The “Pulled” Term Sheet

A reader asked me an interesting question via email today that I thought I’d answer out loud on this blog.

He told me that he has a signed term sheet with a VC (congratulations to him) and asked if it is common for a VC firm to "pull" a term sheet.  This means that the VC firm decides, after signing a term sheet with a company, that it does not want to close the transaction.

Is it common?  No, not common.

Does it happen?  Yes, it does.

And for many reasons.  Some good, some bad.

We were taking a bit about this issue in our office yesterday.  When do we feel comfortable signing a term sheet with a company? 

Well, it depends. 

On an investment where we have a lot of market and product due diligence to do, we would not be comfortable signing a term sheet before we completed that work.  The same is true with background and reference checks on a management team we don’t know well.

On an investment where we really understand the market, the product/service, and know the team well, the diligence is primarily double checking the facts as described to us by the entrepreneur.  In this situation, we would move more quickly to a term sheet.

I guess that’s a roundabout way of saying we don’t want to mislead an entrepreneur by signing a term sheet when we still have concerns about the opportunity.  If we are sold on the opportunity and just need to do our own third party verification work, we’ll move more quickly because if there is a surprise, it means the entrepreneur misled us in some way and then a "pulled" term sheet is a fair and reasonable thing to do.

The other thing that leads to "pulled" term sheets is a hot deal or a hot market.  If a company is out raising capital and there are a lot of interested investors, the investors have an incentive to get a signed term sheet to "lock up" the deal.  In that instance, it is often the case that a VC firm signs a term sheet well before they have been able to do the required work.  And then they get in and do the work and find out they don’t want to do the investment or want to do it on different terms.

This is a bad thing for everyone involved.  So my advice in these situations is for the company to cool the situation by forcing the investors to get their work done before signing a term sheet.  And that may be hard advice to follow when the investor is waving the term sheet at an attractive price in the entrepreneur’s face. 

But I think it’s important for the entrepreneur to have confidence that a term sheet will get to close.  The best way I know to insure that happens is to wait until the VC firm has done its work and is completely comfortable with the investment before signing the term sheet.

It is not a bad idea for the entrepreneur to ask for a term sheet from the VC firm to understand the basic terms of the deal and then to sit on it while the VC firms does its work.  This can work to both sides’ advantage.  They both understand where the deal will get done but the commitment is not formalized until the work is completed.

There are also issues around "no shop" clauses in term sheets that are worth discussing.  Some term sheets require that the entrepreneur stop talking to other investors.  Some term sheets do not have this provision.

In my opinion, it is a sign of good faith on both sides to have a "no shop" in the term sheet.  But it means that both sides, including the VC firm (even though the "no shop" is only an obligation of the entrepreneur), are serious about getting to a close.

Even if the term sheet doesn’t have a "no shop" in it, the reality is that the entrepreneur is going to have their hands full getting a deal closed and is not likely to want to shop the deal around during that process.

So I think "no shops" are mostly just words to describe what is going to happen with or without them.  Term sheets are made to be taken seriously by both sides.  They should not be waved around like flags.  And they should not be signed without a serious committment by both sides to get the deal done.