11. Dark Patterns - Predatory Terms to Avoid¶

11.1 Executive Summary¶

• Dark patterns are predatory term sheet provisions designed to maximize investor returns at founder expense through asymmetric risk allocation
• Full ratchet anti-dilution is the "founder killer": Resets investor conversion price to down round price regardless of size, causing catastrophic founder dilution
• Participating preferred uncapped enables "double dipping": Investors get liquidation preference PLUS pro-rata share of remaining proceeds, capturing disproportionate value in medium exits
• Multiple liquidation preferences (2x, 3x+) create liquidation overhang: Founders may receive nothing even in substantial exits (e.g., $30M exit yields $0 to founders with $20M invested at 2x preference)
• Personal guarantees expose founders to unlimited liability: Turns limited liability corporation into unlimited personal risk
• Severity ratings help prioritize: Use color-coded warnings to identify deal-breakers vs. negotiable terms

Term sheets contain clauses that appear innocuous in good times but become weaponized in difficult situations. These "dark patterns" are legal provisions that shift risk dramatically toward founders while providing investors with downside protection that goes far beyond normal investor rights. This chapter systematically catalogs the 10 most dangerous predatory terms, explains exactly how they harm founders, provides real case studies demonstrating their impact, and equips you with specific negotiation strategies to avoid or modify each pattern.

11.2 Understanding Dark Patterns: What Makes a Term "Predatory"?¶

Legitimate Investor Protection vs Predatory Terms¶

Not all investor-favorable terms are dark patterns. Investors deserve protection for their capital:

Legitimate Protections:

• 1x non-participating liquidation preference: Investors get money back before common stockholders in a sale
• Broad-based weighted average anti-dilution: Protection against severe down rounds
• Veto rights on new fundraising, M&A, or fundamental changes: Prevents dilutive or destructive decisions
• Information rights: Regular financials and board oversight
• Preemptive rights (pro-rata): Ability to maintain ownership percentage in future rounds

These terms are standard, fair, and align investor-founder interests around building a valuable company.

Predatory Dark Patterns:

Dark patterns go far beyond protection. They are characterized by:

1. Asymmetric outcomes: Terms that give investors outsized returns in mediocre exits while harming founders
2. Punishment for normal business challenges: Provisions triggered by ordinary setbacks (down rounds, missing targets)
3. Misalignment of incentives: Terms that make investors whole even when founders get nothing
4. Opacity through complexity: Complicated provisions whose impact isn't obvious until mathematical modeling
5. Transfer of founder control or wealth: Provisions that enable investor takeover or appropriate value disproportionately

The Severity Rating System¶

Each dark pattern in this chapter is rated by severity:

11.3 Dark Pattern #1: Full Ratchet Anti-Dilution¶

Severity: CRITICAL - WALK AWAY¶

What It Is¶

Full ratchet anti-dilution protection resets the investor's conversion price to the price of any subsequent down round, regardless of the round's size. The investor's shares convert as if they had invested at the lower price, issuing them additional shares and massively diluting founders.

Standard Formula:

New Conversion Price = Down Round Price Per Share

New Shares for Investor = Original Investment Amount / New Conversion Price

Additional Shares Issued = New Shares - Original Shares

Anti-Dilution Protection: Impact Comparison¶

graph TD
    A[Down Round Scenario<br/>Original: $10/share<br/>Down Round: $5/share] --> B{Anti-Dilution Type}

    B -->|No Protection| C[Original Price: $10<br/>Shares: 100,000<br/>Total: 100,000 shares]

    B -->|Broad-Based Weighted Average| D[Adjusted Price: $7.50<br/>Conversion: 133,333 shares<br/>Dilution: 33% increase]

    B -->|Narrow-Based Weighted Average| E[Adjusted Price: $6.67<br/>Conversion: 150,000 shares<br/>Dilution: 50% increase]

    B -->|Full Ratchet| F[Adjusted Price: $5.00<br/>Conversion: 200,000 shares<br/>Dilution: 100% increase]

    style C fill:#c8e6c9
    style D fill:#fff9c4
    style E fill:#ffecb3
    style F fill:#ffcdd2

Founder Impact:

• No Protection (Green): Founders unaffected (rare in practice)
• Broad-Based Weighted Average (Light Yellow): 33% investor protection - founder-friendly standard
• Narrow-Based Weighted Average (Orange): 50% protection - concerning, negotiate to broad-based
• Full Ratchet (Red): 100% protection - catastrophic for founders - WALK AWAY

How It Harms Founders¶

Full ratchet creates catastrophic dilution even from tiny down rounds:

Example: The Startup Massacre

Setup:

• FinTech Solutions raised $5M Series A at $4/share = 1,250,000 shares
• Post-money valuation: $20M
• Founders own 3,000,000 shares (60% pre-money, 57% post-money)
• Series A has full ratchet anti-dilution
• Company struggles and raises $500K bridge round at $2/share (50% down)

Without Full Ratchet:

• Bridge round: $500K / $2 = 250,000 shares
• Total shares: 4,500,000
• Founder ownership: 3,000,000 / 4,500,000 = 66.7%
• Series A ownership: 1,250,000 / 4,500,000 = 27.8%
• Bridge ownership: 250,000 / 4,500,000 = 5.6%

With Full Ratchet:

• Series A conversion price resets: $4 → $2
• Series A shares convert to: $5,000,000 / $2 = 2,500,000 shares (was 1,250,000)
• Additional shares issued to Series A: 1,250,000
• Total shares: 4,500,000 + 1,250,000 = 5,750,000
• Founder ownership: 3,000,000 / 5,750,000 = 52.2% (down from 66.7%)
• Series A ownership: 2,500,000 / 5,750,000 = 43.5% (up from 27.8%)
• Bridge ownership: 250,000 / 5,750,000 = 4.3%

Impact: A $500K bridge round (11% of Series A size) caused founders to lose 14.5 percentage points. Even a tiny down round triggers massive dilution.

Extreme Scenario - The Death Spiral:

If the company raises $100K at $1/share:

• Series A resets to $1/share = 5,000,000 shares (from 1,250,000)
• Founders diluted from 60% to 38%
• One small bridge financing destroys founder ownership

Why It's Called the "Founder Killer"¶

Unlike weighted average anti-dilution (which considers the size and amount of the down round), full ratchet punishes founders for:

• Market downturns beyond their control
• Any price decrease, no matter how small
• Strategic bridge rounds at slightly lower prices
• Down rounds from tiny investors (even 1 share triggers full reset)

It's called a "ratchet" because it only moves in one direction (down), never up.

How It's Disguised¶

Investor Pitch: "This protects us against massive dilution if things go wrong. It's standard Series A protection."

Reality: Full ratchet is NOT standard. Broad-based weighted average is standard. Any investor who calls full ratchet "standard" is either inexperienced or deliberately misleading.

Red Flag Language in Term Sheets:

• "Anti-dilution protection: Full ratchet"
• "Conversion price shall be adjusted to the lowest price of any subsequent issuance"
• "Ratchet-down price protection" (sometimes called "ratchet" without "full" to obscure)

Case Study: (Anonymous - NDA-Protected Scenario)¶

Venture debt provider Lighter Capital published anonymized case studies showing full ratchet destroying companies. In one case:

• Series A at $10M valuation with full ratchet
• Down round at $4M valuation (company still viable, just slower growth than projected)
• Founder ownership diluted from 45% to 18% due to anti-dilution adjustment
• Founders lost majority control and board seats
• Company sold 18 months later for $25M
• After liquidation preference and anti-dilution adjustments, founders received less than $1M (4% of exit value on 18% ownership)
• Had they had weighted average instead of full ratchet, founders would have received $6M+

Negotiation Strategy¶

Best Approach: Absolute No

Simply reject any term sheet with full ratchet. State clearly: "Full ratchet anti-dilution is unacceptable. We'll accept broad-based weighted average or narrow-based weighted average, but not full ratchet."

