Are Exploding Term Sheets Fair To Startups?

Ever heard of an “Exploding Term Sheet” and wondered what the heck it is? Well, you already know that term sheets are a vital and intricate part of the dance that is done to invest in a startup. This dance usually takes place between an investor/ venture capitalist and a startup.

Term sheets lay out the foundation of any investment from the Investor or VC and are usually offered by the investor to the startup after a great deal of due diligence, presentations, and Q&A sessions.

However, these term sheets can be lopsided due to the nature of the situation …one group has money and the other wants a capital investment. The startup needs to go through due diligence, meet with the investors and answer a ton of questions. This process usually takes weeks or in some cases even months. In the end, the VC or investor issues a term sheet with the outline of the deal or declines to make an offer. The startup then gets their lawyers and maybe their Board Members to help them review and decide if it’s a “good deal”. Based on that they then sign the term sheet and move forward together or just forget it and see if a different VC/investor will offer better terms.

However, in recent years the “Exploding Term Sheet” has emerged. Imagine you are a startup and you’ve met with the VC and provided all the information they required, answered every question, and spent days putting together presentations to address certain concerns. Finally, the day comes that the VC/Investors decide to offer you a term sheet.

You and your team are sooooo excited until you find out it is an “exploding term sheet” and you have less than 24 hours to give them a Yes or No answer!

That might be an oversimplification, but the result is the same. After spending weeks answering questions and providing documentation you only have maybe 24 hours to give an answer. Does that seem fair?

Well, that depends. The VC / Investor might say that they spent an equal amount of time reviewing and analyzing all the data, getting to know the startup only to offer a term sheet and find that the Startup takes it and “shops it around” to other investors to see if they can wrangle a better deal. Or they use the term sheet to extract follow-on investment from their existing shareholders at a better valuation. Either way, the VC/Investor has wasted their time.

So, what is the right answer? Well, read a little further to learn more about exploding terms sheets and how it all works. Then make your own decision.

While term sheets aren’t exclusive to startup evaluations, they play a massive role that must be analyzed with their potential fairness to the startup. When a venture capitalist company gives notice of 24 hours or less to respond to their term sheet, that is a red flag for the startup.

With insufficient time to review the terms and consult with both lawyers and other stakeholders, startup founders may find they’ve doomed their startup to failure or worse created a situation where they can be squeezed out of their own company. Investors and VCs are focused on their own best interests first and foremost. They are a business that needs to make very good returns for their partners and limited partners. While many investors / VCs talk about being a true partner with a startup, that might not always be the case. It is up to the founders to stand up for and protect their company, even if it means turning down investments. Investors and VCs might tip you off to the type of partner they would be if they offer you an exploding term sheet.

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What Makes Up a Term Sheet?

According to Investopedia, a?term sheet?is a nonbinding agreement that shows the basic terms and conditions of an investment. The term sheet serves as a template and basis for more detailed, legally binding documents. Once the parties involved reach an agreement on the details laid out in the term sheet, a binding agreement or contract that conforms to the term sheet details is drawn up.

Initially, the most important thing to know is that a term sheet is essentially the contract before the contract. The term sheet itself is non-binding. Once both parties agree on the term sheet, however, the actual contract for investment or acquisition is drawn up following what the term sheet laid out.

Term sheets are effectively used all the time to broach financial subjects between startups and venture capitalist groups. It is industry standard when it comes to presenting anyone with an offer of investment.

Term sheets highlight important aspects of every deal without breaking down every single micro-detail out there. The goal of every term sheet is to have a general understanding between both parties on the business transaction. Inside the term sheet, there are specific components that companies want to give in writing to the other party to assure them of some standards of business and information about the startup.

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A Valuation

A valuation is an estimate of what a company is worth as an investment. These evaluations are usually made with current share prices and equity value involved in an equation to reach a number standard for the industry. The valuation is without a doubt a necessary piece of every term sheet.

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?????????Securities Being Issued

Any shares or securities that the investor is purchasing and terms are found in the term sheet. Also noted is the preference of any potential sale of the company or liquidation of the company. Some investors require a certain type of shares and this part provides for such a request.

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?????????Board Rights

The right of any investor to appoint or nominate to the company’s board of directors. Investors don’t usually ask to appoint the entirety of the board of directors, but they do hope to get a few of their people on the board. Within every company, the balance of power in the boardroom can get messy.

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?????????Investor Protections

Certain corporate actions requiring the approval of the investor are written down in the term sheet. Examples of this can be creating and issuing shares of the company. Additionally, this could include declaring dividends on shares, incurring debt, and buying back shares. Separately from the financials of the company, there could be hiring and firing decisions put down here. Also, there could be vital changes to the direction of the business that is written down in this part of the term sheet.

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?????????Dealing with Shares

The ability of a shareholder to sell shares or to acquire shares of the company is included in the term sheet. Also, the right of the company to force shareholders to sell their shares in an approved sale of the business is called for.

