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Many entrepreneurs view their first round of funding as the end game for their startup. They’re so excited by the prospect of “big money” that they don’t look at the long term implications of selling their soul. This article will show excerpts of an actual venture capital term sheet (which I signed, btw) and what these terms actually turn out to mean in the long term.

There are situations where using venture capital can be a Good Thing. There are also times when it can be an absolute disaster for the company. The problem is that venture capitalists tend to look for and invest in deals where it doesn’t make sense for the company. Make no mistake – this is an adversarial process. There’s a reason both sides lawyer up to do the deal. No matter what they say, the VC is not your friend. Their responsibility is to their investors, not some higher principle of “doing good.”

The best situation to use venture capital is when you have very little time or money invested in your startup and the startup requires large amounts of capital in order to achieve any results. Being able to leverage capital to achieve your goals can be a wonderful thing. These are the only kinds of deals that entrepreneurs should do.

Unfortunately, most VCs aren’t interested in these kinds of deals because their standard benchmark is that they want to see market acceptance of the concept before they invest. Will the dogs eat the dog food? “Come to us when you’ve got $1M in revenue” is a common phrase. Of course, at that point, you’ve made a serious investment in time or your own money to get that far. And since you’ve been living lean, by definition you probably have a profitable business that you can support at that level.

The worst situation to use venture capital is when you have a on-going, profitable business. Many entrepreneurs think that they can take an infusion of capital to “get to the next level.” You may very well be able to use the capital to grow the business, but it will no longer be your business.

Let’s take a look at an actual term sheet. I’m not a lawyer, nor do I play one on TV. My lawyers looked at this term sheet, explained the downsides to me, and then asked me if I really, really needed the money. The answer was Yes, so we signed it.

The first nasty term is the lock-up during negotiations:

The company covenants and agrees that neither it, nor any of its officers, directors, employees, agents or representatives will, directly or indirectly solicit or initiate inquiries, offers or proposals from, or participate in any discussions or negotiations with, any person or entity (other than the Investor or their respective officers, directors, employees, agents or representatives) concerning any Transaction.

What they’re doing here is taking your deal off the market. Their big fear is that you’ll get a bidding war going during the negotiations and they might have to pay a market price. You’re in a bidding war for their attention since they’re not agreeing not to look at other deals at the same time, so this is a one-way provision.

Your big problem is that no VC wants to do a deal that someone else did due diligence on and then turned down. If they pass on the deal, you’ll find it very hard to do another deal, even though they promised not to disclose anything about your deal. These guys all have lunch together and cooperate pretty heavily, so a black ball from one is enough to destroy your chances for a deal in an entire area.

The lesson to learn is that you shouldn’t accept a term sheet unless the deal is exactly the way you want it. Once you accept the term sheet, you’re committed to either completing a deal with this particular VC, or pretty much starting over.

Another standard term is a preferred dividend for the investors:

The Series A will receive an annual cumulative dividend, initially equal to 10% of the Series A Purchase Price, payable quarterly, which shall compound and accrue quarterly unless paid in cash. Quarterly cash dividend payments shall be required after three years.

How to read this: This isn’t really an investment, they’re loaning you money at 10% plus they’re getting a huge kicker if you end up being successful. And you’ve got a ticking time bomb, because in 3 years you’ve either got to be able to make the quarterly cash payments, or they can foreclose on the company.

How about when the company has an exit?

Upon a Liquidity Event, the holders of the Series A shall be entitled to receive in preference to the holders of the common stock an amount equal to the Aggregate Purchase Price plus the Cumulative Dividend. Any remaining proceeds shall be allocated between the holders of the common stock and the Series A on a pro rata basis, treating the Series A on an as-converted basis.

If no Liquidity Event has occurred by the fourth anniversary of the closing, each of the holders of the Series A will have the option to redeem their holdings for an amount equal to three times the Aggregate Purchase Price (subject to appropriate adjustment in the event of any stock dividends, stock splits, combinations or other similar recapitalizations affecting such shares) plus the Cumulative Dividend (including any accrued but unpaid dividends). This amount (the “Redemption Amount”) shall be paid in two equal installments at the dates of the sixth and seventh anniversaries of the initial closing.

This keeps with the concept of they’re not really making an investment. When you cash out the company, they get their investment plus dividends back first, then you split the proceeds with them according to their percentage.