If Investor Insists:

This is a red flag about the investor. Ask:

• "Can you explain why full ratchet is necessary when weighted average is market standard?"
• "Have you used full ratchet in other investments? What happened?"
• Request portfolio references to check how investor behaved in previous down rounds

Acceptable Compromise:

If you're in a desperate situation with no alternatives:

• Accept only if full ratchet sunsets after 24 months (converts to weighted average)
• Negotiate cap: "Full ratchet only applies to rounds >$1M; rounds <$1M use weighted average"
• Require pay-to-play: Full ratchet only applies if investor participates in down round pro-rata

Never Accept:

• Permanent full ratchet
• Full ratchet triggered by any issuance (including options, warrants, or tiny bridge rounds)
• Full ratchet without any floor price

11.4 Dark Pattern #2: Participating Preferred (Uncapped)¶

Severity: CRITICAL - WALK AWAY¶

What It Is¶

Participating preferred gives investors BOTH their liquidation preference AND their pro-rata share of remaining proceeds. This "double-dipping" allows investors to get paid twice while founders get paid once (or not at all).

Standard Formula:

Preference Payment = Investment Amount × Preference Multiple (typically 1x)
Remaining Proceeds = Total Exit Value - All Preference Payments
Participation Payment = Remaining Proceeds × (Investor Shares / Total Shares)
Total Investor Payout = Preference Payment + Participation Payment

Non-Participating (Standard) Formula for Comparison:

Investor chooses MAX of:
  (a) Preference Payment
  (b) Pro-Rata Share (as if converted to common)

How It Harms Founders¶

Participating preferred is asymmetric: investors capture disproportionate value in medium exits while founders get little or nothing.

Worked Example: The Double-Dip

Setup:

• Company raises $10M Series A with 1x participating preferred
• Founders own 60% post-money
• Investors own 40% post-money
• Company sells for $30M

With Non-Participating (Standard):

• Investor gets MAX($10M preference, or 40% × $30M = $12M)
• Investor takes $12M (conversion is better)
• Founders get $30M - $12M = $18M (60% of exit, as expected)

With Participating (Uncapped):

• Investors get $10M preference first
• Remaining $20M split pro-rata: Investors 40% × $20M = $8M
• Investor total: $10M + $8M = $18M (60% of exit on 40% ownership!)
• Founders get $30M - $18M = $12M (40% of exit despite 60% ownership)

Impact: Investors captured 60% of exit value despite owning 40%. Founders captured 40% despite owning 60%. This is the "double dip."

Why It's Called "Double Dipping"¶

Investors get paid twice:

1. First, they get their preference ($10M = money back)
2. Then, they participate as if they were common shareholders in the remainder

Founders only get paid once (if anything remains).

Participating Preferred: Side-by-Side Comparison¶

The Pernicious Effect in Mediocre Exits¶

Participating preferred is most harmful in exits between 1x and 3x invested capital:

Exit at $15M (1.5x):

• Non-participating: Investor converts to 40%, gets $6M
• Participating: Investor gets $10M pref + 40% × $5M = $12M (80% of exit on 40% ownership)
• Founders get $3M (20%) despite 60% ownership

Exit at $20M (2x):

• Non-participating: Investor converts to 40%, gets $8M
• Participating: Investor gets $10M + 40% × $10M = $14M (70%)
• Founders get $6M (30%)

Exit at $50M (5x):

• Non-participating: Investor converts to 40%, gets $20M
• Participating: Investor gets $10M + 40% × $40M = $26M (52%)
• Founders get $24M (48%)

Notice: Even at a 5x return ($50M exit), participating investors still capture more than their pro-rata share.

The "Conversion Point"¶

Participating investors only convert to common stock when conversion gives them MORE than preference + participation. This happens at high exit multiples.

Calculation:

Conversion Point = Investment Amount / (Ownership % - Preference Multiple × Ownership %)

For our example:
$10M / (40% - 1 × 40%) = undefined (participating never converts at 1x preference)

More generally, for 1x participating preferred:
Conversion never happens (investor always prefers preference + participation)

Implication: With 1x participating uncapped, investors NEVER convert. They always take the double dip.

How It's Disguised¶

Investor Pitch: "We want to be aligned with you. Participating preferred ensures we have shared upside."

Reality: Participating preferred creates MISalignment. Investors have incentive to sell at mediocre prices because they get disproportionate share. Founders want to hold out for larger exits to overcome the double-dip.

Misleading Language:

• "Preferred stock with full participation rights" (sounds positive, means double dip)
• "Participating liquidation preference" (emphasizes liquidation preference, downplays participation)
• "Standard preferred terms" (lie—participating is not standard in seed/A rounds)

Case Study: WeWork's Toxic Preference Stack¶

While WeWork's failure had many causes, the cap table structure with multiple participating preferred rounds created severe misalignment.

Structure:

• Multiple rounds (Series A through Series G) with participating preferred
• Late-stage investors (SoftBank) had 2x participating preferred
• Total invested capital: $12+ billion across all rounds
• Peak valuation: $47 billion (January 2019)

Impact:

• When valuation collapsed to $8 billion (September 2019), liquidation waterfall analysis showed:
• Senior preferred investors would receive $12B+ even though company worth $8B (preference overhang)
• Founders and employees would receive $0 in an $8B exit
• Company needed to exit at $30B+ for common shareholders to get meaningful value

The Spiral:

• Investors with participating preferred had incentive to accept lower valuations
• Founders had incentive to hold out for massive exits (needed to overcome preference overhang)
• Misalignment contributed to disastrous decision-making and eventual bankruptcy

Negotiation Strategy¶

Best Approach: Reject Completely

"We'll accept 1x non-participating liquidation preference, which is standard for Series A. Participating preferred is non-standard and creates misalignment."

If Investor Insists, Demand Caps:

If you must accept participating preferred (e.g., down round, rescue financing):

Participation Formula with Cap:
Total Payout = MIN(
  Preference + Participation,
  Cap Multiple × Investment Amount
)

Example with 3x cap on $10M investment:
- Cap = $10M × 3 = $30M
- If preference + participation > $30M, investor converts to common instead

Effect of Cap:

• 2x cap: Investor converts at ~$40M exit (depending on ownership %)
• 3x cap: Investor converts at ~$60M exit
• Caps align incentives at high exit values

Never Accept:

• Uncapped participating preferred
• Participating preferred with multiple liquidation preference (2x participating = quadruple dip)
• Participating preferred that applies to ALL future rounds (blocks clean fundraising)

Specific Language to Add: "The participating liquidation preference shall be capped at three times (3x) the original investment amount. Upon reaching the cap, the Preferred Stock shall be deemed to have converted to Common Stock."

11.5 Dark Pattern #3: Multiple Liquidation Preferences (2x, 3x+)¶

Severity: CRITICAL - WALK AWAY (2x+), IMPORTANT - NEGOTIATE HARD (1.5x)¶

What It Is¶

A liquidation preference multiple means investors get back 2x, 3x, or even higher multiples of their investment before anyone else gets paid.

Formula:

Investor Preference = Investment Amount × Preference Multiple
Remaining to Common = MAX(0, Exit Value - All Preference Payments)

Liquidation Waterfall: How Money Flows¶

flowchart TD
    A[Exit Event: $50M Acquisition] --> B{Liquidation<br/>Preference Type?}

    B -->|1x Non-Participating| C[Step 1: Pay 1x preference<br/>Investors get $20M]
    C --> D[Step 2: Distribute remaining $30M<br/>pro-rata by ownership]
    D --> E[Final: Investors $26M 52%<br/>Founders $24M 48%]

    B -->|Participating Preferred| F[Step 1: Pay 1x preference<br/>Investors get $20M]
    F --> G[Step 2: Investors also get<br/>pro-rata of remaining $30M]
    G --> H[Final: Investors $32M 64%<br/>Founders $18M 36%]

    B -->|2x Preference| I[Step 1: Pay 2x preference<br/>Investors get $40M]
    I --> J[Step 2: Only $10M remaining<br/>for pro-rata distribution]
    J --> K[Final: Investors $44M 88%<br/>Founders $6M 12%]

    style E fill:#c8e6c9
    style H fill:#fff9c4
    style K fill:#ffcdd2

Explanation: This diagram visualizes three liquidation scenarios with $20M invested at 40% ownership:

• Green (Founder-Friendly): 1x non-participating = Fair split (52/48 close to 40/60 ownership)
• Yellow (Concerning): Participating preferred = Double-dipping (64/36 despite 40/60 ownership)
• Red (Predatory): 2x preference = Founders get almost nothing (88/12 - founders receive only 12% despite 60% ownership)

How It Harms Founders¶

High liquidation preference multiples create "liquidation overhang" where founders and employees get nothing even in substantial exits.

