Term Sheets: To be bound or not to be bound!
In January this year, one of my clients (a VC) came to me with a new investment mandate along with specific instructions to close the deal in 45 days. At that point it looked doable. The company being fairly young (8 months of operations), we did not expect any glitches. The term sheet stage was uneventful. In spite of our repeated requests, the entrepreneurs decided to proceed without a lawyer, assuring us that they are in the process of “shortlisting” law firms and will hire one in time for the binding investment documents. We did not want to take our chances, so we walked them through the term sheet and made sure that the entrepreneurs understood the implication of each and every term. They requested a few changes, and after some back and forth, the term sheet was signed in 10 days.
We initiated the legal due diligence, while simultaneously working on investment documents. Everything seemed to be progressing smoothly. We even managed to send them the investment documents in 5 days. Silence! Heard nothing from the entrepreneurs for almost 2 weeks and then we receive heavily marked up documents.
It reminded me of my chemistry answer papers in school. Where the red marks literally overshadowed my so obviously badly written answers in blue. On closer scrutiny, we learnt to our utter dismay that the entrepreneurs and their counsel had decided to change all the terms that they had agreed to in the term sheet. Every single one of them, except the name of parties and governing law (Yes, how kind!). When our client reached out to the entrepreneurs to understand the rationale for reneging on the term sheet, the entrepreneurs’ response was that “when we spoke to our lawyer, he was of the opinion that the terms were not in our favour. Hence we thought we should suggest changes”. Seriously!!! Lucky for the entrepreneurs, our client was a very patient VC. Most of the early stage VCs are. Deal terms were renegotiated. Some accepted, some rejected and finally the deal closed in June. From 45 days’ target to 180 days.
Well this is not the first instance where an entrepreneur has gone back and renegotiated deal terms. In the last 6 months, I have come across at least 5 instances where entrepreneurs have signed a term sheet and then reneged on the terms at the time of the binding investment agreements.
If you were to ask me, I would say that’s a bad idea! By reopening all the terms you had agreed to earlier, you not only push your fundraising timeline by at least a couple of months, but also create a negative impression with the investor at the potential start of a long relationship. Overall it leaves a bad taste in the mouth. From an investor’s perspective, it is extremely annoying and frustrating, because now they need to spend additional time and resources in re-discussing points that they had closed out with you, plus they have to explain to their investment committee the rationale for changing all terms in an agreed document.
Why would an entrepreneur do this? Everyone knows how important it is for an entrepreneur to have cash in bank at the earliest. I am sure, no entrepreneur wants to waste precious time being distracted by investment documents and negotiations, when they can be creating value in their ventures.
I think it is the term “non-binding” that is the culprit. You know how all term sheets start with the words “non-binding”. This makes the entrepreneur believe that the terms in the term sheet are not cast in stone and can be discussed again at a later stage. Hence, in their urgency to close out the term sheet, so that the investor proceeds with the innumerable other formalities, they just sign on the terms without probably understanding the implications of some of them. It is also for the same reason that they don’t hire a lawyer at the term sheet stage.
After all, lawyers will also delay the process! They therefore just read it themselves, consult a friend or family member and proceed.
Well, to all the entrepreneurs out there, please bear in mind that what the terms “non-binding” actually mean is that by executing a term sheet, an investor is not bound to invest in the company.
It is not a promise to invest, but, if the investor decides to proceed with the investment, then the terms as agreed in the term sheet will form the basis of such investment. The term sheet therefore sets the tone for the binding investment agreement and if you have agreed to any terms in the term sheet, it is expected of you not to renegotiate them later. Of course you are free to discuss, ask questions and negotiate in case of ambiguity in interpretation. Some digression from the term sheet is expected and acceptable, but not extensive.
It is therefore advisable to engage a lawyer at the term sheet stage. May cost a few thousand rupees extra but compare that to the value of delayed investments! I am sure when it is all done, you will agree it is money well spent!