I wrote an original version of How Venture Term Sheets explode (and implode) quite some time back, and TechCrunch was gracious enough to publish it here. Then, the advice for a little while seemed obsolete in the go-go days from 2H’20-2H’21. VCs stopped doing much diligence, deals closed in days, and term sheets rarely exploded, or imploded.
But now we’re back full circle. In a tougher public market for SaaS companies, VCs are pulling term sheets again, and deals are also falling apart again after soft commitments. And it’s painful — but note it’s often not the VCs’ entire fault. At least, it’s never 100% either side’s fault.
Why do deals fall apart post-term sheet?
As it turns out, this happens a lot more than you might realize. First, understand that even with deals slowing down a bit, a lot of diligence is still done post-term sheet.
And deals can fall apart here, when the deal isn’t quite as it seems. VCs operate in one of two modes — greed or fear. As a founder, your job is to make sure nothing really comes up post-term sheet, but pre-closing that creates enough fear to trump the greed. Most importantly, minimize surprises. All startups have issues and challenges, and all deals have some “hair” on them. But finding out post-term sheet about too many material issues can lead VCs to run for the hills.
Remember — 99% of term sheets in venture are non-binding. You have to increase confidence once the term sheet is signed but before the money is wired. Not let it evaporate.
Here my checklist of the Top 10+ Issues that may lead a VC to pull a term sheet:
1. Missing your financial plan in the middle of a financing.
While startups have ups and downs, if you tell the VCs you’re going to hit $250,000 in revenue this month … make 100 percent sure you hit that projection. At least, just that one month during the funding process. This suggests any number of other undisclosed issues if you can’t even hit the projection you gave me two weeks ago. This happens all too often. And as frustrating as it may be to hear, it’s a fair reason in many cases not to proceed with a venture financing. Even if a term sheet is signed.
2. Venture-inappropriate debt and equity docs. And clean any quirky stuff up first.
Founder-friendly is still the name of the game today. But don’t push it into the Totally Non-standard territory, especially when it comes to convertible debt and SAFE-like instruments. For example, a super-aggressive term you sometimes see is that the company can buy out the investors any time for 1x before the next round. No VC is going to agree to that. Up to a point, everything can be negotiated. But if you seem too hard to deal with, if you push it too far — VCs will walk. Use standard, clean, fair deal terms and docs. And any odd stuff on the cap table, or existing terms — at least highlight them, and come with a solution.
3. Nondisclosure of loans and repayments of founder “debts” from proceeds, and/or other unusual payments to founders or other execs.
I don’t see this all the time, but I see it too often. At the last minute, a founder brings up that he wants to be repaid say, $150,000 in expenses from the round. Different VCs will have different views on this. But if you disclose it at the last moment, it can kill a deal. Fast. If you want to do this, disclose it up front and discuss it. Also, be aware VCs are a lot more sensitive to early and unusual founder secondary liquidity than they were in the Go-Go Days of 2021.
4. A stock option plan that is too small, without back-up or consultation.
These days, every founder is pushing for a small stock option plan. The real goal here is to push up the effective price by having the VCs “pay” for an increase to the pool after the financing closes. Sometimes that’s fine. VCs get it, and get how it works. But don’t disclose this at the last minute. Don’t force VCs to find out in due diligence that only 2 percent of the pool, not the customary 15 percent or so, is available for new hires. If you discuss this in advance, it can always be worked out. But you don’t want to argue about this at the 11th hour.
5. Too many founder vesting issues.
If you don’t have much founder vesting left, disclose it early. When it comes up in due diligence, again, it creates anxiety. VCs have different views here, but almost everyone wants you to have some portion of your founder equity still vesting. The best hack is to have just enough vesting that the VC won’t be thrilled, but can live with it. In any event, learning from your lawyers at the 11th hour that the founders are 100 percent vested creates anxiety and stress, and can kill deals.