Worked Example: The $30M Exit Worth $0

Setup:

• Company raises three rounds:
• Seed: $1M at 1x preference
• Series A: $5M at 1x preference
• Series B (troubled): $10M at 3x preference (rescue financing)
• Total invested: $16M
• Total liquidation preference: $1M + $5M + $30M = $36M

Exit Scenario: Company Sells for $30M

Series B preference: $10M × 3 = $30M (takes entire exit proceeds)
Series A gets: $0 (nothing remaining after Series B)
Seed gets: $0
Founders/employees get: $0

Despite $30M exit (success by most measures), founders receive nothing.

What's Required for Founders to Get Paid:

Exit must exceed total preference: $36M+ for common to receive anything.

If company exits at $40M:

• Series B gets $30M
• Series A gets $5M
• Seed gets $1M
• Founders/employees share remaining $4M (10% of exit value)

To get 50% of exit value, company must exit at $72M+

The "Preference Overhang" Trap¶

Multiple liquidation preferences create a death trap:

1. Misaligned incentives: Investors with high multiples are fine with mediocre exits (they get 3x return). Founders need massive exits (to overcome overhang).

2. Difficult subsequent fundraising: New investors see the preference overhang and demand even higher preferences to invest (creating spiral).

3. M&A challenges: Acquirers see preference stack and offer less (they know founders have no leverage to reject lowball offers—founders get nothing anyway).

4. Recruitment problems: Top candidates don't join because ESOP is worthless unless company exits at 5x+ invested capital.

When Multiple Preferences Appear¶

Multiple preferences are rare in healthy companies. They typically appear in:

Down Rounds: Investors demand 2x or 3x to invest in struggling company
Bridge Financing: Company desperate for cash accepts punitive terms
Sector Crashes: During market downturns (2001, 2008, 2023-24) some investors exploited founder desperation
Venture Debt Conversion: Some debt converts to equity with high liquidation multiple

How It's Disguised¶

Investor Pitch: "The 3x preference reflects the risk we're taking on a difficult situation. We need downside protection."

Reality: The preference is so high that it creates a "heads I win, tails you lose" situation. Investor gets 3x return in mediocre outcome; founders get crushed.

Misleading Framing:

• Presenting 2x as "only double" (vs 1x standard) when it actually doubles the overhang
• Emphasizing the capital provided without modeling the preference impact
• Comparing to debt ("This is safer than venture debt at 2x return" when debt doesn't have preference rights)

Case Study: Preference Overhang in Practice¶

Brad Feld's "Venture Deals" book shares an anonymized case:

Company: Raised $50M across multiple rounds with escalating preferences

• Early rounds: 1x
• Later rounds (growth capital): 1.5x to 2x
• Final round (turnaround): 3x on $15M

Total Preference: $85M on $50M invested

Outcome: Company sold for $75M after turnaround

• Preference holders got entire $75M
• Founders and employees got $0
• Company was "worth" $75M but common stock was worth $0

Lesson: Preference overhang made the common stock worthless despite significant exit value.

Negotiation Strategy¶

Never Accept:

• 3x or higher liquidation preference
• Multiple preferences combined with participating preferred (the "quadruple dip")
• Multiple preferences without sunset (converts to 1x after 5 years or specific milestones)

Acceptable Only in Distress:

If you're in dire straits with no alternatives, you might accept 1.5x or 2x with conditions:

✅ 1.5x Non-Participating: Acceptable in down round if:

• Converts to 1x after company hits milestones (profitability, $10M revenue, etc.)
• Applies only to this round, not future rounds
• Investor agrees to favorable terms in subsequent rounds if milestones hit

✅ 2x Non-Participating: Only acceptable if:

• Company is genuinely distressed (weeks from shutdown)
• This is truly rescue financing
• Includes clear path to reducing preference (milestone-based reduction)
• Sunset clause: Converts to 1x after 36 months

Better Alternatives to High Multiples:

If investor wants downside protection, offer:

• Debt instead of equity (fixed return, no equity dilution)
• PIK (payment-in-kind) preferred: Accrues dividends that compound but no liquidation multiple
• Senior preferred with specific seniority over other series (gets paid first at 1x, but not 2x)

Specific Language to Include: "The liquidation preference multiple shall reduce by 0.5x upon achieving trailing twelve-month revenue of $5,000,000, and shall further reduce to 1x upon achieving positive EBITDA for two consecutive quarters."

11.6 Dark Pattern #4: Cumulative Compounding Dividends¶

Severity: IMPORTANT - NEGOTIATE HARD¶

What It Is¶

Cumulative dividends are predetermined dividend payments (typically 6-10% annually) that accrue whether or not the company pays them. They accumulate and compound, effectively increasing the liquidation preference amount every year.

Formula:

Accrued Dividend = Original Investment × Annual Dividend Rate × Years
Compounding: Year 1 = $1M × 8%, Year 2 = ($1M + $80K) × 8%, etc.

Effective Liquidation Preference After N Years:
= Original Investment × (1 + Dividend Rate)^N

Example after 5 years at 8%:
= $10M × (1.08)^5 = $14.69M

How It Harms Founders¶

Cumulative dividends are a silent equity drain that grows the investor's claim every year:

Worked Example: The Hidden 50% Increase

Setup:

• Series A: $10M at 1x preference with 8% cumulative compounding dividend
• Company operates for 6 years before exit
• Company sells for $30M

Without Dividends:

• Series A gets $10M preference
• Remaining $20M split pro-rata between all shareholders

With Cumulative Compounding Dividends:

Year 1: $10M × 1.08 = $10.8M
Year 2: $10.8M × 1.08 = $11.66M
Year 3: $11.66M × 1.08 = $12.60M
Year 4: $12.60M × 1.08 = $13.60M
Year 5: $13.60M × 1.08 = $14.69M
Year 6: $14.69M × 1.08 = $15.87M

At Exit:

• Series A preference = $15.87M (not $10M)
• Remaining to common: $30M - $15.87M = $14.13M

Impact: Founders lost $5.87M (29% of exit proceeds) to dividend accretion. This is a 59% increase over the original investment amount for the investor.

The Compounding Trap¶

With compounding dividends:

• 8% annually becomes 58.7% over 6 years
• 10% annually becomes 77.2% over 6 years
• 12% annually becomes 97.4% over 6 years (nearly doubles the preference)

Long-Duration Impact:

If company takes 10 years to exit:

• 8% dividend: $10M → $21.6M (2.16x)
• 10% dividend: $10M → $25.9M (2.59x)
• 12% dividend: $10M → $31.1M (3.11x)

This effectively converts a 1x preference into a 2-3x preference without calling it that.

Cumulative vs Non-Cumulative¶

Non-Cumulative (Acceptable):

• Dividends are owed annually but don't accumulate if unpaid
• If company doesn't pay Year 1 dividend, that amount is forfeited
• Only unpaid dividends from current year are owed

Cumulative (Problematic):

• All unpaid dividends accumulate indefinitely
• Even if company never pays, dividends pile up and get paid at exit

Cumulative Compounding (Highly Problematic):

• Unpaid dividends earn interest on themselves
• Creates exponential growth in preference amount

How It's Disguised¶

Investor Pitch: "The 8% dividend is standard preferred stock terms. It aligns us with debt-like downside protection while giving us equity upside."

