Is Your VC a Chicken or a Pig? Part II: The Role of the Lead Investor – From Term Sheet to Closing (and Beyond)

In Part I we talked about the critical importance of focusing your fund raising efforts on identifying a lead investor – a “pig” – and reaching agreement on a term sheet with them before you spend significant time lining up “chickens” to “follow” along in the deal. Today, we’ll look at what role your lead investor plays post-term sheet agreement when it comes to getting your deal closed.

The first role of the lead investor post-term sheet is working with the company to build out the investment syndicate: that is, to find and close on chickens/followers. The lead becomes, in effect, a part of your pitch team – albeit, without abandoning its primary role as an arms-length investor/skeptic.

The “selling” role of the lead includes identifying, prioritizing, and even pitching potential followers. That typically includes folks the lead brings to the table from its own network as well as appropriate candidates the company suggests. While the company will still be front and center in pitching chickens, the lead is usually the primary due diligence source for potential followers, both “deal” and “legal” due diligence, and actively shares their own thinking on why the deal is compelling with various chickens.

This dual role, working with the company to build the syndicate while also being the principal due diligence resource for the syndicate, makes managing the company/lead relationship complicated as well as critical. The lead, at this point, wants the deal to happen and is committed to making it happen. But only to a point. The lead’s enthusiasm is tempered by its continuing obligation to act in the best interests of its own investors. In addition, its credibility is on the line with other investors, which is something that can cut both ways in terms of how it reacts to any bumps in the road on the journey to closing.

The lead also manages the “deal” part of the deal: that is, the concerns of followers about the terms of the deal. On that score, the lead should focus on convincing followers that the term sheet is “good to go” as is. Indeed, the company should resist any material changes to the term sheet based on follower concerns, just as it would if the lead was the only investor. The whole point of agreeing on a term sheet was to finalize the material terms of the deal. As a practical matter, one or more immaterial changes to accommodate a valuable follower may be acceptable. Any material changes, though, should be viewed as putting in play changes the company might want in exchange, or even grounds for the company backing out of the deal altogether.

The lead also manages the legal process associated with negotiation of closing documents and related legal requirements. Typically, there is one counsel for the investment syndicate, and that counsel works through the lead investor and is paid by the company out of closing proceeds from the financing. (If a follower wants to have an independent legal review, they should pay for it, and that counsel should work through the lead and its counsel in terms of communicating any concerns to the company.) If a lead can’t persuade followers to work through the lead and its counsel, that’s a good sign that the lead is not up to the job.

Once the deal is closed, the lead is usually the “point” investor for the rest of the investment syndicate. If the investors have a director on the Board, it will usually be someone from the lead investor. (Someone that should have been identified at the term sheet stage). When the company has news to share with the investors – good, bad, or indifferent – the lead is usually the first to get it, and often has input on what to share with the rest of the syndicate, when, and how. As with the period of time from the term sheet to the closing, this dual role of investor/advisor can be complex and must be managed carefully.

Lead investors make deals happen, and typically play central roles even after the closing. Smart entrepreneurs know that raising money is first and foremost about getting a credible lead’s name on a solid term sheet. Be a smart entrepreneur: don’t waste time and energy collecting followers until you’ve got a lead for them to follow.

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A Term Sheet is Not a Deal

First the good news. If you get a signed term sheet with a reputable angel or venture investor, there is a very good chance you will get a deal done. Unless, of course, you don’t.

Probably the most common element of every term sheet is the provision that states unequivocally that by signing the term sheet neither party is obligating itself to enter into an investment transaction, whether on the terms reflected in the term sheet or otherwise. Still, if the parties do reach agreement on a term sheet, there usually is a deal made, and usually on terms mostly consistent with the term sheet. That said, herewith a look at the most common reasons a “done term sheet” does not lead to a “done deal.”

