Can startups just walk away from an investment term sheet?

You and your co-founders have been pitching for the past several months, and now you’ve finally got the investment term sheet from venture capital. You later sat down with the signed term sheet to discuss the next steps with your team members. Eventually, after asking around for feedback and inputs you and your team later concluded that it may not be good to take up the deal now and felt that it may be better to wait for a ‘better timing’ or other commercial reasons. What can you do next?

Contract 101: Binding vs non-binding term sheet

Firstly, there’s no such thing as an “unterminable” or “irrevocable” contract. There’s no contract out there where parties are stuck forever, and they can’t break free from such contract once it has been signed. Any contracting party can terminate or ‘break’ a contract so long as they know and understand the consequences of such a decision.

In my experience as a startup lawyer, they are some venture capital funds that may want to have a binding term sheet right away. In other words, once the term sheet is signed the terms set out in the term sheet becomes the ‘shareholders agreement’ that sets out all the commercial rights and obligations by the existing shareholders and the new third party investor in the company.

So once you’ve satisfied all the usual commercial conditions set out by the investor like getting the company secretary to prepare the necessary paperwork and resolutions, the funding amount will get disbursed immediately.

This is different in a scenario where a non-binding investment term sheet where either party can usually walk away at any time during the term sheet period. Additionally, the actual investment will only happen once the investee company and the founders have signed an assortment of different fundraising documents like subscription agreement and shareholders agreement to give effect to the investment and set out the terms of the shareholders post-investment respectively.

How about an investment term sheet?

An investment term sheet is like any other agreement. The document will be binding against all parties if it is expressly specified in the document. In other words, if the term sheet is stated as non-binding, you and the investor are usually free to walk away anytime if any party doesn’t want to do the deal.

On a side note, it may be a good time to onboard a startup lawyer at this time to help you vet the investment term sheet so that you can know if the commercial terms provided are industry standard rather than signing off the term sheet right away.

What else to know before terminating a term sheet?

Just take note that just because a term sheet is “non-binding” does not necessarily mean that all the terms or clauses in the term sheet are intended to be “non-binding”. Usually, they are several customary terms that will be binding against the parties. The first is the confidentiality clause which covers protection of usual confidential documents sharing and other proprietary information during the ‘discovery’ or due diligence period.

Another standard binding clause is exclusivity (also known as the “no-shop” clause). The investor should restrict the company’s founders from soliciting and going around with the current investor’s signed term sheet to get a better offer from other third-party investors.

Additionally, in recent years, some investors have also included that the investee companies need to pay for the fees and costs incurred in the investment process including investor’s costs in engaging third-party service providers and professionals like legal firms, accounting firms, and auditors and so on.

Depending on the level of negotiation or investment process when you decide to terminate the term sheet, you may need to pay for these third-party service providers’ costs. For example, specific ‘abortive fees’ payable depending on whether the engagement is directly under the investee company or separately through the investor (which in practice, the investor may invoice against your company to recoup their costs on a ‘back to back basis’ ).

The final point that you should consider is reputational risks. It may be useful to ask your startup mentor on what would be the best way to strategise the discussion so that you could revisit the deal again in the future if there’s an angle to do so. Just remember that the South East Asia startup ecosystem, especially in Malaysia is small and you’re bound to meet the same investor again at some startup events somewhere.

Can’t find the article covering the topic that you’re currently finding for your startup? I’m always figuring out new topics to write about on this blog. Feel free to drop me a note using the contact form, so that I know what to write about next time.