Reality: Compounding cumulative dividends are not standard in seed/Series A. When used, they're typically non-compounding and convert to participation rights at exit (not added to preference).

Red Flag Language:

• "8% cumulative annual dividend" (missing "compounding" but often compounding in practice)
• "Accruing dividend" (implies cumulative)
• "Dividend that accumulates and compounds" (explicit but sometimes buried in definitions)

Case Study: PIK Dividend Destroying Common Value¶

In 2009-2010, during the financial crisis, some late-stage companies accepted PIK (payment-in-kind) preferred with high compounding dividends:

Anonymous Example:

• Company raised $20M Series C in 2009 with 12% cumulative compounding dividend
• Company couldn't exit during 2009-2013 downturn
• By 2014 (5 years later), preference accreted to $35.2M
• Company sold in 2015 for $45M after 6 years
• Series C preference: $38.1M (from $20M original)
• Earlier investors got $6.9M
• Founders/employees got ~$0

What Happened: The 12% compounding dividend consumed 85% of the exit value, leaving almost nothing for common stockholders despite a $45M exit (2.25x the investment amount).

Negotiation Strategy¶

Never Accept:

• Cumulative compounding dividends above 8%
• Cumulative dividends that accrue in perpetuity (no cap)
• Dividends that are paid in shares (causes massive dilution)

Acceptable with Modifications:

✅ Cumulative with Cap: "Cumulative annual dividend of 8% shall accrue but shall not compound. Maximum total accrued dividends shall not exceed 40% of the original investment amount (i.e., capped at 5 years of accrual)."

✅ Cumulative with Conversion: "Accrued but unpaid dividends shall, at the Company's option, convert to additional shares of Common Stock at the then-current fair market value rather than being added to the liquidation preference."

Pushback Language:

"We're comfortable with a reasonable dividend provision, but cumulative compounding dividends create an exponentially growing preference that consumes exit value. We propose non-cumulative dividends or cumulative with a 5-year cap."

11.7 Dark Pattern #5: Broad Redemption Rights¶

Severity: IMPORTANT - NEGOTIATE HARD¶

What It Is¶

Redemption rights allow investors to force the company to buy back their shares at the original investment amount (or higher) after a certain period, typically 5-7 years.

Standard Formula:

Redemption Amount = Original Investment + Accrued Dividends
Redemption Timeline = Annual installments over 3 years (typical)

How It Harms Founders¶

Redemption rights create a "ticking time bomb" that can bankrupt the company:

Worked Example: The Forced Buyback

Setup:

• Series A: $10M invested with redemption rights starting Year 5
• Company growing but not profitable, has $2M in bank at Year 5
• Investor exercises redemption rights

Redemption Demand:

• Year 5: Pay back $10M (or $3.33M/year over 3 years)
• Company has $2M in bank
• Company cannot pay from operations ($500K annual profit)

Options:

1. Negotiate new financing: Raise money to buy out Series A (dilutive and difficult)
2. Force sale: Sell company to generate cash for redemption (investors get preference anyway)
3. Default: Fail to redeem, giving investors basis for lawsuits and potential control seizure

Impact: Redemption rights give investors a "put option" on the company. They can force liquidation or sale even if founders want to keep building.

When Redemption Rights Are Exercised¶

In practice, redemption rights are rarely exercised because:

• Companies rarely have cash to redeem
• Exercising triggers company sale, which achieves same outcome as redemption
• Investors prefer to wait for exit rather than force distressed sale

However, the existence of redemption rights creates leverage:

Negotiation Leverage:

• Investor threatens redemption to force down-round at favorable terms
• Investor uses redemption to pressure founder exit or sale to strategic buyer
• Investor exercises redemption to trigger board crisis and restructuring

Strategic Use: In acquisitions, redemption rights can be triggered deliberately to force seller to accept offer (buyer knows company must generate cash for redemption).

How It's Disguised¶

Investor Pitch: "Redemption rights are standard for preferred stock. They give us a path to liquidity if you don't go public or get acquired. Think of them as an insurance policy."

Reality: Redemption rights are NOT commonly enforced but exist as a weapon. They're more common in:

• Later-stage preferred (Series C+)
• Private equity investments
• Bridge rounds

They're less common and less accepted in:

• Seed and Series A rounds (getting pushback)
• Founder-friendly VCs

Misleading Language:

• "Optional redemption" (implies investor choice to redeem, sounds benign)
• "Redemption available starting Year 5" (hides the forced buyback nature)
• "Standard liquidity provision" (conflates redemption with normal exit rights)

Case Study: Vista Equity's Redemption Strategy¶

Vista Equity Partners (a growth equity firm, not VC) is known for using redemption provisions aggressively:

Reported Strategy:

• Invests in software companies with strong cash flow
• Includes 5-7 year redemption rights
• As redemption window approaches, Vista evaluates:
• If company performing well: Waives redemption, rolls into new preferred round at higher valuation
• If company underperforming: Threatens redemption to force sale or down-round recap
• Uses redemption leverage to push out underperforming management

Effect: Vista's redemption rights create a "decision point" forcing management and other investors to either:

1. Buy out Vista (difficult)
2. Sell company (Vista gets liquidity)
3. Accept Vista-favorable terms to extend redemption

Indian Context: Private equity firms in India (like TPG, KKR, Carlyle) sometimes use redemption provisions in minority growth investments. Indian founders should be aware this is PE practice, not typical VC practice.

Negotiation Strategy¶

Never Accept:

• Redemption rights triggered by anything other than time passage (e.g., redemption if milestones missed)
• Redemption amounts above investment + accrued dividends (some try to include return multiples)
• Immediate redemption (all shares at once), which could bankrupt company

Acceptable with Strong Limitations:

✅ Extend Timeline: "Redemption rights shall begin no earlier than Year 7 (vs Year 5) after investment."

✅ Require Supermajority Investor Vote: "Redemption may only be initiated by vote of at least 66% of the Series A holders (prevents single investor from forcing redemption)."

✅ Subordinate to Company Solvency: "Redemption shall only be exercised to the extent Company has sufficient surplus cash and such redemption would not render the Company insolvent under applicable law."

✅ Annual Installment Limits: "Redemption shall occur in equal annual installments over five (5) years, with no single year's redemption exceeding 20% of the total investment amount."

Complete Elimination (Best Case): "The Series A Preferred Stock shall not be subject to mandatory or optional redemption by the holders."

Pushback Language: "Redemption rights are unusual for venture-backed companies at this stage and create financial risk that could force premature sale. We're building for a large outcome, and redemption rights undermine that goal. We propose removing redemption rights entirely."

Compromise Language: "We'll accept redemption rights beginning Year 7, exercisable over 5 annual installments, requiring supermajority investor vote, and subordinated to Company solvency."

11.8 Dark Pattern #6: Excessive Founder Vesting Without Acceleration¶

Severity: IMPORTANT - NEGOTIATE HARD¶

What It Is¶

Investor imposes new vesting schedules on founder shares post-investment, treating founders like employees. Particularly problematic when combined with lack of acceleration provisions in acquisition scenarios.

Standard Founder Vesting (Acceptable):

• 4-year vesting with 1-year cliff
• Applies to shares issued at or after investment
• Single-trigger acceleration in acquisition (all shares vest upon sale)
• Double-trigger acceleration for termination without cause

Excessive Vesting (Problematic):

• Vesting ALL founder shares including previously vested shares
• 5-year or longer vesting periods
• No acceleration provisions (founders lose unvested shares in acquisition)
• Termination "for cause" includes minor issues

How It Harms Founders¶

Worked Example: The Acqui-Hire Trap

Setup:

• Founder has 3,000,000 shares (60%) fully vested at incorporation
• Series A investor demands all founder shares be subject to new 4-year vesting (starts over)
• No acceleration provisions
• Company acquired 2 years after Series A

Without Vesting/No Acceleration:

• Founder has vested: 50% of 3,000,000 = 1,500,000 shares (30% of company)
• Founder loses: 1,500,000 unvested shares
• Acquirer gets: 1,500,000 shares returned to company, diluting founder further

With Single-Trigger Acceleration:

• All 3,000,000 shares vest upon acquisition
• Founder retains full 60% ownership in deal

Impact: Without acceleration, founder's payout cut in half in acquisition. This discourages founders from accepting acquisition offers (misalignment with investors who want exits).

