VC Term Sheets – Investors’ Option to Walkby Scott Edward Walker on September 14th, 2011
This post originally appeared in the “Ask the Attorney” column I am writing for VentureBeat; it is part of my ongoing series regarding venture capital term sheets. Here are the issues I have addressed to date:
- common mistakes dealing with VC’s
- liquidation preferences
- stock options
- exploding term sheets and no-shop provisions
- anti-dilution provisions
- Board control
- protective provisions
- drag-along provisions
- pay-to-play and pull-up provisions
- conversion rights
- non-contractual rights
- redemption rights
In today’s post, I examine the non-binding and conditional language in term sheets.
The Investors’ Right to Walk
VC Term Sheets Are Non-Binding. It is important for founders to understand that VC term sheets are usually deemed to be “non-binding” (other than perhaps a few provisions, such as the “no-shop” provision and legal fees and expenses). What does this mean? It generally means that investors may walk away from the deal at any time prior to the execution of the definitive agreements. Indeed, this is what recently happened to SEOMoz, as Rand Fish (its co-founder and CEO) eloquently describes in his post, “Misadventures in VC Funding: The $24 Million Moz Almost Raised.”
VC Term Sheets Are Conditional. In addition to being non-binding, VC terms sheets are also expressly subject to certain conditions being met (so-called “conditions precedent”). For example, most term sheets will provide that they are “conditioned upon the completion of due diligence satisfactory to the investors.” What does this mean? It means that investors may walk away from the deal at any time prior to the execution of the definitive agreements if a specific condition (such as satisfactory diligence) has not been met.
Why Are Investors Granted This Option to Walk? It’s called the “golden rule” — he who has the gold, makes the rules. From the investors’ perspective, they do not want to be committed to invest in a startup until they are comfortable that there are no significant legal or business problems; and they are generally not going to expend the time and money to determine if there are significant problems until the startup has committed to them (that is, by agreeing to a “no shop”).
What Are the Key Issues for Founders? There are a number of issues founders should focus on regarding the non-binding and conditional aspects of term sheets.
First (and needless to say), founders should do extensive due diligence on the investors prior to executing a term sheet to ensure that they are dealing with trustworthy and reputable investors (both the firms and the individuals involved), and that there’s no history of them walking away from deals. I have previously discussed this issue in detail, and the importance of choosing solid investors, in my post “Doing Deals In The New Decade: 7 Tips For Entrepreneurs” (see tip #1).
Second, founders should only agree to pay the investors’ legal fees and expenses if the deal actually closes. Otherwise, if the investors choose to walk, the company is on the hook for both the investors’ legal fees and the company’s. (Talk about a nightmare – no deal and a pile of legal fees.)
Third, as previously discussed, founders should push hard to knock-out the no-shop provision so that they can move quickly if they think their investors are getting cold feet — and talk to other investors that they have hopefully kept “warm” on the sidelines. Indeed, some very pro-entrepreneur investors, like Fred Wilson, do not require no-shop provisions (see rule #4 in Fred’s post “Competing To Win Deals”).
Fourth, founders should button-down all of the key issues in the term sheet. Once a startup has executed a term sheet, it has lost all of its negotiating leverage. A common mistake founders make is not negotiating the major terms of their employment agreements in the term sheet (particularly the termination provisions).
Fifth, founders should push to knock-out any unusual conditions. Keep in mind that investors have an implicit duty to negotiate in good faith. Accordingly, even though the term sheet is “non-binding,” a Court will hold investors liable if they have acted in bad faith (not to say that suing your prospective investors is good business). This is why it is important to limit the number of conditions in the term sheet and to ensure that they are narrowly drafted.
Finally (and this will only work if the founders have extraordinary leverage), founders should add an expense reimbursement or “reverse break-up” fee to the term sheet requiring the investors to reimburse them for their expenses (including legal fees) and/or pay liquidated damages in the event the investors walk through no fault of the company. This is common in the M&A world and hopefully will find its way into VC term sheets.
I hope the foregoing is helpful. If you have any questions, please feel free to call me directly at 310-288-6667 (Los Angeles) or 415-979-9998 (San Francisco). Many thanks, Scott