Should Term Sheets Include Break Fees?

There is little that can do more to sap a startup of energy, momentum and positivity than a failed fundraising and yet it happens all the time. Depending on where you are geographically, or maybe universally, early stage startups are often resource constrained and running on a short runway. Founders are tasked with the seemingly impossible task of building product, growing revenue, reporting to a board, motivating and managing the team just to name a few.

In my experience you have to pitch twenty or more professional investors in order to land one. Even pitching twenty professional investors is an achievement that generally doesn't happen without the help of a lead investor. So when the stars align and that terms sheet comes in it is only natural to be elated. It is also only natural to be concerned when the closing is delayed and angry when the terms sheet is not honored and replaced with something ruinous or investors simply walk away. In most cases the founders at this point are exhausted, demoralized, running out of money, doing layoffs and have a hefty legal to boot. Furthermore depending on the extent of the due diligence, you have also likley exposed sensative information about your company that you would not have shared with someone who is not an employee, founder or investor.

I believe happy founders are necessary you want an early stage startup to have a chance of surviving the long odds of providing a return to a venture fund. I should say you need founders that are happy enough because nobody gets everything they want and any well negotiated deal leaves everyone a little disappointed. Furthermore being a founder is really hard so you aren't goin to be happy all the time but you need to be happy enough in my opinion.

Despite the negative impact of a failed round and the damage it does to startups it happens ALL THE TIME. It happened to me and it's happened to most founders I know more than once. Why? I can't fully answer except to say that not all investors are equal. I've had a good experiences with most of the professional investors I've worked with but there are bad actors out there. Maybe someone just wants to look under the hood and kick the tires? Who knows but the hard it does a company is very real. I do know that getting a deal done is hard and there are legitimate reasons for deals to fall apart. So how can you help protect yourself and your company from the harm of a failed investment?

1. Work with an attorney you trust and heed their advice and expertise. I am not an attorney so don't take this as legal advice.
2. Ask around and know who you are dealing with. If you ask a contact and there is a red flag get more sources and detail.
3. Consider setting an automatic termination date of 30 or 60 days for due diligence and legal docs. This can be extended in writing but typically this isn't a good sign.
4. Avoid terms that require your company to pay investors legal fees unless it's contingent on a successful closing and be mindful of the total amount.
5. Consider a no-shop/break fee clause. Shopping a term sheet will likely go sideways on you quickly and generally isn't in good faith. However, since no-shop clauses are common in terms sheets and given the above, I think break fees should be as well. Now it's unlikely you'll get even a month of runway out of a break fee after legal fees and that isn't the point. The point of a break fee is to help protect the company and keep everyone working toward the successful close of the deal.

Now I know there are founders reading this right now rolling their eyes thinking "so you want me to run a marathon and then insist on red Gatorade or you don't cross the finish line?" Yeah I know. You are lucky to have a terms sheet and someone willing to back you and your company. That's huge and I know the validation and feeling when someone else believes in your company as much as you do. But don't let that prevent you from being smart in your negotiations. I guarantee you they will respect smart negotiations and likely be reassured in their investment decision if you handle yourself well.

Could I be wrong? Absolutely. And if you think I am please share your thoughts. It's a great time to be a founder right and I'm wishing you all good luck out there. If there is something you are struggling with or just want to jam please hit me up.

Cheers!