You may have already read the post by Rand Fishkin about his experience with a busted investment deal. In his post, Rand goes into exceptional detail about the experience, including getting into the details of the deal itself. If you haven’t read it, you need to. Go ahead and read it now… I’ll wait…
What Rand describes is not an unusual event. Venture deals do break up post term sheet (LOI) signature–and they do often. While we at OpenView aim for a 100% close rate, we forecast one in three term sheets not closing. Busted deals are a reality. The key is to figure out how to minimize the probability of it happening… and when it happens, how to minimize the impact on both the company and the VC’s reputation.
Coming at it from the Venture Capital side, balancing diligence and decisions in the pre-LOI stage is a very tricky thing. One of the key issues is how much time and energy both sides can and should spend pre-LOI in deciding whether an investment is a good fit. That’s not even considering whether the cultural fit is the right one.
Before the LOI is signed, not only is the company not typically willing to open up the whole kimono to VC diligence, the VC will also be reluctant to spend too much time on the opportunity without knowing that there’s a high probability of a term sheet being signed. Hence the catch-22.
So the pre-LOI dance becomes a tricky one. As a VC, one has to keep showing very strong interest and passion for the company and its market, yet that interest is not based on complete insights and a solid understanding of the company and the market.
Once the LOI is signed, the investment team and process spring into hyper-action. It is at that point that the barrage of questions/concerns comes from the VC’s investment committee, the necessary diligence kicks in, and insights about the company/market begin to take near final shape.
And it is at this point that deals can go south. This is especially so in highly competitive deals (VCs competing for the deal), and especially so for expensive deals (where the deal team will need to show with high probability the path to a big enough exit). This latter point is key: One of the downsides of negotiating a high valuation is that the company will need to show a reasonable path to a big exit… and actually deliver on it. The higher the valuation and the tougher the market analysis required to justify the valuation, the more likely the deal to bust.
What the VC should do to minimize the impact of a busted deal:
- Provide extreme clarity and be open: Make it clear to the company that a term sheet signature is no guarantee that the deal will close. Urge the company to keep the news about the funding process limited only to the senior managers, which would contain the damage internally if the deal falls through.
- Complete the majority of business diligence in the first 2-3 weeks: Focus all the deal team’s efforts on conducting business diligence on the front end of the process. Focus on the top objections of the investment committee. At the end of that period, get a committee vote on the deal moving forward to legal and accounting diligence. At this point, if the vote is yes, the deal has a very high probability of closing.
- Engage the CEO in tackling the top deal issues: Keep the CEO constantly informed on the weekly mood of the investment committee regarding the deal, and be sure to point out the specific open objections. Engage the CEO in tackling the objections.
- Limit the distraction to the company: Limit the deal interaction to the CEO and one other senior manager (typically the head of finance). Avoid excessive time spent with other senior managers. Make sure to remind the CEO that his top priority should continue to be company execution, not deal diligence.
What the CEO should do to minimize the impact:
- Don’t be desperate to raise money: Approach fund raising as “nice to have”, not a must have. If you need capital in the short term, explore other options to bridge you to the next VC round (e.g. angel round, bridge funding from existing investors, venture debt, bank debt). So simply don’t be desperate for the money until you have raised it. Be capital efficient.
- Balance valuation with probability of closing: The higher the valuation, the higher the bar the VC deal team needs to reach to justify the deal. This is a key issue, not just for funding, but also for the exit expectation your VC will have going forward. Your goal should be to find the right VC with the right alignment of interests. Don’t push your VC too far on valuation.
- Be ready for diligence before you sign the LOI: Ask one of your prospective VCs for a list of their business diligence templates. Use that list to prepare all the diligence materials required. This way you can share some of the material with prospective VCs as they are preparing to offer you a term sheet.
- Allow the VC to do some diligence pre-LOI: Naturally you have to be very selective here. Qualify the prospect VCs to one or two. Pick a couple of customers and a couple of non-company people who know your company and/or market, and connect them with the VC.
- Spend as much time as you can with the VC investment committee: One meeting is not enough. Ask your partner VC to brief you on each member, and his/her particular issues/objections/interests. The more the VC partners get to know you (and the assumption here is that you make a good impression), the more they will be inclined to vote for you.
- Be willing to walk away yourself: Think of the diligence period as an engagement to be married. If you uncover things about the VC during that period that gives you second thoughts about the firm, walk away. There’s nothing worse than being stuck with the wrong VC.