The Acceleration Mechanisms¶

Single-Trigger Acceleration:

• Vesting accelerates upon "change of control" (acquisition, IPO, asset sale)
• Protects founders: Ensures founder gets full value of shares in exit
• Investor concern: Founder might leave immediately after acquisition with all shares vested

Double-Trigger Acceleration:

• Vesting accelerates only if two conditions met: (1) Change of control, AND (2) Founder terminated without cause or constructive termination
• Protects founders: If acquirer fires founder, shares vest
• Investor preference: Prevents founder from leaving immediately post-acquisition while protecting against unfair termination

Partial Acceleration:

• Some percentage vests on single trigger (e.g., 50%)
• Remaining percentage vests on double trigger
• Compromise position

How It's Disguised¶

Investor Pitch: "Vesting ensures you're committed for the long term. It's how we protect the investment. We need to know you'll be here for 4 years."

Reality: Founders have already been working on the company for 1-3 years before investment. Restarting the vesting clock ignores their sweat equity and commitment. It treats founders like new hires.

Misleading Framing:

• Emphasizing "standard 4-year vesting" without disclosing it applies to already-vested founder shares
• Calling it "founder alignment" when it's actually "founder control"
• Not mentioning acceleration provisions at all (assumes founders understand to ask)

Case Study: Instagram Founders and Acceleration¶

When Facebook acquired Instagram for $1 billion in 2012, Kevin Systrom and Mike Krieger had standard vesting with acceleration:

Structure:

• Founder shares had 4-year vesting
• Single-trigger acceleration on acquisition
• All shares vested immediately when Facebook deal closed

Outcome:

• Systrom owned ~40% at acquisition, valued at ~$400M
• Because of acceleration, he received full $400M immediately (vesting didn't matter)
• He stayed at Facebook for 6 years by choice, not contractual obligation

If No Acceleration:

• Assume 2 years into vesting at acquisition
• Only 50% vested = $200M
• To get remaining $200M, would need to stay at Facebook for 2 more years
• If he left or was terminated, would lose $200M

Why It Matters: Acceleration protects founders from acquirer changing terms post-acquisition. Without acceleration, acquirer can fire founder immediately after close and keep unvested shares.

Negotiation Strategy¶

Never Accept:

• Re-vesting of previously vested shares without acceleration
• Vesting periods longer than 4 years
• No acceleration provisions at all
• "For cause" termination defined to include minor issues

Standard Acceptable Terms:

✅ Vesting New Shares Only: "Vesting shall apply only to shares issued after the Series A investment. Founder shares held prior to this investment are fully vested and not subject to this vesting schedule."

✅ Credit for Time Served: "Founder vesting shall be deemed to have commenced on the date of Company incorporation [or date founder joined], providing full credit for time and effort contributed prior to this investment."

✅ Single-Trigger Acceleration: "Upon a Change of Control, 100% of unvested shares shall immediately vest."

✅ Double-Trigger Acceleration (Minimum): "Upon a Change of Control, if Founder is terminated without Cause or resigns for Good Reason within 12 months following such Change of Control, 100% of unvested shares shall immediately vest."

Negotiation Priorities:

1. Primary: Get credit for time served (vesting starts from incorporation, not investment)
2. Secondary: Single-trigger acceleration in acquisition
3. Minimum: Double-trigger acceleration with broad definition of "cause"

Pushback Language: "We've been building this company for [X] years before this investment. Restarting vesting ignores our sweat equity and commitment. We propose vesting begins from incorporation date, with single-trigger acceleration to align incentives in an acquisition scenario."

11.9 Dark Pattern #7: Personal Guarantees¶

Severity: CRITICAL - WALK AWAY¶

What It Is¶

Investor requires founders to personally guarantee company obligations (debt, lease payments, or even the investment itself), making founders personally liable if the company fails.

Types:

1. Debt Guarantees: Founder personally liable for company debt
2. Lease Guarantees: Founder liable for office lease
3. Investment Guarantees: Founder must repay investment if company fails (rare but exists)
4. Performance Guarantees: Founder liable if revenue targets not met

How It Harms Founders¶

Personal guarantees eliminate the fundamental principle of limited liability that makes entrepreneurship possible.

Worked Example: The Unlimited Downside

Setup:

• Founder takes $2M Series A with personal guarantee
• Company also has $500K in venture debt (founder guaranteed)
• Company has office lease at $30K/month for 3 years ($1.08M total)
• Company fails after 18 months

Without Personal Guarantees:

• Company shuts down
• Creditors write off debts
• Founder walks away (limited liability)
• Founder can start new venture

With Personal Guarantees:

• Investor demands repayment: $2M
• Lender demands debt repayment: $500K
• Landlord demands remaining lease: $540K (18 months × $30K)
• Total personal liability: $3.04M

Founder Outcomes:

• If founder has personal assets: Bankruptcy, assets seized, credit destroyed
• If founder has no assets: Wage garnishment for years/decades
• Future entrepreneurship impossible (no capital, no credit)

Why Personal Guarantees Destroy Entrepreneurship¶

The entire purpose of the corporate form is limited liability—shareholders risk only their investment, not personal wealth. Personal guarantees:

1. Eliminate entrepreneurial experimentation: Founders won't take calculated risks if downside is personal ruin
2. Favor wealthy founders: Only founders with family wealth can absorb personal guarantee risk
3. Create perverse incentives: Founders may engage in risky behavior to avoid guarantee trigger
4. Violate venture capital principles: VCs are supposed to absorb downside risk in exchange for upside potential

When Personal Guarantees Appear¶

Personal guarantees are rare in venture capital but appear in:

Venture Debt (Common):

• Most venture debt providers (banks, specialty lenders) require personal guarantees from founders
• Can be negotiated away or capped if company has significant assets or VC backing

Bridge Loans (Problematic):

• Desperate companies accepting bridge loans from angels or non-traditional investors
• Often includes personal guarantees due to high risk

Real Estate Leases (Standard):

• Many commercial landlords require personal guarantees for startups without long operating history
• Can often be negotiated to cap at 12 months rent or eliminated after company reaches profitability

Never in Equity:

• Legitimate VCs DO NOT require personal guarantees on equity investments
• If a VC demands personal guarantee on equity, walk away immediately

How It's Disguised¶

Investor Pitch: "We need assurance you're fully committed. The personal guarantee ensures you have skin in the game."

Reality: Founders already have maximum skin in the game—they're dedicating years of their lives and foregone salaries. Personal guarantees are about transferring risk from investor to founder, not about commitment.

Red Flag Language:

• "Founders shall jointly and severally guarantee the Company's obligations" (unlimited liability)
• "Personal recourse to Founders in the event of Company failure" (direct guarantee)
• "Founders shall maintain net worth of $X to secure investment" (indirect guarantee)

Case Study: Stayzilla Founder Arrest (India)¶

Background: Yogendra Vasupal founded Stayzilla, a travel booking startup, and raised venture capital. The company also had contracts with vendors for services.

What Happened:

• March 2017: Stayzilla shut down after failing to achieve product-market fit
• Vendor filed complaint alleging Stayzilla owed ₹1.6 crore ($240K) for advertising services
• Vendor claimed personal guarantee from Vasupal
• Police arrested Vasupal under Section 420 IPC (cheating) based on alleged personal guarantee
• Vasupal spent 4 days in jail before being released on bail
• Case eventually resolved, but reputational damage and legal costs were severe

Controversy:

• Whether Vasupal actually gave personal guarantee was disputed
• Vendor alleged oral agreement; Vasupal denied
• Incident highlighted dangers of personal guarantees in Indian startup ecosystem

Lesson: Personal guarantees can expose founders to criminal liability in India (not just civil liability). Indian Contract Act and IPC provisions create unique risks.

