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Term Sheet Terror: The Ghost of Deals Gone Wrong

July 29th, 2020

“I was talking with a VC recently about a ‘deal gone wrong’. They had agreed to a term sheet, and the VC digitally signed it. They waited a day or two but hadn’t heard anything. Apparently, the entrepreneur had some other interest, signed a different term sheet with another firm, and the round essentially got filled out without the VC knowing.”

Misunderstandings with term sheets seem to be a common occurrence among VCs and startup founders. And when that happens, one party typically backs out of a deal resulting in a missed opportunity, and sometimes even bad blood.

During a special DiffuseTap event, we were joined by Lance Dietz, Principal at KB partners, and Drew Whiting, Senior Counsel at Michael Best & Friedrich, who shared their own term sheet terror tales from both sides of the table. DiffuseTap is a weekly virtual event hosted by Diffuse that is part networking (you’ll meet at least a half dozen high calibre startup players) and part purposeful (you’ll DiffuseTap new ideas). If you’re interested in making new friends from our VC ecosystem, feel free to contact us.

Horror stories and deals gone wrong

Poor handling of term sheets is often the reason why parties back out of a deal, and misunderstandings are commonly at the crux of it. Drew, who has been counselling companies for almost a decade, shared one story from his own experience:

“We had one deal with a VC out in California that was quick with a term sheet on their existing lead, and they were coming in to lead the next round. And after the term sheet was fully negotiated – it’s out via DocuSign – the VC was re-trading some major terms at the 11th hour, claiming they didn’t know about certain things, when they had a representative on the board of directors. It just created some bad blood with the company, and ultimately the person that was handling that for the VC ended up getting some blowback internally on their side, because of the optics of how that went down.”

The same thing happens on the founder’s side, as well. More often than not, first-time entrepreneurs might find it difficult to fully understand the nuances in a term sheet, especially when they are not able to have an honest discussion with the VCs that are courting them. This often leads them to sign it haphazardly, only for grave misunderstandings to surface later on.

“Those are problematic situations and can burn bridges that you don’t want to burn,” Drew said.

What NOT to get wrong in a term sheet

With that in mind, what is the most important part to get right in dealing with a term sheet? Lance answered with a good example:

“Once, we had a situation in which, after a fantastic few weeks of getting to know a startup and the founding team, we issued a term sheet to the company. The founders were really excited, as were we, and quickly agreed to the deal verbally, probably without having fully understood the entirety of the term sheet. I think there was some miscommunication/misunderstanding regarding certain terms, even though both sides were excited about working together. The deal lost momentum, unfortunately, and we weren’t able to finalize it. Both parties were disappointed but also respected the needs/priorities of the other in trying to get a deal done.”

Thus, Lance explained that the most important part is making sure that both parties have a clear understanding of what they’re agreeing to. Potentially walking through various parts of the term sheet, discussing the economic and control items (and the rationale for those), could be helpful. Using advisors and counsel to get feedback on the term sheet in a timely manner is also worthwhile.

“Being open, clear, and communicative is the best practice, and realizing that you’re looking for the best partnership, not necessarily just the highest valuation. How VCs and founders think about managing that relationship starts before and during term sheet talks/negotiations, in my opinion.” Lance shared.

What causes a misunderstanding

Company founders have all the resources in the world available to them to learn about term sheets and yet, misunderstandings are still very common. Why is that?

Two reasons come to mind, according to Drew. One is that typically, founders that are extremely passionate and competent in their subject area want to leave the parts that are outside of their purview to others. And when they don’t get help before they sign a term sheet, it becomes a problem.

Another reason for this comes from a psychological standpoint. Drew argues that from what he’s seen, entrepreneurs sometimes have a tendency to avoid asking about parts they’re unsure of and avoid having those difficult discussions in fear of being judged.

“I think some of the reasons for why people do that are psychological. It’s avoidance anxiety, they don’t want to sound stupid. They’re afraid that if they ask a question about something, it might look like they don’t know what they’re doing. And they may not have people around them that are giving them good advice as well, that could be it also. At the very early stages you see a lot of that,” Drew explained.

Drew Whiting is a Senior Counsel at Michael Best & Friedrich, where he advises high-potential venture-backed companies and the angels, family offices, and funds behind them. Lance Dietz is a VC Principal at KB Partners, a Chicago-based venture firm that invests in passionate innovators at the intersection of sports and technology.

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