Raising money will rarely proceed on schedule. A venture capital raise is like building or remodeling a house. It’s like developing a new version of software. Complex stuff doesn’t go as planned and is rarely completed on time or on budget. So when you finally get that fish on the hook and you land a term sheet, it may feel like it is time to take a sigh of relief, lift a glass, sit back, and relax.
Don’t do it, it’s a trap. You may think you have the fish on the hook but haven’t landed him in the boat. Don’t think that you’re dealing with toothless trout; that’s a shark on the other end of the hook. Sometimes you get the shark and sometimes the shark gets you….. or is that the bear? Bear, shark, skunk vulture, the species is really not the point, you get the idea…. you get the point; the struggle just begun.
There is going to be a lot of shark infested water flowing under the bridge between the time you sign your term sheet until the time you deposit the check. Due diligence is going to take longer than you think. Imagine yourself walking on one of those Indiana Jones-style, rickety, rotting swinging bridges over that shark invested water. You’re about to cross that bridge in the form of the “No Shop” clause.
When a VC tenders a term sheet to a company seeking funding, the no-shop clause commits the company seeking funding to shut down negotiations with any other investors. Agreeing to that clause means cutting off all other efforts to raise money, ending discussions with other VCs, and becoming totally dependent on this one prospective investor for cash.
So what’s wrong with that? Why is that a problem if the term sheet spells out the 1) proposed closing date, 2) valuation, and 3) the amount of money? What’s the catch you ask? Well, the catch is that those terms are only proposed and are all subject to change based on the results of the due diligence process and that the due diligence process will take longer than expected and will not come off without a snag.
It’s like when you sell a house. You get a contract contingent on a home inspection (due diligence). If the inspector finds that the roof is rotted and the heater needs replacing, the buyer will renegotiate the price or back out of the deal altogether. So imagine you’ve signed the agreement, and due diligence drags on and cash dwindles. Imagine that during diligence, the potential investor found some warts or “hair” on the deal.
Now, they want to renegotiate the valuation or other terms. What are you going to do? You’ve turned off all the other potential investors and your relationship with them has cooled. You need cash and the deal, and your options are now limited.
Before signing that agreement, you might want to look hard at your current cash and cash flow. What would happen if the close is delayed 30 days, 45 days, or even longer?
The fact is that unless you are unquestionably the next Google or Facebook, you’re going to agree to a no-shop clause. An investor isn’t going to dedicate the resources required for due diligence if you’re negotiating with other parties. So the no shop is a necessary evil. Before signing the term sheet, your deal is part of an open auction market; hopefully, it’s a seller’s market. Once you have a signed term sheet, the power shifts from seller to buyer.
One option you can negotiate into the deal is an expiration of the clause. So, take a stab at negotiating a 45 – 60-day time limit on the no-shop.
If you’re going to raise money, you will most likely be snared by the no-shop trap. If you have the cash to make it through a delayed and lengthy due diligence process, you will be better prepared to come out of that process as a well-funded company. If you enter it without the cash reserves, you may find yourself in the belly of a well-fed shark.
