Demystifying the VC term sheet: The investors’ option to walk

(Editor’s note: Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs. He submitted this column to VentureBeat.)

For the past few months, I’ve been exploring some of the more confusing terminology in VC term sheets.  In my last post, I discussed redemption rights.  Today, I’m looking at the non-binding and conditional language in term sheets. 

VC term sheets are non-binding –  With the exception of a few provisions, such as the “no-shop” provision and legal fees and expenses, VC term sheets are usually deemed to be non-binding.  This means investors may walk away from the deal at any time prior to the execution of the definitive agreements. SEOMoz co-founder and CEO Rand Fish offers an eloquent first person perspective on this in his blog post “Misadventures in VC Funding: The $24 Million Moz Almost Raised.”

VC term sheets are conditional – VC terms sheets are 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.”  In plain English, this means investors can 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 do investors get to do this? – It’s called the “golden rule” — he who has the gold, makes the rules.  Investors don’t want to be committed to putting money into a startup until they comfortable that there are no significant legal or business problems – and they’re 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? – 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.

Founders should also 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.)

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 pro-entrepreneur investors, like Fred Wilson, do not require no-shop provisions.

Founders should also button-down all 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 is failing to negotiate the material terms of their employment agreements in the term sheet (particularly the termination provisions).

And don’t forget to 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.

(Missed previous installments in this ongoing series?  Click to learn more about the following issues:)

• dividends
• price-based anti-dilution provisions
• exploding term sheets and no shop provisions
• valuation
• liquidation preferences
• stock options
• Board control
• protective provisions
• drag-along rights
• pay to play provisions
• conversion rights
• redemption rights

Startup owners: Got a legal question about your business? Submit it in the comments below or email Scott directly. It could end up in an upcoming “Ask the Attorney” column.

Disclaimer: This “Ask the Attorney” post discusses general legal issues, but it does not constitute legal advice in any respect.  No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  VentureBeat, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.