Monday, July 28, 2014

Why investors and entrepreneurs should ditch the "Term Sheet"?

"I just got a term sheet from a venture capital investor, I am so happy about the deal!", a friend gushed on phone. I said a customary congrats, and warned him, "Boss, money in the bank is equal to done deal, nothing else." Few months later, the VC went back on the investment, and the entrepreneur was back to square one, and maybe back to negative one.

I say ditch the term sheet - want to know why, read more.

YGO CAPTION THIS PIC - thanks for giving me money

Let me start with sharing what the investment process is for those who want to understand from AB initio. Entrepreneurs call/meet/pitch the VCs, who show interest in the idea/plan/project. Once the investors have enough confidence and intent to share their money with the entrepreneur for a share in their venture, they offer a term sheet - which in simple terms is a list of terms on which the deal will be further negotiated. Wait a minute, what did I tell you? More negotiations? Exactly.

After the term sheet is offered and signed by both parties, it takes nearly 2-3 months for due diligence, make final shareholder agreements and followed by amendments to MOA/AOA, few board resolutions, RoC filings before money hits the bank. In between, everything is negotiable - valuation, rights, Esops, budgets etc.

Now, ask me why term sheet is not a great idea:

1. Who makes money in term sheets
Except the lawyers who copy paste the term sheets, nobody makes money. Most VCs insist that entrepreneurs pay the lawyer who drafted it (irrespective of whether they will invest or not ultimately), while some with higher business ethics take the tab on themselves as a business expense. Further, additional money is spend on drafting shareholder agreements, and other documents. Neither the VC nor the entrepreneur makes money via term sheets.
2. Loss of time
One of the biggest frustration for startups is the time wasted in process of fund raising. Giving a term sheet buys time for the VCs, so they can lock the entrepreneur into exclusively dealing with them, without any legal or binding commitment to invest. Entrepreneur on the other hand cannot shop around (legally speaking, but most of them do ;-). Its like doing a ring ceremony 6 months before getting married.
3. 10-15 pages term sheet or 70-80 page shareholder agreement
Nobody signs a term sheet or shareholder agreement without looking at it personally and/or taking an expert opinion from their trusted/paid source. Why do it two times then? Though up front, it may seem that the deal is moving fast, with so many exchanges of documents, but ultimately deal is not done till it is done. I will love to negotiate and close a detailed document in single go rather than 2-3 stages.
4. What about due diligence?
Most VCs appoint their favorite CAs as a due diligence agency, which is supposed to find any business/auditing/technical issues in the target company. This process generally takes place between term sheet signing and shareholder agreement signing stage. Biggest issue is there no defined timeline for closing this process - most term sheets are live for 45-60 days, but imagine being an entrepreneur - after 75 days if you still have not got the money, what options you have? What would you want - initial exuberance with semi-commitment or a commitment to close the deal.

As a parallel instance, think of a train - you buy the ticket, turn up at the right time and occupy your seat after basic security checks. Now imagine taking a flight - you buy the ticket, go through 2-3 security checks, convert your ticket into a boarding pass (with a chance you will not be allowed to board). Given the recent airlines accidents, I do not want to recommend removing the security checks, but let your ticket be the boarding pass.

I dream of a day when we can have a stronger startup ecosystem with more quality and quantity of deals, but till then lets do what we are doing more efficiently, and keep building.

And at all times, be awesome!