In defense of “explosive” term sheets

Aaron Harris – Former Head of Series A at Y Combinator

There is a lot of controversial content that claims that “explosive” term sheets (which expire after a certain amount of time, whether they’re accepted or not) are bad. Some come from founders who can’t handle the pressure; some are from venture capital firms that want to support their founder. However, the reality is that all term sheets “explode”, the main problem for everyone is when.

I’ll even get ahead of myself: If there were no “explosive” term sheets, it would be much more difficult for founders to raise funds. In a well-organized process of attracting investments, the founders control it to a large extent. They can dictate when to pitch and when to release information. Ultimately, they decide whether and when they sign the offer. At the extreme, this can lead to a ridiculous situation: Pitch on Monday, proposals on Tuesday, signing on Friday. (To be fair, this sometimes works.) VCs have only one control: to say yes or no, and when to say it.

Now, in fully liquid or public markets, investors can decide to buy or sell for as long as they want, and if the fundamentals change in the meantime, well, they can continue their “joyful journey.” But in VC rounds, the default is that if a VC says yes to an investment, they can’t take it back. This is rather strange.

Term sheets are not really contracts, but they are considered (mostly) binding. This means that once an investor makes an offer, he is exposed to two types of risk: firstly, of course, his investment may not be successful, and secondly, the risk of learning lost profits associated with the fact that he spent a lot of time working, thinking and allocating funds to a deal he might not win. If you multiply this second problem by the number of trades an investor can make, you run into an even bigger problem. Investors can only value or commit to a certain number of trades at a time. An investor who cannot control the life of their offers will quickly run out of resources to evaluate new deals. This is bad for everyone. If an investor is ready to invest, he must know when to expect a response.

The uncertainty of the process also creates problems for founders, who have the right to know when to expect a yes or no answer. But once the offer is made, they would prefer that it be left open until they make a decision, however long it takes. VCs prefer the offer to expire relatively quickly.

It seems to me that both sides want something reasonable. What is missing is a common set of rules for determining what is fair. So here’s what I suggest: Founders should have at least as much time to decide whether to accept the terms or not as it took the VC to make the offer. I will explain. If an investor decides to invest within 24 hours of starting the fundraising process, then making an agreement on a 24-hour schedule seems reasonable. Think of it as a bonus for VCs who make quick decisions. Their time in uncertainty is short, so they should be able to process more trades in less time than slower funds.

On the other hand, investors who need more time to think should give the founders the same courtesy. The VC might even present this as an advantage: “Yes, we need time to study you in depth, think carefully and all that. But when we make a decision, we will accept it with conviction, and we ourselves will run after you and convince you, dear founder, accept our offer.

VCs can also publicly commit to specific time frames. “Once we meet at the pitch, we will make a decision within a week. Once we provide you with a term sheet, you will have a week to make a decision.” A day on either side could work. A month on either side could work. As long as both parties understand the terms in advance, trading is on an equal footing.

From the founder’s point of view, all this should look fair. And for the same reason, if he needs an offer by a certain date or time, he must return the decision in symmetrical terms.

However, negotiations are not easy, and the principle of reciprocity does not always work perfectly. Sometimes the founder delays the deadlines too much, which scares everyone away. Sometimes a venture capitalist does the same. But an interesting fact: “explosive” term sheets do not literally explode. The venture investor, if he is still interested, can always make a decision and make another proposal after the deadline, he can ignore this deadline altogether. It’s just a negotiating tactic.

Thanks for the translation Aleksey Potekhin

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