The Case of the Verbal Term Sheet

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HEIDI: Welcome to The Startup Solution and "The Case of the Verbal Term Sheet." I’m Heidi Roizen from Threshold Ventures.

I was going to talk about something else today, but then I got a message that kind of lit my fuse – so I’m going to talk about that instead. The message was from a friend of mine that I’ll call Rudy, who said a bunch of things about his seed fundraise that didn’t sit right with me.

. . .

RUDY: Hey Heidi, I just wanted to let you know I have some really good news from this weekend. One of the investors just reached out to me out of the blue and said that he is interested in taking the whole round. It will be like 40% dilution on our side. He wants to be exclusive, so what he’s saying is that right now, he’s giving me the verbal term sheet. But if I can make sure he’s the only one in the round, then he’ll give me the real term sheet. So, now I’m wondering if I should reach out to everyone else who is interested and follow up and see if they have any final counters to this. If not, I’m just ready to wrap this up. It has been a long process. I’m ready to get done with this and get back to building the product and working on the science and the tech. So, let me know what you think.

. . .

HEIDI: There’s so much I don’t like about this message I barely even know where to start! But let’s start with this – there’s no such thing as a verbal term sheet. That doesn’t mean anything.

The whole point of a term sheet is to lay out, in relatively detailed written form, the main terms of an investment offer. That’s why it’s called a term sheet.

A proper term sheet will lay out in writing the key terms of the investment, including the amount being offered by the lead investor, the total amount expected to be raised in the round, the valuation, the liquidity preference, and the board structure. Having all this written down in some level of detail will make it much less likely that one of these terms will turn into a deal breaker later in the process – because once you both sign, you and the investor have committed in good faith to execute what’s in that term sheet.

Even a written and signed term sheet is usually non-binding, so there’s no guarantee that you’ll get your financing done even if you’ve signed one. But while term sheets are not legally binding, they’re reputationally binding on both sides. If you sign one, you ought to take it very seriously. And if a VC signs one, they ought to take it very seriously, too.

. . .

Unfortunately, that’s not always how people work. Some VCs sign term sheets as a way to keep the conversation going, rationalizing that since term sheets are non-binding, they don’t really have to do the deal even after they sign one.

And that bugs the hell out of me.

I couldn’t find precise data about how many term sheets fall out after signing, but the web seems to congregate around the figure of 10%. My guess is that underlying that ten percent average are some big variations. For example, I remember one VC during the dotcom days bragging to me that he had just issued term sheets to two of the hottest companies in the same space. His plan was to get all the data from both of them and then invest in the one he liked better once he saw the details while pulling the term sheet on the other one.

Uh, he’s not a VC anymore.

. . .

On the other hand, speaking for Threshold, I can’t think of a time that we pulled a term sheet once it’s been signed by both sides. So, like I said, your odds may vary greatly depending on who you’re dealing with. And because of that, finding out more about the VC and their firm is going to be very important before signing on the dotted line.

By the way, a pulled term sheet isn’t even the worst thing that can happen during a financing. A few entrepreneurs I know have had the terrible experience of a new investor pulling out at the last minute – literally when the deal docs were completed and they were only a few days from closing the round.

As you can probably imagine, this is way worse than a term sheet being pulled. Once you’ve gone to docs, and you’re a month or two past having turned everyone else down, it’s really hard to spin those other investors back up again. Luckily for the entrepreneurs I know who had this happen to them, they both managed to get other deals done – but it was still super painful and cost months of precious time to put those new rounds together.

. . .

So, how do you avoid getting left at the altar of your fundraise?

Well, you can’t guarantee that it won’t happen. But, as I said, it’s going to be more or less likely, depending on who you’re dealing with. So, well before you’re presented with a term sheet, it’s a good idea to do some diligence on your prospective investors.

After all, not only do you want to be sure that if you sign the term sheet the financing will get done, but you’ll then be working with this person for the next five to seven years. And like most other things in life where humans are involved, there’s a wide variety of style and quality in the investor community. So, it’s a good idea to find out as much as possible before you’re legally bound to each other.

Diligencing an investor is not that different from the diligence they’re probably doing on you. You should ask them for introductions to entrepreneurs they’ve backed before – including at least one or two where the outcome was not positive. As my partner Emily Melton likes to say, we VCs build our track record on the hits, but we build our reputations on the rest. So, it helps to talk to entrepreneurs who’ve worked with that VC during difficult times because you’re probably going to go through some difficult times too.