Negotiation Strategy¶

Absolute No on Equity:

If any equity investor (VC, angel, family office) requests personal guarantee on the equity investment:

Response: "Personal guarantees on equity investments are not standard and fundamentally contradict venture capital risk-taking principles. We will not provide personal guarantees. If you require guarantee, this is not the right investment for us."

Walk away. This is a red flag about the investor.

Debt and Leases (Negotiate Hard):

For venture debt or leases, personal guarantees are more common but should be limited:

✅ Cap Amount: "Personal guarantee shall be capped at 12 months of principal and interest payments, not to exceed $500,000 in aggregate."

✅ Sunset Provision: "Personal guarantee shall terminate upon Company achieving positive EBITDA for two consecutive quarters or raising additional equity financing of at least $5,000,000."

✅ Joint and Several Limit: "Personal guarantees, if any, shall be several (each founder liable only for pro-rata share based on ownership %) and not joint and several (all founders liable for full amount)."

✅ Asset-Based Limit: "Personal guarantee shall be limited to identified assets (e.g., specific real property) and shall not extend to all personal assets or future earnings."

Complete Avoidance (Best Case): "Founders shall not provide personal guarantees. Company has sufficient assets and venture capital backing to support credit obligations without personal recourse."

Alternative Structures:

• Pledge company assets as collateral instead of personal guarantee
• Provide corporate guarantee from parent company (if flip structure)
• Offer higher interest rate or warrant coverage in lieu of personal guarantee

11.10 Dark Pattern #8: ROFR Abuse (Blocking Favorable Acquisitions)¶

Severity: IMPORTANT - NEGOTIATE HARD¶

What It Is¶

Right of First Refusal (ROFR) gives investors the right to purchase founder shares before founders can sell to third parties. While standard as a concept, ROFR can be structured to block founders from accepting favorable acquisition offers.

Standard ROFR (Acceptable):

• Investor has right to match third-party offer for founder shares
• Investor must match terms within 30 days
• If investor declines, founder free to sell to third party

Abusive ROFR:

• ROFR applies to acquisition of entire company (not just founder share sales)
• Investor can match acquisition offer, blocking sale
• ROFR extends to strategic partnerships or other transactions
• No time limit for investor to exercise ROFR

How It Harms Founders¶

Worked Example: The Blocked Exit

Setup:

• Strategic acquirer offers $50M for entire company
• Terms: $30M cash upfront, $20M earnout over 2 years
• Series A investor has ROFR on "any sale of shares"
• Investor exercises ROFR

ROFR Exercise:

• Investor matches offer: Pays $50M for entire company
• Strategic partnership benefits (distribution, technology) evaporate (investor is financial buyer, not strategic)
• Earnout structure changed (investor doesn't want earnout risk, renegotiates to $35M cash)
• Deal falls apart due to mismatch between what acquirer wanted and investor offering

Alternative Abusive Scenario:

• Investor exercises ROFR but negotiates worse terms
• Founder stuck with investor's inferior offer due to ROFR language preventing sale to original acquirer

The Strategic Acquirer Premium¶

Strategic acquirers often pay premiums for:

• Technology integration
• Customer base
• Distribution channels
• Team talent ("acqui-hire")

Financial buyers (VCs exercising ROFR) don't value these strategic elements. By exercising ROFR, investors can:

1. Block strategic sales and force financial sales at lower valuations
2. Capture strategic premium for themselves (buy at ROFR price, flip to strategic acquirer)
3. Prevent exits that don't meet investor return thresholds

How It's Disguised¶

Investor Pitch: "ROFR is standard. It prevents you from selling shares to unknown parties who might be problematic. It's for everyone's protection."

Reality: ROFR on founder share sales is standard. ROFR on company sales, strategic partnerships, or with blocking provisions is abusive.

Misleading Language:

• "Right of first refusal on any sale or transfer of securities" (sounds standard, includes company sales)
• "ROFR applies to any change of control transaction" (blocks M&A)
• "Investor may assign ROFR rights" (investor can give ROFR to affiliated fund who blocks deal)

Case Study: ROFR in M&A Negotiations¶

Brad Feld's "Venture Deals" describes a case where:

Scenario:

• Company received $100M acquisition offer from strategic acquirer
• Lead investor had ROFR on "any sale of securities"
• Investor exercised ROFR, offering $80M (claimed $100M offer overvalued)
• Founder challenged ROFR interpretation (does ROFR apply to entire company sale?)
• Legal battle ensued
• Strategic acquirer walked away due to uncertainty
• Company sold 18 months later for $60M to different buyer

Outcome: ROFR language destroyed $100M deal and resulted in $60M sale (40% reduction). Founder and early investors lost $40M in value due to ROFR abuse.

Indian Context: ROFR in Shareholders' Agreements¶

Indian shareholders' agreements commonly include ROFR provisions:

Companies Act 2013:

• Section 58: Private companies can restrict share transfers through Articles of Association
• ROFR provisions are standard in Articles and SHA

Standard Practice:

• ROFR applies to any transfer of shares by founders or investors
• Company and then other shareholders have right to purchase before external sale
• ROFR is waived for acquisitions where all shareholders participate (standard M&A)

Problem Areas:

• Vague language: "any transaction involving a change in control"
• No time limits for exercise
• ROFR extends to strategic partnerships or asset sales (beyond share transfers)

Negotiation Strategy¶

Carve-Outs to Demand:

✅ Exclude Company Sales: "ROFR shall apply only to transfers of shares by individual shareholders and shall not apply to acquisitions, mergers, or other transactions in which all shareholders participate pro-rata."

✅ Exclude Strategic Transactions: "ROFR shall not apply to strategic partnerships, joint ventures, or commercial arrangements that do not result in transfer of majority ownership or control."

✅ Time Limits: "Investor shall have 30 days from receipt of written notice to exercise ROFR. Failure to exercise within 30 days constitutes waiver."

✅ Match All Terms: "Investor exercising ROFR must match all material terms of the third-party offer, including price, payment structure, earnouts, employment terms, and strategic benefits."

✅ Limit Assignment: "ROFR rights are personal to the investor and may not be assigned without Company and founder consent."

Complete Elimination (Aggressive): "Founders shall not be subject to ROFR provisions. Only investors shall be subject to ROFR."

This is unusual but negotiable in founder-friendly rounds.

Pushback Language: "We're comfortable with ROFR on share transfers to prevent unknown parties from joining cap table. However, ROFR should not apply to strategic M&A transactions where all shareholders participate. We propose excluding company sales and strategic partnerships from ROFR scope."

11.11 Dark Pattern #9: Board Control from Day One¶

Severity: CRITICAL - WALK AWAY (Early Stage)¶

What It Is¶

Investor demands majority control of board seats at seed or Series A stage, giving them the power to fire founders or override strategic decisions.

Standard (Acceptable):

• Seed: 3-seat board (2 founders, 1 investor)
• Series A: 3-5 seat board (2 founders, 1-2 investors, 0-1 independent)
• Series B: 5 seat board (2 founders, 2 investors, 1 independent)

Problematic:

• Seed: Investor demands 2 of 3 board seats
• Series A: Investor demands 3 of 5 board seats (majority)
• Any stage: Investor demands sole authority to appoint independent directors

How It Harms Founders¶

Board control means operational control. The board:

• Hires and fires CEO
• Approves strategy and budget
• Approves material contracts
• Makes acquisition and fundraising decisions

Worked Example: The Premature Firing

Setup:

• Seed round: Investor gets 2 of 3 board seats (majority control)
• Founder struggling with product-market fit after 18 months
• Investor identifies external CEO candidate with "scaling experience"

Board Action:

• Board votes 2-1 to replace founder as CEO
• Founder opposed but overruled
• Founder becomes "Chief Product Officer" reporting to new CEO
• New CEO disagrees with product direction, founder marginalized
• 12 months later, founder leaves with no role

Impact: Investor control led to founder removal before company reached inflection point. Company may have succeeded with more founder patience, or may have failed anyway—but founder lost agency.

