Clean Deal Terms

Sam Altman has a nice post here on a founder-friendly term sheet. He said one thing there that I agree with 100%, among others:

I have an allergic reaction to complex deal structures, as they invariably end up with all sorts of unintended consequences. (link).

Lately I’ve seen more complex “deal terms” in early stage financings. One glaring example is the “super pro-rata right of X%.” This basically says that an early investor gets the right to invest not only their pro-rata in a next round of financing but X% more. A typical number might be 50%.

At first blush, this seems pretty harmless. It simply says that the investor can invest more than they have the rights to. The investor wins because if the company is a rocket ship, they can own more of the company. The company neither wins nor loses because it doesn’t preclude other investors from participating. And in exchange for giving this super pro-rata, the company can negotiate for other terms – namely a higher valuation. We’ve seen this happen a few times.

But as Sam would say, there are unintended consequences. Namely, the super pro-rata can act as an effective blocking right to some subsequent deals. It’s not an actual blocking right because the investor doesn’t have the legal right to approve a future financing. But the economic right to invest more could effectively block out certain deal opportunities and leave the company with limited options.

The super pro-rata can act as a blocking right because it doesn’t leave enough “room” for future investors to get their desired ownership. And so the new investors either get lower ownership (deal-breaker for many, or at least the important subset) or the seed investor has to waive their super pro-rata (doesn’t always happen).

In the example above, if the company had limited options and/or really wanted the investor, we’d generally advise a lower valuation without the super pro-rata (many investors would accept that). Just keep it clean. It may seem like a bitter pill at the time but better the devil you know, in my opinion.