Raising Capital: The No-Shop Clause Trap

Glen Hellman August 22, 2011 Tweet

Raising money will rarely proceed on schedule.  It is like building or remodeling a house or developing a new version of software. Complex stuff just doesn’t go as planned and is rarely completed on time or on budget. So when you finally get that fish hooked, and you land a term sheet, it may feel like it is time to take a sigh of relief, lift a glass, sit back and relax.

Don’t do it! It’s a trap.  You may have a fish on the line, but you haven’t landed him in the boat just yet. It isn’t time to relax, because you didn’t just land a toothless trout – that’s a shark on the other end of the line.  You know what they say, sometimes you get the shark and sometimes the shark gets you…or is that the bear?  Anyway, you get the idea: The struggle is just beginning.

There is going to be a lot of shark infested water flowing under the bridge between the time you sign your term sheet until the time you deposit the check.  Due diligence is going to take longer than you think. Imagine walking on one of those Indiana Jones-style rickety, rotting swinging bridges over that shark infested water.  You’re about to cross that bridge in the form of the “No-Shop” clause.

When a VC tenders a term sheet to a company seeking funding, the no-shop clause commits the company seeking funding to shut down negotiations with any other investors. Agreeing to that clause means cutting off all other efforts to raise money, ending discussions with other VCs and becoming totally dependent on this one prospective investor for cash.

So what’s wrong with that?  Why is it a problem if the term sheet spells out the: 1) proposed closing date, 2) valuation, 3) the amount of money.  What’s the catch, you ask?  Well, the catch is that those terms are only proposed and are all subject to change based on the results of the due diligence process, and that due diligence process will take longer than expected and will not come off without a snag.

It’s like when you sell a house.  You get a contract, but the contract is contingent on a home inspection (due diligence).  If the inspector finds that the roof is rotted and the furnace needs replacing, the buyer is going to renegotiate the price or back out of the deal altogether.  So imagine you’ve signed the agreement, and due diligence drags on and cash dwindles. Imagine that during diligence, the potential investor found some warts on the deal, like IP violations of open source software, or ex-founders who claim stock rights.

And when the warts appear, the VCs will want to renegotiate valuation or other terms.  What are you going to do? You’ve turned off all the other potential investors and your relationship with them has cooled. You need cash, you need the deal, and you’re options are now limited.

Before signing that agreement, you might just want to take a hard look at your current cash and cash flow.  What would happen if the close is delayed 30 days, 45 days or even longer?

The fact is that unless you are unquestionably the next Google or Facebook, you’re going to agree to a no-shop clause. An investor isn’t going to dedicate the resources required for due diligence if you’re negotiating with other parties.  So the no-shop is a necessary evil. Prior to signing the term sheet, your deal is part of an open auction market, and hopefully it’s a sellers market.  Once you have a signed term sheet the power shifts from seller to buyer.

One fallback and rare position could be to negotiate a no-shop expiration clause.  This would say that if due-diligence isn’t complete in a certain amount of time, the no-shop clause expires and you are free to start shopping other funding sources.

If you’re going to raise money, you’re most likely going to be snared by the no-shop trap. If you have the cash to make it through a delayed and lengthy due diligence process, you will be better prepared to come out of that process as a well funded company.  If you enter it without the cash reserves, you may wind up finding yourself in the belly of a well fed shark.