You can also find most VCs prior investment history online at places like Crunchbase. I think most entrepreneurs want to help each other out, and most of them are pretty easy to find on LinkedIn. So, you’re likely to get at least some responses if you reach out to other entrepreneurs to ask them about an investor. And if you send out a dozen requests and no one responds, well, that may be a signal in and of itself.

You can also find a surprising amount about investors online. Many are quite active on social media, and for some of those, I find their posts highly illuminating, to say the least. Doing some smart searching may also uncover things that you’ll be glad you knew before deciding whether to commit or not.

. . .

Let me tell you a story from my own history to explain why I’m such a big fan of thorough searches before business commitments. My situation involved a CEO I started working with when I took over a board seat from another VC who was retiring. The company was in the final stretch of closing a new financing when the prospective investor called me to say that they were not going to move forward. They said that in their due diligence, they’d discovered that the CEO had had a run-in with the SEC. When I confronted him and asked him why he’d never disclosed this to me, he said, “Well, you should have Googled me.”

So, I learned my lesson, and as a result, I’ve gotten pretty good at online searches. And now there’s a new tool to use. For fun, I just asked ChatGPT about this former CEO. I asked, “I’m considering making an investment in a company run by Joe Blow, who used to be the CEO of XYZ. Using all public records and media available, can you tell me if I should have any concerns about his prior reputational or legal issues?

Well, in about two heartbeats, ChatGPT responded with the details of the SEC probe and settlement. So, it’s probably worth trying it out on anyone you’re considering working with as well.

. . .

Another good source of VC due diligence can come from your attorney. This is yet another good reason to hire an attorney who specializes in early-stage financings because they’ll probably have access to more industry scuttlebutt about VCs than you do. And, of course, a lawyer experienced with startup financing will also understand the nuances of the terms in your term sheet and help you negotiate them if you’re hoping for something different. And once the term sheet is signed, they’ll also be there to ensure that those terms are accurately codified in the final documentation. Those of you who’ve been listeners for a while know that I’m a big fan of the right professional to help at the right time, and raising a round is definitely one of those times.

Ideally, you will have done your due diligence on prospective investors well before you get a term sheet – because you’re going to get really busy once that first term sheet shows up. Let’s talk about what happens then.

Most term sheets include a no-shop clause, which means that by signing one, the entrepreneur agrees to not actively look for another investor while they either convert that signed term sheet into funding, or not – usually over a 30-to-60-day period.

Given that signing a term sheet typically means agreeing to a no-shop, entrepreneurs usually do their most intense negotiating in the time between getting their first term sheet and signing one. This usually takes about a week or two and can be as fast as a day or two, depending on how competitive things are and how close the term sheet is to what the entrepreneur is looking for.

Most VCs don’t want to leave term sheets just hanging out there, so they’ll often include an expiration date that may only be a few days from the issue date. Likewise, entrepreneurs don’t want to lose the momentum of their fundraise and don’t want to sour investors with a lot of delays, so they’ll usually approach this process with a lot of urgency, too.

During this short and intense period of time, the entrepreneur will try to hammer out anything in the terms that they want to change. Of course, they may also be negotiating with multiple VCs to get not only the most optimized terms but also to get an acceptable term sheet from the investor that they most want to work with. And we VCs also understand that this is the time to put our best foot forward in both the term sheet as well as anything else the entrepreneur may need to help them make their decision.

With any luck, the entrepreneur and the VC they most want to work with will hammer out an acceptable term sheet, sign it – and then it’s time to work with the lawyers to turn that term sheet into closing documents and, ultimately, money in the bank.

. . .

But Rudy, the entrepreneur who messaged me about the ‘verbal term sheet,’ is not at this point yet, so we need to backtrack a bit. I said there were other things in his message that I didn’t like. And before we’re out of time, I want to touch on those, too.

Rudy said that the investor was not going to issue a term sheet until Rudy committed to exclusivity. Well, that’s just backward. As I hope you all understand by now, how could Rudy possibly commit to exclusivity when he doesn’t have a firm offer that lays out the stuff that term sheets usually cover – like amount, valuation, preference structure. There’s no way he should be asked to commit until all this is made clear in a written term sheet.