The Control Tipping Point¶

Board control shifts at different stages:

Seed/Early Series A:

• Founder control appropriate (founder building, experimenting, proving concept)
• Investor oversight through 1-2 seats and protective provisions
• Independent directors premature (company too early for governance overhead)

Series B/C:

• Balanced board (no party has majority)
• Independent directors provide tie-breaking function
• Investor influence grows as capital invested increases

Later Stage/Troubled Companies:

• Investor control may be appropriate if founder underperforming or company in crisis
• Board can recruit professional management
• Founder may continue as chairman, CTO, or depart

How It's Disguised¶

Investor Pitch: "We want to be hands-on partners. Having majority board seats ensures we can help guide strategy and prevent mistakes."

Reality: "Guiding strategy" means controlling strategy. Investor priority is protecting capital and generating returns, which may conflict with founder's long-term vision.

Misleading Framing:

• "Collaborative board structure" (disguises investor majority)
• "Experienced board oversight" (implies founder needs oversight from day one)
• "Bringing in industry experts to board" (those "experts" are investor appointees)

Case Study: Housing.com and Rahul Yadav¶

Background: Housing.com raised significant funding from SoftBank and others. Board composition gave investors majority control.

The Conflict:

• Founder-CEO Rahul Yadav known for erratic behavior (public letter insulting Sequoia, threats to quit)
• Yadav made unilateral strategic decisions without board approval
• Board-investor tension escalated through 2014-2015

The Ouster:

• July 2015: Board voted to remove Yadav as CEO
• Board composition: Investor majority (SoftBank, other VCs)
• Yadav opposed but had no voting power to prevent removal
• Yadav fired despite being co-founder and major shareholder

Outcome:

• Housing.com struggled post-Yadav, eventually sold to PropTiger (Elara Capital) in 2017
• Yadav received settlement but lost control of company he founded

Lessons:

1. Board control = power to fire founder, regardless of shareholding
2. Erratic founder behavior gives investors ammunition for removal
3. Once investors have majority board control, founder operates at board's pleasure

Was Removal Justified? Opinions differ. Yadav's public behavior was problematic, but some argue he was building a valuable company and board overreacted. The point: Board control gave investors unilateral power to make that decision.

Negotiation Strategy¶

Never Accept (Early Stage):

• Investor majority board control at seed or Series A
• Investor sole authority to appoint "independent" directors (nominally independent but actually investor-aligned)
• Board provisions allowing investor to increase board size without founder approval (dilutes founder seats)

Standard Acceptable Structures:

✅ Seed: 3 Seats

• 2 founder seats
• 1 investor seat (lead investor)

✅ Series A: 3-5 Seats

• 2 founder seats
• 1-2 investor seats (one per major investor if co-led)
• 0-1 independent (if 5 seats)

✅ Series B: 5 Seats

• 2 founder seats
• 2 investor seats
• 1 independent (mutually agreed)

Independent Director Selection: "Independent directors shall be nominated by the founders and require approval of both founders and [X]% of investors. Either party can veto a proposed independent director."

Or:

"Each party nominates one candidate. If parties cannot agree, a third candidate is selected by mutual agreement or through mediated process."

Board Expansion Protections: "Board size may only be increased by unanimous vote of existing board members, or by shareholder vote requiring [75%] supermajority."

Pushback Language: "At this stage, founder control of the board is essential for agility and experimentation. We propose a 3-seat board with 2 founder seats and 1 investor seat, with protective provisions giving you veto rights on major decisions. As we scale and raise Series B, we'll transition to a balanced 5-seat board."

11.12 Dark Pattern #10: Super-Voting Provisions for Investors¶

Severity: CRITICAL - WALK AWAY¶

What It Is¶

Investors receive shares with 10x, 100x, or even higher voting rights per share, while founders and employees have 1 vote per share. This inverts the usual founder control pattern.

Problematic Structure:

• Investors: Class A with 10 votes per share
• Founders: Class B with 1 vote per share
• Result: Investor minority ownership with majority voting control

Why This Is Backwards: Founders typically have super-voting shares to maintain control while raising capital. Investors receiving super-voting shares means they control the company with minimal capital commitment.

How It Harms Founders¶

Worked Example: Inverted Control

Setup:

• Investor invests $5M for 20% of company, receiving Class A shares with 10 votes each
• Founders own 80% of company with Class B shares with 1 vote each
• Total shares: 2,000,000 (investor) + 8,000,000 (founders) = 10,000,000

Voting Power:

Investor votes: 2,000,000 × 10 = 20,000,000 votes
Founder votes: 8,000,000 × 1 = 8,000,000 votes
Total votes: 28,000,000

Investor voting control: 20,000,000 / 28,000,000 = 71.4%
Founder voting control: 8,000,000 / 28,000,000 = 28.6%

Impact: Investor owns 20% economically but controls 71% of votes. Founders own 80% economically but have only 29% voting power.

Outcomes:

• Investor unilaterally controls all shareholder votes
• Investor can replace board, sell company, raise dilutive rounds
• Founder has no recourse despite majority economic ownership

When This Structure Appears¶

Super-voting rights for investors are extremely rare in venture capital but can appear in:

Down Rounds/Rescue Financing:

• Company desperate for capital accepts investor control terms
• Investors argue they're taking extreme risk and need control

Venture Debt/Structured Deals:

• Some lenders convert to equity with super-voting rights if company fails to meet covenants
• Structures from private credit or non-traditional investors

International Investors in Restricted Sectors:

• Rarely, foreign investors in restricted sectors negotiate super-voting to offset regulatory ownership limits
• Example: Foreign investor limited to 26% ownership but negotiates 5x votes to achieve effective control

Never in Legitimate VC:

• Standard venture capital does NOT include super-voting rights for investors
• Any VC proposing this is predatory

How It's Disguised¶

Investor Pitch: "Given the risk we're taking, we need assurance we can protect the investment through voting control. This structure ensures we can intervene if management underperforms."

Reality: This is a hostile takeover disguised as investment. Investors get control without paying control premium.

Red Flag Language:

• "Class A Preferred with enhanced voting rights"
• "Voting rights proportionate to risk undertaken" (implies investor risk > founder risk)
• "Preferred stock with 10 votes per share"

Negotiation Strategy¶

Absolute No:

Response: "We will not accept a capital structure where investors have super-voting rights. Founder control through voting rights is fundamental to our governance model. If you require voting control, you should acquire the company outright through a buyout, not invest as a minority shareholder with voting control."

Walk away. This is a complete red flag.

No Compromise Available:

There is no middle ground on this term. Super-voting rights for investors in a venture equity round are unacceptable.

Only Exception: If you're selling the company in a structured acquisition where buyer takes control, that's a sale—not an investment. In that case, governance transfers to buyer, which is appropriate.

11.13 Red Flags Summary: Severity-Rated Checklist¶

11.14 Action Items¶

1. Review existing term sheets against dark patterns checklist: For any current fundraising discussions, systematically check for each of the 10 dark patterns. Flag any concerning provisions.

2. Calculate liquidation waterfall scenarios: Model your current cap table across 5 exit values ($10M, $25M, $50M, $100M, $200M) to understand founder payout at each level. Identify "liquidation overhang" threshold where founders get meaningful returns.

3. Analyze anti-dilution impact: If you have or are considering anti-dilution provisions, model the dilution impact of a 25%, 50%, and 75% down round. Quantify the difference between weighted average and full ratchet.

4. Document all personal guarantees: List any personal guarantees you've given (debt, leases, contracts). Develop plan to eliminate or cap each guarantee as company scales.

5. Audit board composition and control: Map current board seats, appointment rights, and decision authorities. Project how board composition changes through next 2 rounds. Identify when founder control shifts.

6. Review vesting schedules and acceleration: Confirm vesting schedules for all founders and key employees. Check for acceleration provisions. If missing, negotiate to add acceleration in next round.

