This is the story of a trap into which I’ve fallen twice at Posse. Investors often set the trap unknowingly – no harm is intended – while they are figuring out whether they would like to invest. Both times this happened I felt heartbroken and exhausted, with my business in turmoil. We were lucky to survive.
It all starts so well. You meet venture capitalists and deliver a knockout pitch. They love it, you exchange business cards and they set out the next steps. First, you have to meet a few other people from the firm. They are busy so it can take a few weeks to secure the appointments, but they are genuinely interested and they ensure that you are seen as quickly as possible. You meet again for lunch, then dinner, then drinks. You become friends.
You discuss the wondrous opportunities for your business and the ways in which they can help you reach those opportunities. Watch out: You’ve started to fall in love. You discuss generalities about the deal terms, big stuff like the valuation and how much they’ll invest (a lot). And of course, they will want a seat on the board. You are excited; this will transform your world. In no time, you are planning how you will spend the money, looking at new office space and thinking about recruiting new team members.
One of the senior partners you needed to meet with was traveling, so you wait six weeks for the meeting. It is promising, too; he wasn’t as excited as the junior guys, but he likes them to be autonomous and allows them to pick their own deals. The senior partner suggests you meet a friend of his who runs a big company that, he says, would make a great partner for your business. It sounds helpful, but you know he really wants to know what his friend thinks of you. The company is based in Chicago; you have to travel and the meeting takes two more weeks to set up. All goes well, and after a week you hear the firm wants to move forward with your deal.
Next comes due diligence. This starts with a long list of requests and a promise that, once all the information is together, this will not drag on. They guarantee you will receive the term sheet within two weeks, so you pull in your team and work late — very late — to assemble the material. It may include questions like: Who owns all these shares on the capitalization table? Is there anyone here without an employment contract? Why did you model revenue this way? Will you really need all those engineers?
You answer all of the questions diligently, repeatedly rework your financial model, and either make changes to your contracts or write new ones. More than a month passes. You have spent money you do not have getting help with contracts, accounts and a revenue model to satisfy the investors. You have answered almost every tricky question that could be asked about your business plan, your competition and the market. Everyone seems happy and the firm assures you that due diligence is almost complete. The term sheet is only days away. Four months have past since you first met. There is one more thing — a meeting, a problem, a question, something that is going to take more time. Finally, you start talking about investment terms. And then something happens. It could be any number of things, but it is a knockout blow that kills your deal.
The first time this happened to me, I had negotiated for five months with a big name corporate brand. The company had proposed investing $3 million dollars, and the association would have catapulted Posse’s profile to the stars. I liked the executives leading the deal and could not wait to build the business with them. They assured me that they could move quickly and that they would reach a decision within a month. But the months dragged on and more people became involved, asking more questions. I was not even worried; I was so sure we would close the deal. After all, they would not invest so much of their company’s time if they were not serious, would they? But when the terms came back, they killed the deal; they were nothing like the proposal we had discussed when we first met. The company would invest, but it came up with a valuation of less than half what we expected. I might have accepted anyway, but our board refused.
Last year, I spent six months attending to the whims of a group of angel investors from New York. It took three months to complete a series of qualification presentations, after which they selected a cast of a dozen members to perform the due diligence. I answered their questions, reworked financial models and met every relevant person full time. They said they would invest more than a million dollars, and the process required only four to six weeks. Then they told me they could not invest nearly as much as they had thought. The exercise had been a gigantic waste of time, distracting me from talking to other, serious investors.
I remember venting my frustration during one of these drawn out episodes with one of my mentors. He said, “Never start due diligence until you’ve agreed on a term sheet.” With hindsight, it seems so obvious. If I had refused to do any work until a term sheet had been worked out up front, then I would not have spent months and tens of thousands of dollars pleasing investors who were not serious, did not have the money or whose deal expectations were vastly different from ours.
The problem is, refusing to do any work until a term sheet is signed sounds great but is hard to do. When you first meet, you are excited and the investor promises that the process will take only a few weeks. You can afford to invest a few weeks. Even as time drags on, everything appears to be proceeding, and you are certain the deal will close. As time drags on, costs pile up and cash reserves dwindle. You realize that, with so much time invested, you cannot afford to start the process again.
I will never get stuck in this situation again. I will never let an investor seduce me into believing that a term sheet is around the corner while I put time and money into meetings and answering thousands of questions. I will ensure that a term sheet is agreed upon up front and then start the due diligence process. If the V.C.s find something they do not like during due diligence, they can always back out of the deal, but at least I will have established that there is a deal to be done. Even though I know their firm is big and my company is small, I will do this because I know that time and energy are my biggest assets.