6. Problematic customer due diligence; e.g., not disclosing customers are also investors, or ex-employees, etc.
VCs will ask you for customer references to call. If these customers used to work for you — disclose it! If these customers are your friends — disclose it! And if they are seed investing in the round (surprisingly common) — disclose it! VCs will discount the quality of the feedback from these customers, but making them find out during the calls will raise questions about your judgment.
7. Problematic on-site management due diligence.
There are often problems on the management team. That’s probably OK. VCs aren’t expecting that everyone on the team today can go the distance. But give your VCs a heads-up. If a VC is assuming you have a great VP of Sales, and it turns out the VC has to learn from talking to them that they’ve never done sales (this happens all the time) … again, that’s a big red flag as to your leadership skills. Identify the weaknesses on your team upfront. It’s OK — if you have a plan to make upgrades. If you don’t see these weaknesses though, that’s a red flag.
8. Who is the CEO?
This is surprisingly common in startups with more than two or three founders. Maybe Linda is nominally the CEO, but not really. Five folks are “in control.” Most VCs see this as a real issue, and will want it worked out before the financing closes. If they find out at the last minute that there isn’t 100 percent agreement as to who really runs the company, VCs may bolt. At the very least, it may bring a deal to a standstill until it can be worked out. Half of a VC investment is in the CEO. If you don’t know who that really is, it’s difficult to invest.
9. Highly suboptimal investor syndicate.
If it’s a party round, or at least, a group round … at least make sure the VCs in the round know who else is investing. Finding out at the 11th hour that the rest of the syndicate is unlikely to write another check can spook some VCs. VCs know we often have to put more money into the company to get over bumps and humps. If the rest of the syndicate can’t do that, and we’re the only one that realistically will write a second check … it may be OK. But again, finding out at the 11th hour can blow up the deal. Talk about the syndicate upfront, and get VC buy-in early, if you can.
10. Non-standard, “Us vs. Them” vesting.
Again, another late uncovered issue. You see things like the founders insisting on vesting acceleration if they are terminated for any or no reason. Or additional non-standard option grants if they hit certain milestones. Or full anti-dilution protection. The problem with non-standard vesting terms like these is that they clearly present an “us vs. them” mentality to VCs. That may be OK if you are Airbnb doing a round at $20 billion. But it can totally undermine trust in an early-stage deal.
In the end, it all boils down to trust. Even in the hottest of deals, post-term sheet, both sides need to continue to earn each other’s trust. After all, you probably haven’t known each other too long. VC investing is often like getting married after just one date. Avoid the rookie errors discussed here and you’ll still be walking to the altar.
And a few other related points that can kill deals:
11. Financials and metrics that aren’t quite accurate. Founders that are too aggressive, claiming deals that aren’t signed are “booked”, or “close to it”. Claiming unpaid pilots are paying customers. Confusing (intentionally) quarterly with monthly metrics. Just don’t do this stuff. It never helps in the end.
12. The rest of the team isn’t good enough. I see this more often these days. A charismatic CEO is able to get investors excited, but the CTO, and/or the rest of the team is just weak. Seed deals can be fast, and sometimes, the CTO and other team members aren’t really “diligenced”. But few things make me less excited about a deal that when I see an aggressive CEO — without a great CTO to ship the product. At a minimum, don’t cover up for weak team members. Be honest about everyone’s strengths and weaknesses. No VC expects everyone on the team to be strong. But hiding a key weak team member, talking for them, etc. That just spooks folks. Even me.
13. Nonstandard investors. A final note, traditional VCs and investors that do a lot of startup deals know the drill, the cadence, and the general set of terms. Outsiders generally do not. If you decide to take money from an investor with less experience in venture, just be aware they tend to fall apart a lot more often. And involve a lot more quirky terms, and more diligence on more points than most traditional tech investors do.
[And a few related posts on my top mistakes (here). Why VCs need Unicorns to survive (here). Why most VCs are actually failing (here). And even … why it’s OK to lose all your VCs’ money (here).]