Also, the investor said he wanted to take the whole round. OK, maybe that’s not terrible, but generally, investors should be open to collaboration, and most want to include other investors who can help the company along. Maybe this isn’t a red flag, but it’s at least a yellow one for me.

The investor also said he’d need to get forty percent of the company to move forward. That’s a lot of dilution for a seed round.

It’s going to take me a whole episode to explain how to think about dilution, so I promise I’ll get back to it in the near future. But for now, the headline is this – you only ever have 100% of a company. Selling almost half of it in a seed round will likely mean that you won’t have enough left for future rounds – let alone for employees and for you and your other co-founders. Sure, you can issue more shares in the future, and you probably will, but that still doesn’t change the 100% thing, and any shares that you issue in the future will dilute everyone’s holdings – including your own.

There’s no strict rule about how much dilution is appropriate for a seed round. Even the term seed round has gotten kind of meaningless – I mean, one of my former students just announced his $220 million dollar seed round. So, not only kudos to him, but that might be one for the record books when it comes to seed rounds.

For the more typical seeds I’m seeing today, say one to five million dollars – the general guideline is that you don’t want to be giving up more than about twenty percent of your company in the round.

. . .

This is also why many seed financings are done as SAFEs, which stands for Simple Agreement for Future Equity. A SAFE is basically debt that will convert into equity once you do a larger priced round – after you’ve made more progress and built some enterprise value – in part by using the money that the SAFE provides.

The benefit for you, the entrepreneur, is your stock is priced only after you’ve built more value. And the benefit to the investors in the SAFE is that their debt converts into that priced round at a discount, usually 10-20%, to reward them for having bet on you early.

But remember, SAFEs will ultimately turn into shares of stock, and hence dilution, so you still need to understand how the SAFE converts into equity and the ultimate dilution range you are signing up for by taking that SAFE money in the first place. There’s a lot of material online about SAFEs and I’ve also put some links to them in the show notes. I recommend that every entrepreneur looking for seed funding should get up to speed on SAFEs since they can be a great alternative to a priced round.

. . .

Let’s get back to Rudy’s message one more time before we wrap up. There’s one more problem I gleaned from it, but it’s not about the investor this time. It’s about Rudy – and his expectations around fundraising.

I already knew before he left me this message, that he’d started his fundraise about six weeks earlier and that he’d talked to maybe a dozen prospective investors so far. And now he’s already sounding weary about the process and anxious to be done with it.

I think Rudy needs to reset his expectations.

Here’s a data point to consider. At Threshold, each of our investors will make two, maybe three, new investments a year. Each investor will also take introductory meetings with one to two hundred entrepreneurs each year, give or take. So, if we take something like fifty meetings for every investment we make, it makes sense that any entrepreneur out fundraising may likewise talk to fifty investors before they get a term sheet. Rudy needs to be prepared that this fundraise will likely take at least a few more months and dozens more coffees and pitch meetings before he gets a term sheet that he’ll want to take. And he’d better gear up for that.

Look, I was in the same boat once and I remember how frustrating fundraising was. It took me nine and a half months to raise our first round of venture – I’ve made whole humans in less time than that! But most fund raises are in fact not quick, and the sooner Rudy adapts to that reality, the better attitude and stamina he’ll be able to put into it.

. . .

Well, I guess it’s time to stop talking and call Rudy back. I’m going to walk him through everything I just said and also tell him that my spidey senses are tingling about this investor based on the message he left me. I’ll tell him that I think he should ask the guy for a written term sheet but that he should also thoroughly diligence the guy to see if he’s someone Rudy would actually want to work with for the next five years.

And then I’m going to encourage Rudy to set his expectations on a much longer time frame for his fundraise. If it takes him as long as I’m guessing, at least he’ll be prepared. And if it goes faster, he’ll be pleasantly surprised.

. . .

And that concludes "The Case of the Verbal Term Sheet." For the record, this situation is real, but Rudy is a composite. And no startups were harmed in the making of this podcast.

Thanks for listening to The Startup Solution. We hope you have enjoyed this episode, and if you have, please pass it along to someone who could use it. I’m Heidi Roizen from Threshold Ventures.

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