What Are Exploding Term Sheets and No-Shop Provisions?

by Scott Edward Walker on February 9th, 2011

Introduction


This post originally appeared as part of the “Ask the Attorney” series I am writing for VentureBeat.  Below is a longer, more comprehensive version.  Please shoot me any questions in the comments section or, if you prefer confidentiality, via email at .

Question

We just got a term sheet from a VC and we were hoping you could help us understand certain timing provisions.  In the last paragraph, there is language about the term sheet expiring “at 5:00pm on the day following the date hereof if not accepted by the company prior to such time.”  Also, in a section called “No Shop” there is language that the company “shall not negotiate with or enter into any agreement with any other person…for a period of 90 days following the date hereof.”  We’ve been talking to a bunch of VC’s and don’t want to lock ourselves in.  Are these provisions customary?

Answer

As I noted in my post 7 Negotiating Tips for Entrepreneurs, in order to obtain negotiating leverage in any transaction, including a VC financing, you need to create a competitive environment (or the perception of one).  As a result, VC’s can be played-off of each other, and you can get the best possible terms.

No VC, however, wants to be a stalking horse.  If a venture capital firm offers you a term sheet, they want you to sign it — not shop it.  That’s why a term sheet will often include language about it expiring if not signed by a certain date – commonly referred to an “exploding term sheet”; and that’s why most term sheets include language prohibiting the company from negotiating with other parties for a period of time once it has been executed – commonly referred to as a “no shop” or “exclusivity” provision.  Let’s look at each of those in the context of your question.

Exploding Term Sheets.  An exploding term sheet like yours is a huge red flag.  What a way to start a relationship – a relationship that could last 5-10 years.  Basically, you’ve been given 24+ hours to sign the term sheet, which is ridiculous (and which I assume has already passed).  My advice is to just ignore this paragraph or, better yet, immediately call the VC and advise him/her that you’re going to need a little time to review the term sheet with your lawyer and to check references (i.e., to speak to a few of the CEO’s at the VC’s portfolio companies).

This will slow the process down in a respectful manner – and you should be diligencing your investors in any event (as I discuss in tip #1 of my post Doing Deals with the Big Boys: 10 Tips for Entrepreneurs).  If that creates a problem for the VC, I strongly suggest you find another VC.

No Shop Provisions.  I can understand that your VC doesn’t want to expend time and money for legal fees, etc. after the term sheet has been executed only to have you shop the deal to another VC; however, 90 days is way over the top.  You should push back hard on this and try to limit it to a few weeks (with 30 days being a reasonable compromise).

And if you have a lot of leverage (e.g., lots of VCs interested in your company), you may be able to knock this provision out entirely — like Michael Robertson, Founder of MP3.com, did in his deal with Sequoia a few years back.  Michael is a brilliant, serial entrepreneur and he discusses his no-shop provision in this recent video interview (starting at 44:38):

This is an important issue because if your VC walks away after you sign the term sheet (which happens from time to time), your company will be considered damaged goods and it will be difficult for you to find another investor.  Accordingly, if you get any indication that your VC is getting cold feet, you want to be able to move quickly to re-kindle discussions with other investors, if possible.

Moreover, the no-shop provision is not reciprocal – meaning your VC can be out in the marketplace talking to other startups while negotiating your definitive agreements and can walk away from your deal with no legal recourse.

Some pro-entrepreneur VCs, like Fred Wilson, do not require no-shop provisions.  Indeed, Fred noted 10 deal rules he follows in a relatively recent post.  Here is #4:

Don’t pressure the entrepreneur to make a decision. Don’t issue exploding term sheets. Don’t put no shops into your term sheets. Those kinds of things are signs of insecurity. I prefer to tell people that we’ll have an exclusive relationship when the deal closes and not before then. If someone wants to leave me at the altar, better it happens then than after we are married.

Those are the kind of VCs you should partner with, but they’re hard to find.

Conclusion

The big take-away here (which Michael also discusses in his video) is that every term is negotiable – no matter what anyone tells you.  That’s why creating negotiating leverage is so critical.

Tags: , , , , , , ,

« Newer Posts
Older Posts »

Comments are closed.