Backing out of Term Sheets Should Never Happen, Except Sometimes You Should

Chris Dixon has a great post about not backing out of term sheets. Dixon doesn't name names but it's usually not too hard to figure these things out. Generally, I agree with the comment that you should never back out of term sheets except in extraordinary situations. The trick is, extraordinary is a subjective term.

I never have backed out of either an institutional round or an angel round. However, I can think of one instance where I wish I had or at least gotten off the "my word is my bond shtick". While doing docs I felt like the CEO was being unusually ornery in several odd elements of final docs, the cash burn was excessive for the rapidly changing environment, and most notably September 11th hit and it was a telecom deal. Generally most telecom deals at that point had died or were dying and we were going to try and pick a winner to save. Telecom was already struggling and while this company had prospects, the diligence was done prior to the attack and spending clamped down materially after the attacks.

I wrestle with the decision to this day. How would I have backed out? What would I have said to the co-investors? How about my colleagues and the senior parters at the firm who wanted to do the deal even more than I did? One of their first wins was an IPO with this particular CEO and to back out would have been doubly horrible for the relationship. But the deal made me ill and I hadn't put a dime in yet? Should I have backed out or did I do the right thing?

At the time, I was of the school --your word is your bond -- just like Chris mentions in his post. However, in extraordinary circumstances and you get large amounts of data it's your job to revisit your decision. You really have a fiduciary duty to your LPs to do so, no matter how difficult personally. The trick is to do it with some class.

So how did it turn out? Not well.

The deal turned out to be problematic and a write off--here is what happened. We were in the deal with a lot of old school telecom investors and one of them said to me in a board meeting "John, we can't save our way to success". That's true, but the days of burning through mountains of cash to attract high profile acquisitions were over and not since returned. That whole style of investing was dead and they weren't quite ready to let go. I had gotten a sense of this in the diligence when I talked to the board and that should have stopped me right there or at least revisited the structure of the deal. A wiser man would have done so right?

I was in the deal though, so it was a fight at every board meeting just to get the burn down. I think they burned something like 10 million in cash in one meeting to the next. I was apoplectic and couldn't really focus on doing any new deals. A bad deal can really consume you.

The company had a great technology and an impressive CEO with amazing marketing skills-- to the extent he gave himself time to succeed and a long runway to allow the market to recover, the company had strong prospects and could win. While I was wearing them down, the cash balance was dropping quicker that I could persuade each board member or the CEO. Just a note on the CEO, he truly was one of the best marketing CEO's I have ever seen. The guy's pitch could make you cry it was so good. But he was in a bad situation and the market for his gear was very slow in recovering even though it saved carriers money.

If I had walked away and come back with a more viable structure that reflected the new telecom landscape and a longer runway, I think the outcome could have been very different for him and for the investment. Many of those variables uncovered in the diligence were difficult to control if you are stuck with the original deal designed 5 months prior.

Also, if you walk away, it gives the insiders time to reset their own expectations, test the market, and make some of the harder decisions before your cash goes in. i.e another option besides walking away is a punt.

They say it takes $20 million to train a VC, well I blew a good chunk of it on one deal my own gut said to walk away from. Like all good lessons, I still wrestle with it and I apply it to investments now.

It sounds like in Chris's post, the partner has done this multiple times and is doing this as some sort of stalking horse strategy. If so, that will get around very quickly and make quality deals very difficult stuff for the fellow. However, I'd suggest that in some cases, when the landscape changes or major new data is introduced, sometimes it's better for everyone involved if you either punt or "back out". In my case, I had several chances, I just didn't take them. Given that situation, would it have made me dishonorable (an attribute that is important to me). I'm not sure that it would have.

The bottom line is hard and fast rules are a weaker tool set. A lot of these "hard and fast" rules are often misapplied. Use your best judgement and do what you think is right for your investors and for the company your investors. Never let a rule like "your word is your bond" stop you from doing the right thing. Life is not always best boiled down to one thing.

As a guy who was an entrepreneur once before too, I know one rule that is as hard and fast as they come "the deal isn't done until the wire hits".

Chris Dixon's post here:

Yesterday, one of the 40 or so startups I’ve invested in (either personally or through Founder Collective) had a well-known VC back out of a term sheet for no particular reason besides that they decided they no longer liked the business concept. It’s the first time I’ve seen this happen in my career.

In later stage private equity (leveraged buyouts and such) it is a common trick to “backload diligence” – you give the company a quick, high-valuation term sheet, which then locks the company in (the no-shop clause prohibits them from talking to other investors for 30 days or more). Then the firm does their diligence, finds things to complain about and negotiates the price down or walks away. If they walk away, the company is often considered “damaged goods” by other investors who wonder what the investor discovered in diligence. This gives the investor a ton of negotiating leverage. In later stage private equity, this nasty tactic can work repeatedly since the companies they are buying (e.g. a midwestern auto parts manufacturer) are generally not part of a tight knit community where investment firms depend heavily on their reputation.

I learned the basics of VC when I apprenticed under Jeremy Levineand Rob Stavis at Bessemer. It was at Bessemer that I learned you never back out on a term sheet except in cases of fraud etc. I never saw them back out on one nor have I heard of them doing so. In fact, I remember one case where Rob signed a term sheet and while the final deal documents were being prepared (which usually takes about a month), the company underperformed expectations. The CEO asked Rob if he was going to try to renegotiate the valuation down. Rob said, “Well, if you performed better than expected I don’t think you would try to renegotiate the valuation up, so why should I renegotiate when you performed worse than expected.” That’s how high quality investors behave.