VCs Charging Fees

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I got a question via email yesterday that I’d like to address and then add some additional thoughts on the topic of VCs charging fees to the companies they invest in.

Our startup company recently started seeking funding and the first firm we presented to has shown some interest. However, they have now sent us a Due Diligence Agreement and are requesting a "one time good faith due diligence payment of $9,000".

Is it standard industry practice to charge the entrepreneur a fee for the due diligence? We are obviously short on cash – paying $9k to every VC who shows an interest in us sounds counterproductive.

As I told the person who sent in this question, I believe most high quality venture capital firms would not request a due diligence fee as part of signing a term sheet. Most VC firms are paid a management fee by their investors that is designed to cover the basic due diligence efforts.

However, if there is some particular diligence issue that is not usual, like a dicey patent situation, some arcane tax issue, a lawsuit, some highly technical diligence that requires an expert to weigh in, I have seen and have even asked the company to cover those costs out of the proceeds of the financing.

Also, most VC firms ask the companies to pay the legal expenses associated with closing the transaction. Those fees are often taken out of the proceeds of the financing. I know of a few entrepreneurs, like my friend Steve, who find that very distateful and I certainly understand why, but it is customary and has been the industry practice for years.

So my point of view is this. You should not feel like you have to pay a fee to a venture firm to get a term sheet signed or even close a deal (like is customary in the buyout business). But you should be prepared to pay for the VC’s legal fees and if there is something unusual that the VC cannot get comfortable in the normal course, you may end up having to cover that cost as well.

All of this begs the question – what happens if the deal doesn’t close? If the entrepreneur raises a significant amount of money it’s not so hard to cover these fees. But what if the deal goes bad?  Who is stuck with the fees?  My feeling is that the VC firm should bear the cost if they walk away from a signed term sheet and the entrepreneur should bear the cost if they walk away. Of course there are times when it’s not even clear who walked away from whom. Fortunately, those are few and far between.

UPDATE: Click on the comments and read what Shivering Timbers has to say about this. He’s even more outraged by the request for $9k than I was.