Chris Dixon, co-founder of Hunch.com and a personal investor in early-stage tech companies such as Skype, TrialPay and others, offered an enlightening take on VC ethics in a column for businessinsider.com. Namely, is it okay for a VC to back out of a term sheet?
A term sheet kicks off the negotiations between a venture capital firm and potential portfolio company. It summarizes the terms that the proposer (issuer or investor) is prepared to accept. It’s similar to a letter of intent, a nonbinding outline of the principle points which formal legal documents will cover in detail, according to the website, vcexperts.com
Although it’s not legally binding, a VC with integrity rarely backs out of a term sheet, Dixon says, unless they discover something truly awful, such as criminal fraud. As a further example, he mentions that Sequoia Capital, the highly successful Menlo Park, CA-based VC firm whose companies account for an astonishing 10 percent of NASDAQ’s market cap, has only backed out on one term sheet in the past 10 years.
Less scrupulous firms, however, may give a company a quick, high-valuation term sheet just to prevent the company from talking to other investors while they then perform in-depth due diligence. When they find something they don’t like, they use it to beat the price down or simply walk away from the deal. This can leave the impression in the marketplace that the company is “damaged goods,” Dixon says. This whole approach gives investors an unfair advantage in the negotiating process.
But taking the more ethical approach and sticking to a legitimate term sheet pays off. The early-stage community, particularly the tech community, is very small and your reputation matters. “Word travels fast when firms trick entrepreneurs. It will come back to haunt you and your firm,” Dixon says.
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