Exploding Term Sheets Are Nasty

Exploding term sheets are nasty. If you don’t know what they are, it’s a fairly literal definition. Someone gives you a term sheet to invest in or acquire your company (or some other transaction), but they put an expiration date into the term sheet and if you don’t accept by that date, the offer explodes. Investor Y Combinator (recently in the news for taking an investment from Sequoia Capital) posted an advisory tonight that their competitors are using exploding term sheets, and suggesting companies ignore them.

Companies use exploding for a variety of reasons. But the goal is to put additional pressure on the company to accept the terms and quickly, without much further negotiation. In particular, they don’t want to see a deal “shopped,” which is when you take their term sheet and go to other buyers/investors looking for a better deal (which is exactly what you should be doing as soon as you get a term sheet from anyone).

But they are bad news for startups, who can’t take their time to find the best deal possible when presented with one. I’ve received a couple of these in the past and have always ignored the clauses. Generally speaking, the day after the explosion they’re still very happy to do business with you. If they’re not, they weren’t good partners anyway. (there are exceptions, such as when certain financial milestones or other important dates are coming up, but those situations are fairly obvious).

The Y Combinator letter is fairly straightforward in its advice. In particular, competitors (which are mainly TechStars and DreamIT, although they aren’t mentioned) are giving exploding term sheets that expire prior to Y Combinator getting a look at the companies. Lawsuits have also been threatened:

Advice to Summer Applicants

March 2009

If you’re also applying to one of the other YC-like organizations, you may find yourself in an awkward situation. Last summer several of them gave startups offers timed to expire before YC interviews.

At least one made groups who got offers sign something promising not to tell anyone. Another actually threatened to sue a startup if they didn’t show up for their program.

Using so-called “exploding termsheets” to pre-empt other offers is not uncommon in the VC world, though even there it’s considered a slightly dubious tactic. But VC funding happens asynchronously. Using this tactic in a stage where funding happens synchronously is not very ethical. It would be like colleges doing it.

(YC asks people to decide that day whether or not to accept an offer from us, but we do this because at that point they already know all they need to, not to pre-empt other offers. There is no other seed firm that decides after us.)

What can you do if you find yourself being pressured to decide before you’re ready? We advise approaching the situation with confidence. If your startup is going to succeed, you’re going to have to learn how to push back against people who try to take advantage of you. So try negotiating. The better you are, the more willing they’ll be to wait for your decision, no matter what they say about their deadlines or the number of “spots” they have.

If you really get into a pinch, let us know and maybe we’ll be able to figure out some way to interview you early.

Sorry about this. We started YC to make it less stressful to start a startup, not more. We never anticipated this sort of situation would arise.

There’s just one problem with the advisory, though. Y Combinator themselves ask companies to make a decision on the day they get their offer. So it’s somewhat hypocritical to complain about the same actions by their competitors. As they say, though, they are the last to interview new startups in each summer and winter class. So startups know who has accepted them by then, and the Y Combinator deal terms and even the contracts they’ll sign are on the website for review.

I’ve emailed both TechStars and DreamIT for a comment. TechStars Executive Director David Cohen writes:

No, TechStars does not ask the founders that it makes offers to not to disclose the offer. We do ask them to accept it quickly (usually in 24-48 hours) or we move on.

TechStars issues a letter of intent when it makes an offer. Once our offer is accepted and signed by both parties, it includes non-disclosure (but not before).

The reason for this is two-fold. First, we are by definition still making offers and we may have to move down the list if some are not accepted. We don’t make all offers at once - it happens over a period of about a week, usually in personal meetings. So we don’t want other applicants that we’re planning to make offers to thinking they won’t get one, etc. Second, we generally advise our startups not to make a bunch of noise on the way in to the program as this is typically too much publicity too early. So, if they enter into the letter of intent, we ask them for confidentiality until such time that we can coach them on working with the media. Then they decide what they want to do. Again, this only happens upon acceptance, and not before.

TechStars has never once threatened to sue a startup or applicant for any reason. I have heard this rumor about another program (not ours), but I have no idea if it’s true or not.

will also tell you that regardless of lots of random innuendo, we have never once set our application or offer deadlines based upon those of any other program. Our program historically sits in the exact dates of the University of Colorado summer break, in order to maximize the likelihood of available temporary housing. We set our dates completely around this, and not based on anything else. In Boston this year, we simply added a two week offset for logistical reasons.

What would be best is if founders didn’t have to make decisions on any of these small incubators/investors until they’d pitched all of them. That’s unlikely to happen, since Y Combinator carries most of the brand weight and would likely get most of the best startups (like Stanford gets all the best students). My guess is we’ll be seeing more of this, not less, over time.