7. Examine ROFR and drag-along provisions: Review all ROFR, tag-along, and drag-along clauses. Ensure M&A carve-outs exist and thresholds are reasonable (>50% for drag-alongs).

8. Prepare investor references: For any investor offering predatory terms, request portfolio company references. Contact founders from their portfolio to ask about investor behavior in difficult situations.

9. Consult legal counsel on dark patterns: Have startup lawyer review term sheets specifically for these 10 dark patterns. Get written explanation of how each clause could harm you in adverse scenarios.

10. Build "walk away" alternatives: Develop alternative funding sources (venture debt, revenue-based financing, grants, customer prepayments) to avoid accepting predatory terms due to desperation.

11.15 Key Takeaways¶

• Dark patterns are legal provisions that shift risk asymmetrically toward founders while providing investors with downside protection beyond legitimate capital protection
• Full ratchet anti-dilution causes catastrophic dilution in even small down rounds; broad-based weighted average is standard protection
• Participating preferred uncapped enables "double dipping" where investors get preference + pro-rata share, capturing disproportionate value in mid-range exits
• Multiple liquidation preferences (2x, 3x+) create liquidation overhang where founders receive nothing even in substantial exits
• Personal guarantees eliminate limited liability and expose founders to unlimited personal financial ruin
• Investor board control from day one gives investors power to fire founders or override strategic decisions
• Term sheet red flags can be identified through severity ratings: 🔴 CRITICAL = walk away, 🟡 IMPORTANT = negotiate hard, 🟢 MONITOR = acceptable with modifications
• Even sophisticated founders can miss dark patterns because they're disguised through complexity, euphemistic language, or buried in dense legal documents

11.16 When to Call a Lawyer¶

Situations REQUIRING Legal Counsel¶

1. Any term sheet with unusual provisions: If investor proposes full ratchet, participating preferred, multiple preferences, or other dark patterns, immediate legal review essential
2. Down round or rescue financing: These situations create leverage imbalance favoring predatory terms; expert legal guidance critical
3. Complex preference structures: Multiple series of preferred stock with different rights require sophisticated waterfall modeling and legal analysis
4. Personal guarantee requests: Any request for personal guarantees demands legal review of limitations, caps, and alternatives
5. Board control disputes: If investors demanding majority board control or firing founder, legal counsel essential for understanding rights and options

Legal Costs (India)¶

• Term sheet review for dark patterns: ₹100,000-₹250,000
• Negotiation support for problematic terms: ₹200,000-₹500,000
• Liquidation waterfall modeling and preference analysis: ₹150,000-₹400,000
• Down round or rescue financing negotiation: ₹400,000-₹1,000,000
• Dispute resolution/litigation: ₹500,000-₹5,000,000+ depending on complexity

Recommended Law Firms¶

India: Trilegal, Khaitan & Co, AZB Partners, IndusLaw, Shardul Amarchand Mangaldas, Argus Partners (all have strong startup/VC practices)

US (for Delaware structures): Wilson Sonsini Goodrich & Rosati, Cooley LLP, Gunderson Dettmer, Fenwick & West

11.17 Indian Context¶

FEMA and RBI Implications¶

Several dark patterns create additional complications under Indian foreign investment regulations:

Down Rounds with Anti-Dilution:

• RBI pricing guidelines require foreign investments at or above Fair Market Value
• Down rounds trigger revaluation requirements
• Anti-dilution adjustments must be disclosed in FC-GPR filings
• Full ratchet anti-dilution may face RBI scrutiny if it results in pricing below FMV in subsequent rounds

Multiple Liquidation Preferences:

• CCPS (Compulsorily Convertible Preference Shares) are standard for Indian VC investments
• Multiple preferences (2x, 3x) are legal but create complex conversion calculations at exit
• Preference terms must be clearly documented in articles of association and shareholders' agreement

Participating Preferred in India:

• Less common in Indian term sheets than US term sheets
• When used, typically in bridge rounds or down rounds
• Requires careful structuring under Companies Act 2013 preference share provisions

Indian Case Law: Housing.com Board Control¶

The Housing.com case (discussed earlier) established important precedent:

Holding: Board of directors has authority to remove CEO under Companies Act 2013, even if CEO is founder and major shareholder, as long as board action follows proper process.

Implication: Board control = operational control in India as in other jurisdictions. Founder shareholding alone does not protect against board removal.

Protection Strategy: Maintain founder majority board seats or balanced board with founder-friendly independent directors.

Companies Act 2013 Personal Guarantee Limitations¶

Under Indian law, personal guarantees can expose founders to both civil and criminal liability:

Criminal Liability (Section 138 Negotiable Instruments Act):

• Dishonored checks can lead to criminal prosecution
• If founder gives personal guarantee backed by check, dishonor can result in imprisonment

Civil Liability (Indian Contract Act):

• Guarantors liable for contract breach
• Courts can attach personal assets to satisfy guarantees

Insolvency and Bankruptcy Code:

• Personal guarantors can be subject to insolvency proceedings
• Recent amendments bring personal guarantors under IBC provisions

Recommendation: Indian founders should be especially cautious about personal guarantees given additional legal risks compared to US founders.

11.18 References¶

1. Feld, Brad, and Jason Mendelson. Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. 4^th ed., Wiley, 2019.

2. Hoffman, Reid, and Chris Yeh. Blitzscaling: The Lightning-Fast Path to Building Massively Valuable Companies. Currency, 2018.

3. Metrick, Andrew, and Ayako Yasuda. Venture Capital and the Finance of Innovation. 3^rd ed., Wiley, 2021.

4. National Venture Capital Association. Model Legal Documents. https://nvca.org/model-legal-documents/

5. WeWork Companies Inc. S-1/A Amendment No. 1. SEC Filing, September 13, 2019. https://www.sec.gov/Archives/edgar/data/1533523/000119312519245394/d781982ds1a.htm

6. Lighter Capital. Case Studies in Venture Capital Terms. https://www.lightercapital.com/blog/venture-capital-terms/

7. Reserve Bank of India. Master Direction on Foreign Investment in India. Updated January 20, 2025. https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11200

8. Ministry of Corporate Affairs. The Companies Act, 2013. Sections 2(71), 43, 47, 55, 58. https://www.mca.gov.in/content/mca/global/en/acts-rules/ebooks/acts.html

9. Sequoia Capital. Sustainable Growth and High Growth: The VC Perspective. https://www.sequoiacap.com/

10. Harvard Business Review. "How VCs Can Improve Their Returns." November 2019.

11. TechCrunch. "The Truth About Liquidation Preferences." Multiple articles 2015-2024.

12. The Economic Times (India). "Housing.com: From SoftBank darling to cautionary tale." June 2015-July 2016.

13. Your Story (India). "Stayzilla founder Yogendra Vasupal arrested over payment dispute." March 2017. https://yourstory.com/2017/03/stayzilla-founder-yogendra-vasupal-arrest

14. Bar Council of India. "Indian Contract Act, 1872 - Sections on Guarantee." https://www.barcouncilofindia.org/

15. Cooley GO. "Understanding Liquidation Preferences." https://www.cooleygo.com/understanding-liquidation-preferences/

16. Fenwick & West. "Trends in Venture Capital Terms." Annual Survey 2015-2024.

17. Wilson Sonsini Goodrich & Rosati. "Entrepreneurs Report: Term Sheet Terms." Annual Reports.

18. CB Insights. "The Venture Capital Funnel Shows Odds Of Becoming A Unicorn." https://www.cbinsights.com/research/venture-capital-funnel-2/

Navigation¶

Previous: Chapter 10: Understanding Equity and Control
Next: Chapter 12: Board Dynamics and Governance
Back to: Table of Contents

Related Chapters:

• Chapter 7: Term Sheet Analysis
• Chapter 13: Down Rounds and Difficult Situations
• Chapter 25: When to Call a Lawyer

Disclaimer¶

This chapter provides educational information about startup funding and is not legal, financial, or investment advice. Every startup situation is unique. Consult qualified professionals (lawyers, accountants, financial advisors) before making any funding decisions.

Last Updated: November 2025