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Quick Thoughts on Term Sheets and LOIs
This is something that isn’t that obvious to founders, so I thought I’d write a quick post.
When a VC invests in a startup, the two parties usually sign a term sheet that lays out the major terms of the investment round. This is usually followed by several weeks or longer of legal due diligence. 90%+ of term sheets result in a closed deal that is more or less equivalent to what was discussed. We have never signed a term sheet that we did not follow-through on, and that is not at all uncommon in venture investing. In almost all cases, when a term sheet doesn’t result in a deal, it’s because of the investor feels like there was some form of indiscretion on the part of the company, or something catastrophic has happened in the outside world or to the partner or fund itself.
In the M&A process, an LOI feels an awful lot like a term sheet. It is a simplified legal document that lays out the relevant terms of the transaction. Usually, the buyer seems very excited to get a deal done and shows a ton of conviction, just like the VC investor.
But LOI’s are not like term sheets. The close rate on LOIs is lower, and the frequency with which a deal is meaningfully renegotiated after an LOI is much higher. Also, you will realize that the minute you sign an LOI, you have lost all negotiating leverage with the other party. All LOIs have an exclusivity period, which means that you will turn off all your other options (and if you go back to them later, they will know it’s because a deal blew up). The acquisition probably means more to you than it does to the other party, so you will be negotiating from a place of relative weakness. Also, the loss of focus and legal costs will end up being a greater burden on you than the other party as well.
This tends to be true for the VC business too. What keeps this bad behavior in check is that VC investors know they are playing a multi-turn game. Any VC that is known to pull a term sheet will get blackballed by entrepreneurs, coinvestors, the media, etc. It’s really really bad business. As a result, most VC’s do most of their due diligence up front, and bring companies through a full evaluation and decision-making process before signing a term sheet. If you pull a term sheet for a weak reason, you look really bad in the industry, and you look really bad to your own partners because you have now tarnished the reputation of everyone in your firm because of your actions.
M&A is much less of a multi-turn game. Most companies aren’t that acquisitive, and a company’s reputation as a buyer is nowhere near as important to a normal company as it is to a venture investor. This is even true for private equity buyers too, who rely a lot less on the social currency that is created by a multi-turn game. As a result, you will find some companies that issue LOIs very quickly. As a founder, this is exciting, but it’s a big red flag. Once you sign the LOI, the company can really start to turn the screws on you, as that is when the due diligence and negotiation really begins.
How do you address this? Couple ideas. First, know that this is way more unpredictable the less active a company is. If you are talking to Microsoft, you should know more or less what to expect. If you are dealing with another company that does not have much of a track record of acquiring technology businesses, you know that you should be more wary. This is also a risk in financing rounds with investors that are unknown (foreign investors, groups that are starting to do early stage investing for the first time, unusual strategic investors, etc).
Second, don’t be too quick to get to the LOI. You want a buyer that is making a measured decision with the right information. It is entirely against your best interest to rush a buyer to sign an LOI with incomplete (or inflated) information. You want them to do the work to really get buy-in for a transaction while you still have leverage. Use that time to figure out where the power resides in the company, and whether you actually have the air cover required to make the deal happen on the terms discussed. And make sure you have options in case the deal does not come together.
Finally, think about including some sort of a break-up fee in the transaction. Very large deals usually have this, but smaller deals often don’t. A failed transaction often creates existential risk to an earlier stage company, so don’t enter into an agreement lightly, and find ways to manage these risks. Fred Wilson wrote a bit about this a few years ago: http://avc.com/2011/02/ma-issues-breakup-fees/
Any other ideas from folks who have negotiated this successfully in the past? Please include them in the comments.