“Once the term sheet is signed, the power shifts away from the startup to the purchaser. The typical term sheet will give the purchaser the discretion to step away from the deal if due diligence is unsatisfactory, or if the necessary internal approvals are not obtained.”

Suzanne Dingwall Williams, on M&A

“… there is a wide range of behavior among VCs—the group that doesn’t put a term sheet down until they are committed are at one end of the spectrum; the group that puts down a term sheet to try to lock up a deal while they think about whether or not they want to do it is at the other.”

Brad Feld

Summary: Complete business diligence and prepare for legal diligence before you sign a term sheet. Signing a term sheet early is a recipe for a hostage negotiation.

A reader asks:

“Our term sheet says ‘any obligation on the part of the investors is subject to satisfactory completion of due diligence by the prospective investors.’ How much diligence should we do before signing the term sheet?”

Whether or not your term sheet includes this term, complete business diligence and prepare for legal diligence before you sign a term sheet.

Signing a term sheet early is dangerous.

Signing a term sheet, with or without a no-shop agreement, while an investor is still conducting business diligence, is a recipe for a hostage negotiation:

You sign a term sheet, let other investors know, and go off the market while your prospective investors do diligence. After 2-4 weeks, your prospective investors say, “Uh, yeah, the results of diligence weren’t so good, we’ll still do the deal but with these (worse) terms instead.”

While you’ve been off the market, your prospective investors have been creating alternatives by looking at other companies. Every company that is raising money, not just your competitors in the marketplace, is competing for your prospective investor’s time and money. Meanwhile, the market your created before signing a term sheet has dissipated.

Even if you turn down these worse terms and approach new investors, you will have to explain why you walked away from a signed term sheet. So, before you sign a term sheet, complete business diligence and prepare for legal diligence.

Complete business diligence.

Business diligence is whatever your investor needs to make his investment decision. Some firms complete business diligence before they offer a term sheet. Other firms offer term sheets before they complete business diligence because they want to lock out the competition while they evaluate the company.

Determine whether business diligence is complete by asking:

  • Has this investment been approved by the entire partnership? Are any other approvals required?
  • Why do you want to invest?
  • Have you done your references? (And have we done our references?)
  • Are there any other steps besides legal diligence once we sign the term sheet?
  • When was the last time you or your partnership signed a term sheet that didn’t close? Why? How many times have you not closed a term sheet in the last five years? Why?
  • Do you agree with our plan for the next two/three/four quarters?
  • How quickly can we close? Under what assumptions are we coming up with this date?

Prepare for legal diligence.

After you sign a term sheet, investors conduct legal diligence, looking for reasons to not invest or reasons to revise the terms.

Legal diligence,

  1. Confirms whether your claims are actually true, e.g. your annual revenue actually is $10M.
  2. Uncovers important facts you didn’t mention, e.g. you’re being sued.
  3. Completes tasks you should have done earlier, e.g. all employees sign NDAs.

Before you sign a term sheet, help your prospective investor eliminate most reasons to not invest by,

  1. Telling the truth. (Duh.)
  2. Disclosing everything.
  3. Working with your lawyer to sign the agreements you need to sign. (If you can afford it.)
  4. Asking your prospective investor, “What diligence remains once we sign the term sheet? Which items can we complete before we sign the term sheet?” Document these items in an email to your investor. This email is normative leverage in case the list suddenly gets bigger during closing.

Desperation is no reason to rush into a term sheet.

You: “It must be great to complete diligence before signing a term sheet—but we’re desperate for money right now.”

Venture Hacks Shift Manager: That’s the worst reason to rush into a term sheet. Signing a term sheet before completing business diligence makes you more desperate, not less. A term sheet with or without a no-shop takes you off the market, dissipates your market, and places you at the mercy of your prospective investor.


Image Source: McDonald’s.

Topics Auctions · Closing · Due Diligence · Term Sheet

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