  1. The investor can’t build a syndicate sufficient to close the deal out. As they teach you in entrepreneurship boot camp, getting a deal done is first about finding a lead investor. Someone credible who can put a stake in the ground and then help the entrepreneur close a syndicate around that stake. If your lead investor is a top tier fund, or even a second tier fund committed to invest 75% or more of the minimum closing amount, chances are somewhere between no-brainer (top tier fund) and highly likely (second tier fund) that you will get the deal done. On the other hand, if your lead investor is an anonymous angel committed to take only 35% of the minimum-closing amount, don’t hold your breath. The take home point here: your chances of turning a term sheet into a deal are pretty closely tied to the market credibility and relative capital commitment of the investor that signed the term sheet.
  2. Deal due diligence uncovers a major issue that either can’t be suitably resolved, or reflects badly on the entrepreneur’s competence. All-too-common issues that come up in due diligence include IP ownership issues (e.g. important IP was developed without appropriate work-for-hire or assignment documentation) and capitalization table issues (e.g. equity distribution is not well-documented; potential claims for significant equity outside of the cap table turn up; previous investors were unaccredited, or paid too high a price). The take home point here is get your due diligence ducks lined up (and shot, if they need shooting) before you sign the term sheet. Investors – good ones, at least – don’t like surprises, particularly when they suggest a careless, clueless or deceptive entrepreneur.
  3. In the rush to get the term sheet done, one of the parties punted on an important issue, figuring that she could take care of it in the fine print of the closing documents. For example, I once saw an investor leave the question of subjecting some of the founder’s stock to vesting for the closing documents. The very fact that the investor thought avoiding the issue at the term sheet stage was a good idea shows what a bad idea it was. A simple lesson: if an issue is material to either party, deal with it in the term sheet. It may kill the deal, but it will save a lot of time, distraction, energy and expense.
  4. The entrepreneur and the investor discover, under the pressure of getting the deal done, that they do not work very well together; or one or both of them loses confidence in the integrity of the other. Closing an early stage deal can put a lot of pressure on an entrepreneur (less so an experienced investor, who does a lot more deals). Pressure can bring out the best in a good entrepreneur. And the worst in a bad entrepreneur. Just as bad investors turn off good entrepreneurs, so bad entrepreneurs turn off good investors. Not that you can’t be an aggressive, take no prisoners entrepreneur and succeed, if that’s your style. But whatever your style, wear it well.
  5. Internal events at the investor’s shop derail the process. Say, for example, the partner leading your deal moves to another firm, or gets hit by a bus. Stuff happens, and when it does, deals often die. Being good is not enough in the high impact entrepreneurship world. You’ve got to be lucky too. Or at least not unlucky.
  6. A major external event shocks the market generally or the particular segment of the market the deal is in. Remember 9/11? I do. And so do several entrepreneurs I know who were trying to close deals at the time. More failed than succeeded. I’ve also seen deals blow up based on a shock to a particular market segment, as for example diagnostic deals in the aftermath of a major patent ruling that basically gutted the IP protection upon which the bulk of diagnostics companies were built. The take home lesson here: after you get the term sheet signed, close your deal with all deliberate speed. And stay lucky.

When an entrepreneur tells me they have a lead investor on board, my first reaction is to ask some questions. Who is it? Have they signed a term sheet? How much are they committing? How confident are you that all of your due diligence ducks are lined up? If the answers to these questions are satisfying, I’ll mentally note that the deal in question will most likely happen. Unless it doesn’t.

VIDEO: Coming to Terms with your Term Sheet

Gregory Lynch, Co-Founder of Michael Best’s Venture Best emerging technology practice and Managing Partner the firm’s Madison office, moderated a Pathways to Innovation Session titled “Coming to Terms with your Term Sheet” at the 2010 Wisconsin Entrepreneurs’ Conference.  This session features a role play regarding a real life term sheet with an early stage company. Paul Jones, who brings a wealth of entrepreneurial and angel/venture capital investing experience to the Venture Best team was a participating Michael Best panelist. Click here to watch the video presentation.