How Venture Capital Deals Fall Apart
Over the last year, I have found that entrepreneurs contemplating taking on expansion stage venture capital are almost universally concerned with the certainty of deal consummation after signing a term sheet. Here at OpenView, we aim to fund 100% of the companies with which we sign term sheets and complete our due diligence, but occasionally, we’ll discover something over the course of diligence that prevents us from continuing down the funding path. Several months ago, my colleague Firas Raouf opined on how to avoid getting yourself into a busted venture capital deal, so I thought I’d get a bit more specific and lay out the key components of how deals fall apart.
Revenues/Bookings are not as advertised
Occasionally, we will find that company management will either intentionally or unintentionally misrepresent the current financial state of the business. There is not much that we can do to mitigate the intentional or nefarious misrepresentation of revenues/booking information. I suppose people do this in the hopes that an investor won’t figure it out, but the odds of that are extremely low. All it does is waste a huge amount of time for both investors and company management alike and take both parties away from otherwise productive activities. Intentionally misrepresenting financial information is rather unscrupulous and leaves a really bad taste in everyone’s mouth.
Unintentional misrepresentation of financials is easier to understand but should also be avoided. This can occur when investor and management have differing definitions of what bookings are so it’s best to establish that definition at the beginning of the discussion. For example, I may think that bookings means contractually obligated revenue for a period of time and that both parties have signed said contract. You may think that bookings is defined as a verbal agreement with a contract to be signed at a future date. These are subtle differences but can have a huge impact on the way we evaluate a business. Another possibility is that deals that you had anticipated closing at the commencement of your discussion with an investor (and that you had included in your quarterly or yearly revenue numbers) end up falling through. This happens quite regularly and depending on the significance of deviation, perhaps can be worked through with your investor. I think a good rule of thumb is to be conservative with your revenue/bookings representations and to be up-front in saying that a deal has not yet officially closed etc.
Company drastically misses its numbers
This is touched on above but in case its not abundantly clear, if a company is projecting doing $X million in revenues during the quarter that we’re conducting diligence and they end up doing $0.5X, the deal can fall apart quickly. As “growth” investors, we are looking for sustained growth and a significantly “down” quarter would certainly give us pause. That being said, timing may be an issue and the revenue will simply be recognized a quarter later. We will certainly work to understand exactly what has happened and make the sensible and prudent decision.
Previously unknown litigation/legal matters
It’s best to make any current litigation, legal infractions, IRS investigations, etc. known upfront as again, the investors will always find out about them. Let us know at the on-set so we can evaluate the situation and determine if it makes sense to go forward.
Failure to release product in certain timeframe
If a company is advertising a significant product release and fails to release it in the timeframe contemplated, that is another worrisome development. That product release was likely factored into the company’s financial projections and our assessment/interest in the business. A failed product release could lead to weaker-than-anticipated financial performance.
Misrepresentation of sales pipeline/market opportunity/customer satisfaction
Generally, investors will have a decent sense of the market opportunity, sales pipeline, and customer satisfaction/opportunity prior to signing a term sheet. It is possible, however, that a company’s management has either misrepresented certain aspects of the opportunity or does not want to share certain pieces of information prior to signing a term sheet.
For example, if a company fails to introduce us to customers prior to signing a term sheet and then after signing we find out that numerous customers have serious issues with the company’s product or services, that will throw a serious wrinkle into the deal process. This can be mitigated by both providing customer introductions prior to signing a term sheet as well as relaying any key issues that customers may have had to the investor. I have also encountered situations in which a company will accurately represent its revenue/booking information, but have totally misrepresented its qualified sales pipeline. Like bookings, it’s best to ensure that both investor and company are aligned in their understanding of what “qualified sales pipeline” really means.
Bad management reference calls
As part of our standard due-diligence process, OpenView typically conducts reference calls for members of the senior management team (CEO, CFO, VP of Sales, VP of Engineering, etc.). It’s possible that something unpleasant would surface during the course of these calls. For example, if the CEO of a company has universally poor references from the references he provided, that would signal a few things: 1) The CEO isn’t the sharpest tool in the shed if he provided references that would unanimously ding him, and 2) There are probably significant issues with the CEO if numerous past employers, partners, and employees fail to paint a positive picture.