Let’s take an example. Let’s say you’ve got a successful consulting company that’s doing $1M/year in revenue. A VC comes along and offers to help you build your company to the next level and gives you a cash infusion of $1M. They give you a pre-money valuation of $9M, so post money of $10M they own 10% of the company. OMG, your company is worth $10M! You’re rich!

You write some blog posts about how the VC is going to help you really build the company. The business community fawns over your success. You have a great Christmas party.

Four years later you haven’t had the 100x increase in sales you were hoping for. $1M turned out to not be nearly as much as you thought it was. In fact, you only tripled your sales (which is pretty darn good for any company in four years). Now the quarterly dividends have kicked in and you’re feeling the cash crunch. The VC can sell the company out from under you because they can force the redemption. A big company comes along and offers you $3M cash for the company, which frankly is about how much you’re worth – consulting companies are worth their yearly revenue. If you think VCs don’t call their buddies at the big companies when there’s blood in the water, think again. Here’s how the math works:

Pay back the VC their original investment: $1M
Pay the VC their extra triple redemption: $2M
Pay the quarterly dividends for four years: $217K
Total Payments: $3.217M

Oops, there’s nothing left over for the other 90% of the shareholders of the company. The VC cashed out and you’ve got nothing but a chance at a job at the company who bought you. The VC tripled their money and you’re looking for a job. Those employees that trusted you to do the right thing got laid off by the buying company because their functions were duplicated.

The horror story continues:

All employees have entered and all new employees will enter into the Confidentiality and Intellectual Property Agreement, which includes 3-year post-employment non-competition terms.

The company that buys you also buys this agreement. So you’re not only unemployed if you don’t go to work for them, but you’re effectively cut out of working in your chosen field. Those employees that got laid off share the same fate. Imagine being a successful SEO consultant and not being able to work in SEO.

It gets worse. Here’s a dirty little secret: VCs under fund companies on purpose. They know the initial $1M investment won’t be enough, so they’ll give you any valuation you ask for. They could give you a $100M valuation for 1% of the company. It doesn’t matter, because they’re protected with anti-dilution:

In the event the Company issues or is deemed to have issued additional shares of stock, either common or preferred or otherwise, with the exception of shares issued pursuant to the option plan reserved at the time of the Series A investment, at a price per share less than the Applicable Conversion Price, then the Applicable Conversion Price shall be reduced to such lesser price.

So when you take a subsequent round of funding, the price they paid for their shares is adjusted if the next round would be a lower valuation. Let’s take our $1M investment example.

Series A was $1M with a valuation of $10M, for 10%.

Series B doesn’t do so well, so the valuation of the company is $5M. Series B puts in $2M for 40% of the company.

Series A is readjusted – instead of $1M buying 10% of the company, now it buys 20% of the company.

Instead of the founders owning 90% of the stock of the company, they now have 40%. The VCs now control the board and effectively own the company. And the VCs get paid first in the exit, so that 40% is as good as zero unless you make truly huge money on the exit.

VCs know this. They will actively encourage you to increase your burn rate, with promises that they can help you get additional rounds of funding as you need it. They talk about velocity and time to market being more important, since money is easy. They would like nothing better than for you to burn through your cash and be dependent upon future rounds.

Now that you’re working for someone else, you’d like to have a salary that’s at a market rate rather than the starvation salary you were working at to build the company.

The Board member representing the Series shall approve the initial establishment of and any changes to the compensation of the President, CEO and any other employee or consultant or vendor who is or becomes a holder of more than 5% of the Company’s common stock on a fully diluted basis.

In other words, your salary will stay the same. You’re faced with the choice of walking away from your baby and leaving your employees, or continue to slog it out, hoping for the big hit. Simply walking away isn’t really an option, because as an officer you’ve got a fiduciary responsibility to the shareholders. It’s a very tough spot to be in.

There are clearly situations where venture capital can really help a company. But if you’ve got an on-going, profitable business, taking an infusion of venture capital could be the worst decision you ever made. VCs invest on the idea that they’ll invest in 20 companies that fail in order to find one that hits the 100x return. If you’ve got a company that’s doing well, there’s absolutely no reason to rip it apart and make it a 20-1 long shot.

Unfortunately, most entrepreneurs that do VC deals are doing their first deal. The 20-somethings doing Web 2.0 startups are no match for VCs that have been playing the game since the 1980s.

And when you see that $1M check, there’s nothing anyone can tell you that will make you turn it down.

But you should. If you’re not the perfect situation for a VC investment, just say No!