What Happens After You Sign a Term Sheet?
You’ve done it!
After weeks of back-to-back meetings and late-nights running your high-velocity fundraising process, you’ve finally signed a term sheet with your dream VC.
So…what comes next?
If you’ve ever been in sales, then you know that the deal isn’t done until the money’s in the bank. So let’s walk through the most common steps that occur between signing a term sheet and that sweet, sweet cash being deposited into your startup’s bank account:
1. Investment Agreements
The most substantial closing task is the negotiation of the final investment documents.
If you’re a Pre-Seed startup and the investment is being done on a SAFE or similar “standard” agreement, then this is usually straightforward. There may be a bit of work that needs to be done if your company isn’t incorporated in Delaware, but that’s about it. You should also expect that the VCs participating in the round will want you to sign a side letter.
If you’re doing an equity round, then this process is more involved (particularly if this is your first equity round). The parties will have to agree on an initial set of shareholder agreements that reflect the terms agreed to in the term sheet you signed. Shareholder agreements govern many aspects of the company going forward and form the basis for all future fundraising rounds. I won’t go into the details, but expect it to take about 2-3 weeks (add an additional 1-2 weeks if you’re an international company).
2. Legal Diligence
In parallel with negotiating your investment agreements, the investors and their lawyers will perform legal diligence. This involves reviewing your incorporation documents (to make sure that your startup has been properly incorporated and is in good standing), any sales or partnership contracts (to ensure that they say what you think they do), and any prior investment agreements.
When reviewing your prior investment agreements, the focus is on identifying non-standard clauses (clauses in the agreements that give prior investors unusual rights or benefits). Unfortunately, there are unscrupulous investors — particularly in smaller ecosystems — that include clauses that give them unreasonable liquidation preferences, clawback provisions, anti-dilution protections and other non-standard rights. Depending on the nature of these terms, the incoming investors may insist that your prior investors give up these rights as a condition of your new round (which can put you in a difficult position with your earlier investors). Rest assured, most Pre-Seed VCs are used to dealing with these types of situations. The good ones are empathetic towards your position and will often try to help negotiate an outcome that works for everyone as part of “cleaning up the cap table”.
3. Cleaning Up the Cap Table
The journey to build a startup isn’t the same for everyone — especially when it comes to funding it. Whether it’s a plethora of small angel investors, a stack of overlapping SAFEs and convertible notes, or “dead space” on the cap table due to cofounders leaving, it’s not unusual for a cap table to look like a hunk of Swiss cheese by the time founders raise their first VC-led round.
Where did that piece of equity I left here go...?
There’s no judgement here — doing whatever you have to in order to move the company forward is worthy of kudos — but at some point, you have to clean out the cobwebs. If things are particularly messy, “cleaning up the cap table” may be a condition of closing the new investment. That could mean signing agreements with departed cofounders to recover their equity, convincing early investors to give up non-standard rights, or even buying out tiny investors in order to simplify things. VCs will typically work with you on this process in order to make sure that your cap table is as clean and simple as it can be coming out of the funding round.
4. Financial Diligence
While the cap table is a big focus for VCs, they’ll also perform broader financial diligence as part of the closing process.
For early-stage rounds, this is typically fairly light (investors will request and review standard financial reports, confirm bank account balances, etc.). Some will request access to your accounting system in order to dig deeper (particularly if you’re a fintech company or are already generating significant revenue). Don’t be surprised if investors make a lot of small requests in order to confirm the company’s financial details (because, no, VCs don’t skip diligence).
5. Founder Background Checks
Many early-stage VCs, including Panache, perform background checks on founders as a condition of investment. In our case, we use a service called Certn, which provides “the world’s easiest background checks.” The simple, straightforward process (which we pay for) confirms that you are-who-you-say-you-are and there aren’t any skeletons in your closet that you haven’t shared with us.
6. Re-Incorporation
In some cases, you may re-incorporate your company in parallel with closing your funding round. This is most common when an international company performs a “Delaware flip” to become a US-based company. Make sure that you involve both legal and tax professionals when going through a re-incorporation, as there can be significant financial implications for founders if not done correctly.
7. Lots of Waiting
There are three certainties in life: death, taxes, and the closing process will take longer than you expect.
When closing a round of funding, it’s pretty normal for unexpected hiccups to arise. Sometimes, it’s because something unexpected is discovered during diligence. A lot of the time, it’s because of simple misunderstandings during the closing game-of-telephone.
The final days of closing can be nerve-wracking for founders. Stay in frequent contact with both your lawyers and your incoming investors. Don’t be afraid to ask why something is taking long or if a delay is unusual. More often than not, it’s simply that both sides are waiting to get enough time from their lawyers to get things across the line (that’s right, VCs have to wait for their lawyers too!).
A Note on European VCs
There’s an important difference to be aware of when it comes to the diligence process of European VCs compared to VCs in other countries:
In Europe, investors typically perform legal and financial diligence before they issue a term sheet. This can make it seem like the process leading up to a term sheet is far more onerous in Europe than in other countries (particularly the US).
If you’re raising in Europe, don’t be surprised if potential investors ask you for far more detailed financial and legal information than the investors you’re meeting with in other countries prior to issuing a term sheet.
Last But Not Least
I started off this post by stating, “if you’ve ever been in sales, then you know that the deal isn’t done until the money’s in the bank.” Whatever you do, don’t take your foot off the gas during closing.
Term sheets are generally non-binding, which means that investors in most countries can legally pull out up until the moment that the shareholder agreements are signed. Absent something materially negative being discovered during diligence, this is morally reprehensible, but it does happen.
The best thing you can do to preempt “buyers remorse” with your new investors is to continue making progress and closing sales, onboarding new users or releasing new features during the 3-5 week closing process. At a minimum, send weekly updates to show them the progress you’re making and keep them excited about their new investment.
And have a backup plan. It sucks to think about, but what will you do if the investment falls through?
Remember: you’re selling up until the moment investors wire the money. Never lose sight of that.
