Five Ways to Reduce Your Risk
The first time your startup’s presented with an investor term sheet, you may feel like you’ve won. OK, maybe you don’t have the trophy (i.e., check) in hand, but you’re on the home stretch with the wind at your back.
Right?
Maybe not.
Getting Engaged
A term sheet is like a marriage proposal. It shows that an investor is seriously interested in your company. But it’s a proposal that comes with more terms and conditions than a Christian Grey NDA.
One potentially problematic term is the “no-shop” clause. It might read something like this:
From the signing date hereof until 5:00 P.M. on the date 30 days following the signing of this document (the “Exclusivity Period”), the Company agrees that it will not directly or indirectly pursue, solicit or participate in the negotiations, or enter into any agreement or commitments regarding investment by any other potential equity investors in the Company or any merger or sale of all or substantially all of the assets or stock of the Company…
(A “no-shop” can also be called an “exclusivity” clause.)
Here’s what a no-shop clause looks like when flagged by LawGeex:
Basically, this clause means you won’t date anyone else while you’re engaged – as a start-up founder, you won’t shop the company around to other potential investors after you sign the term sheet.
This makes sense from the perspective of an investor who’s about to conduct due diligence – confirming that you’re worth investing in. If you’re just going to use the first term sheet as “bait” to attract a better offer, then you’re wasting the first investor’s time and money.
That sounds reasonable, right? It’s also very common. No-shop clauses show up in almost all of the term sheets in our database.
So what’s the problem?
Off the Market
The problem is that if this first investor doesn’t close the deal, you’ve taken your company off the market for X number of days.
The bigger the “X,” the bigger the problem.
If multiple investors are vying for your deal (a good problem to have!) one or more may push you to sign a term sheet before they even know much about your company. The no-shop clause gets the others out of the way while the first investor checks you out.
That first investor may be serious, or may just have a bad case of FOMO. Either way, once you sign that no-shop you’re vulnerable.
While the clock’s ticking, you may be running out of money. Any other investors who were circling may move on to fresher meat. Whatever “heat” you had may dissipate.
Meanwhile, due diligence is proceeding. The investor’s kicking your tires and checking under your hood.
If your tread’s worn or you’ve got an oil leak (for example, your IP ownership is iffy or your cash-flow projections don’t check out), the investor may want to renegotiate the company value or other terms.
But wait, you say. We had a deal – the valuation’s stated in the term sheet!
But a term sheet usually isn’t a firm commitment to invest on those terms. The investor can just walk away. You, on the other hand, are bound by the no-shop — and breaching it can get you sued.
Reducing the Risk
If the deal doesn’t go through, even if there’s nothing really “wrong” with your company you could be seen as “damaged goods” that an investor has passed over. So you want to maximize the chances that the first deal will go through, while minimizing the harm if it doesn’t.
If you have to sign a no-shop, what can you do to reduce your risks?
Here are some ideas:
- Make the no-shop term as short as possible. Try to negotiate it down to two-to-four weeks, rather than six weeks or longer. Our research has shown the typical no-shop period is between 45 and 60 days.
- Have the no-shop period start (or only sign the term sheet) after the investor has started legal and accounting due diligence by hiring a law firm and/or accounting firm. An investor with skin in the game is less likely to waste your time.
- Have a clause that says the no-shop period will end if the investor stops negotiating or conducting due diligence for a specified period. You don’t want to be off the market if the investor isn’t moving the deal forward.
- Only agree to pay the investor’s legal fees if the deal actually goes through. Otherwise, you’re triply screwed if it fails: a) you don’t have the investor’s money, b) other investors have gone away, and c) you’re stuck with a big legal bill. (Note that this applies whether or not you have a no-shop clause.)
- Do your own due diligence on the investors before signing the term sheet. Make sure they actually have the money and don’t have a history of “fishing expeditions” and walking away from deals.
Understand Your Term Sheet
You probably don’t want to negotiate (or sign) a term sheet without the help of a lawyer – there’s too much at stake. But with fast feedback at blog.lawgeex.com you can:
- Understand the term sheet better
- Get legal terms explained in plain English
- See which terms are standard – or not
- Compare your term sheet to our database of many others
Just click the link on the right and upload your term sheet now.
The information and materials in this blog are provided for general informational purposes only and are not intended to be legal advice.
