Red Flags in Investment Agreements: Startup Founders Guide
Raising money is exciting, but bad investment terms can haunt your company for years. Watch for these red flags before accepting investment.
Valuation and Dilution Red Flags
1. Full Ratchet Anti-Dilution
If you raise at a lower valuation later, full ratchet anti-dilution massively dilutes founders. Weighted average is fairer.
2. Participating Preferred
Investors get their money back AND their percentage share. This "double dip" reduces founder payouts significantly.
3. Hidden Option Pool Expansion
Requiring a large option pool pre-money dilutes founders, not investors.
Control Red Flags
4. Investor Board Majority
At early stages, investors having board control is unusual and risky.
5. Protective Provisions Overreach
Some protections are standard. Requiring investor approval for routine business decisions isn't.
6. Founder Vesting Restart
Investors may want founders to re-vest. Negotiate for credit for time already worked.
Future Fundraising Red Flags
7. Super Pro-Rata Rights
Pro-rata rights to maintain percentage are standard. Rights to increase percentage are aggressive.
8. Restrictive Right of First Refusal
ROFR on company stock is standard. ROFR that delays fundraising or gives information to competitors is problematic.
Exit Red Flags
9. Excessive Liquidation Preference
1x non-participating preference is standard. 2x or higher leaves little for founders in moderate exits.
10. Drag-Along at Low Threshold
Drag-along allowing small investor majority to force sale removes founder control of exit.
Information and Time Red Flags
11. Excessive Information Rights
Regular financial updates are standard. Daily access or competitor-usable information isn't.
12. Long Exclusivity Period
30 days exclusivity for due diligence is reasonable. 90+ days prevents shopping the deal.
Frequently Asked Questions
What's the difference between full ratchet and weighted average anti-dilution?
Full ratchet converts early investors' shares as if they invested at the lower price—very dilutive to founders. Weighted average adjusts based on how much money was raised at each price—much more founder-friendly.
What's a fair liquidation preference?
1x non-participating preferred is standard and fair. This means investors get their money back first (1x), then remaining proceeds are split. Anything above 1x or participating preferred reduces founder returns significantly.
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