amount of capital paid in. Honestly, agreeing to full-ratchet in today's uncertain times is asking to marginalize your own role in the company within the next 18 months.