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?????????Other Provisions

There are other matters not specifically laid out in the previous parts of the term sheet. Certain matters such as the right of the investor to conduct due diligence before closing, the exclusivity of the current provision, and the compensation of the investors’ expenses.

You can find information on these sections of a?term sheet?in this blog by Espresso Capital.

All of these sections of a term sheet are by no means required to be written down in every version of a term sheet, but they are good guidelines of what to expect throughout a sample term sheet. Even the savviest and most experienced businessmen will allow for certain “tricks of the trade” of ambiguous statements to sneak into a term sheet, but this is why it is appropriate for each part of the transaction to take the proper time to talk things over with their lawyers and not rush to any signings for at least a week.

It takes a lot to review and negotiate the terms of a deal, so it’s not necessarily unreasonable to take a week or even more to review and “run the numbers”.

Both parties need to make sure this is the correct direction for them. They need to figure out all the legal details on their side of the transaction so there are no surprises when the actual contract is drawn up. They should also be wary of signing any contract without talking to those around them in the business and also outside of the business for proper perspective. A simple time limit of 24 hours does not lend itself to the proper handling of a term sheet. In fact, no decision can be properly made within this time limit because it puts the startup in a rush, which can easily lead to mistakes being made.

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A Term Sheet vs. An Exploding Term Sheet

We have explained that a term sheet is a document that lays out the terms and conditions of a potential investment in a startup (or any company). There is also another type of term sheet that is called an exploding term sheet. The?Law Dictionary?defines an exploding term sheet as an offer to a startup for an investment of a given size that includes a short time limit. It has a date it must be accepted by or the offer is null and void.

So both of these term sheets have mainly the same provisions inside them with one massive exception: the explosion. After a set time limit, oftentimes 24 hours, the offer and the term sheet metaphorically explode and is no longer valid for the startup to accept.

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Startups and the Exploding Term Sheet

The large looming question over all of this information is how these exploding term sheets affect startups and are they fair? The simple answer to this question is they are not fair to startups when assuming that the exploding term sheet expires within 24 hours. That is simply unreasonable. But why would anyone ask to get such a huge transaction completed in such a short amount of time?

According to?TechCrunch, the investors want to apply pressure. As a startup, you are very vulnerable when looking for investors. Most likely you have been searching for a while with no real offers materialized on the table. But all of a sudden, you get a real offer from a real venture capitalist company. The only problem is that you have to decide by the end of the day, effectively before you can talk to your lawyers or even to each other about the situation.

Anytime someone is using time as pressure to squeeze an impulsive decision out of someone, it isn’t fair. The investors in this situation have the power because they have the money to make another person’s dreams come true or be crushed. Because they hold this power, they recognize they can yield it in a nefarious way to perhaps push the startup into making a decision too quickly and thus, making a mistake.

It is difficult for a startup to simply say “No” to the only offer they have gotten, especially if it is a good one. But if they refuse to give you a legitimate timeframe so you can make sure this is the correct direction for your startup both financially and legally, then this isn’t a relationship that is going to bear fruit in the future.

Both parties need to be content with their decision without any potential cloud looming over their heads. It needs to be a fair term sheet that gives proper time for research, discussion, and decision making.

This is why it is always important to surround yourself with people who understand the business decisions that must be made and how they must be made. Also, this is a time when lawyers come in handy to review any tough terms that you aren’t familiar with. Taking time to fulfill the extra steps will only improve your chance of success down the road. Exploding term sheets won’t be the only time someone tries to take advantage of someone else with less power. Every company must have someone that can recognize this power grab and effectively stop it before it eats the company from the inside out.

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Conclusion

As previously stated, a term sheet is an agreement between a company and an investor, often a venture capitalist investor, that lays out guidelines, terms, and conditions for the investment in the company. Anytime a time limit is placed on the offer, then that is considered to be an exploding term sheet, which is extremely unfair to businesses at large.

The main issue with an exploding term sheet is the power dynamic that is placed over a startup company. The startup company has usually been desperately looking for any offer for their company, and in comes an offer from a venture capitalist group that expires before the end of the business day. The pressure this puts on the startup to accept it is immense, even if it provides for terms that the startup does not want to agree to. The pressure of losing this offer could cause them to make a bad business decision.

Raising capital for your startup/company is never easy. You need to be aware at all times since no one is there to do you any favors. Clearly, investors have the upper hand since you need their capital to move forward. However, there is nothing that says you need to be pressured into taking a bad deal. You need to think strategically and look at the long term when considering if you want to partner with a specific Investor or VC. Do you really want to be partnered with someone who only gives you 24 hours or less to make a major decision? It might foretell the kind of situation you will find yourself in with these investors down the road, but maybe investors that are pushing exploding term sheets are not the ones you want to partner with…

While it is so stressful to fundraise for your startup, the temptation is to make the investments and just deal with it. However, working with an investor is a true partnership, you want to find investment partners who are reasonable, enjoyable to work with, and bring more than just their money to the table. Investors that think exploding term sheets are a good idea might not be the best partner for your startup.

Originally Published on JonathanHung.com