No-Shop Clauses: A Founder Miss

When you’re a founder deep in fundraising, receiving a term sheet from a potential investor is a significant milestone. It’s an exciting step, but it also marks the beginning of navigating some intricate legal language. Among the various clauses, the “No-Shop” or “Exclusivity” clause is almost always legally binding, unlike many other parts of a term sheet, and understanding its implications is crucial for protecting your startup’s future.

Definition

A No-Shop / Exclusivity Clause is a provision in a term sheet or letter of intent that legally prevents your startup (and often the founders themselves) from actively seeking, soliciting, negotiating, or even entertaining alternative financing proposals from other investors for a specified period. Essentially, once you sign a term sheet with this clause, you agree not to “shop around” for better deals while you are in exclusive discussions with that particular investor.

Think of it like this: Imagine you’ve agreed to go on a date with someone (the investor) to see if you’re a good match for a long-term relationship (the investment deal). The No-Shop clause is like agreeing that, for a certain period, you won’t go on other dates or even swipe through dating apps while you’re getting to know this one person. It’s about giving that initial investor your undivided attention to finalize the deal.

Why it Matters?

This clause is significant for both investors and founders:

For Investors:

  • Protects Investment of Resources: Investors commit significant time, money, and effort to due diligence (thoroughly checking your company’s financial, legal standing, market, etc.) and legal documentation. The No-Shop clause ensures that these resources aren’t wasted if you suddenly jump to another deal.
  • Minimizes Risk of Being Outbid: It prevents you from using their term sheet as leverage to solicit higher offers from competing investors, thereby protecting their proposed valuation and terms.
  • Ensures Deal Certainty: It provides them with a clear path to closing the deal without the distraction or competitive pressure of other potential bidders.

For Founders:

  • Signals Good Faith and Commitment: Agreeing to a No-Shop clause demonstrates to the investor that you are serious about their offer and committed to the negotiation process. This builds trust and can foster a stronger relationship.
  • Streamlines the Fundraising Process: By focusing on one investor, you can avoid the complexity and distraction of managing multiple simultaneous negotiations, potentially speeding up the closing process.

Common Variations

While the core principle remains the same, No-Shop clauses can vary significantly, impacting how flexible founders can be:

  • Duration of Exclusivity: This is a key negotiation point.
    • Typical: Ranges from 30 to 90 days. For early-stage deals, 30-60 days might suffice due to simpler due diligence. Later-stage or more complex deals might warrant 60-90 days.
    • What to Negotiate: Founders should aim for shorter periods (e.g., 30-45 days) to avoid being unduly restricted if the deal with the current investor falters. The period should align with the realistic time needed for the investor to complete due diligence.
  • Scope of Restriction: What exactly is prohibited?
    • Typical: Prohibits soliciting new lead investors, negotiating or accepting competing term sheets, publicly sharing the term sheet, and using it to create a bidding war.
    • What to Negotiate: Ensure clarity on what is not prohibited. Founders might still be allowed to:
      • Take meetings with angels or non-lead investors for filling out the round.
      • Continue discussions with existing investors or strategic partners.
      • Respond to unsolicited inbound investor interest (as long as they don’t negotiate new terms or actively encourage a competing offer).
  • Exceptions to the No-Shop Clause: These are critical for founder protection.
    • “Fiduciary Out”: Primarily seen in public company M&A deals, this allows a company’s board to consider a superior unsolicited offer if their fiduciary duty to shareholders dictates it. While less common in private VC term sheets, founders with significant leverage might try to include similar protective provisions.
    • “Window-Shop”: This allows the seller to engage in discussions and negotiations regarding unsolicited third-party offers under certain circumstances, usually requiring prompt notification to the initial buyer. The initial buyer often retains a “matching right” to improve their offer.
    • “Go-Shop” Provision: This is rare in VC term sheets but common in M&A. It actually allows the target company to actively solicit alternative offers for a specific, usually short, period after signing the initial agreement. This is intended to ensure the best possible deal.
    • “Fall Away” or Break Clauses: These are crucial for founders. They allow the no-shop restrictions to terminate early if the investor fails to meet agreed-upon milestones (e.g., providing draft documents within a certain timeframe, completing due diligence, or if they introduce material changes to the agreed terms without justification).
  • Consequences of Breach: What happens if the clause is violated?
    • Typical: The deal can be scuttled, and in some cases, it might trigger a “break-up fee” that the company has to pay the original investor.
    • What to Negotiate: Clarify the specific consequences of a breach and ensure any associated fees are reasonable and proportionate to the situation. A breakup fee should typically not exceed 3-4% of the total transaction value.

Examples

Here’s how a No-Shop clause might appear in a term sheet, along with real-world implications:

  • “The Company and the Founders agree that, for a period of [X] days from the date of this Term Sheet, they shall not, directly or indirectly, solicit, initiate, encourage or assist the submission of any proposal, negotiation or offer from any person or entity other than the Investors relating to the sale or issuance of equity or other securities in the Company. The Company will notify the Investors immediately (not later than 24 hours) after receipt of any unsolicited proposal or offer.”
    • Real-World Example: In the Microsoft-LinkedIn merger, Microsoft included a no-shop provision to prevent LinkedIn from engaging with competitors like Salesforce during their acquisition talks. This ensured Microsoft could proceed with due diligence without interference.
  • “Notwithstanding the foregoing, the Company shall not be prohibited from responding to unsolicited inquiries from third parties so long as such response does not involve active solicitation or negotiation of an alternative proposal.”
    • Explanation: This allows founders to acknowledge an unsolicited offer without actively pursuing it, giving them a slight degree of flexibility.
  • “This exclusivity period may be terminated by the Founders if the Investor fails to provide a draft investment agreement within 30 days of the date of this Term Sheet.”
    • Explanation: This is an example of a “fall away” clause, protecting the founders if the investor drags their feet.

Evolv’s Recommendations:

  1. Understand Your Leverage: Before entering negotiations, assess your startup’s value and the level of investor interest. A highly sought-after startup has more bargaining power to negotiate more favourable No-Shop terms.
  2. Negotiate Reasonable Duration: While investors want sufficient time for due diligence, overly long exclusivity periods (e.g., 90+ days for an early-stage deal) can be detrimental. Aim for a period that is reasonable for the investor to complete their work, typically 30-60 days, but not so long that it leaves you vulnerable if the deal falls through.
  3. Insist on “Fall Away” or Break Clauses: This is crucial. Negotiate terms that allow you to terminate the exclusivity period early if the investor fails to meet specific, pre-agreed milestones (e.g., providing a draft of definitive documents by a certain date, or if there’s a significant delay in their due diligence process). This prevents you from being “stuck” if the investor is not progressing as expected.
  4. Clarify the Scope and Exceptions: Ensure the clause clearly defines what you can and cannot do. Specifically, negotiate carve-outs that allow you to:
    • Continue discussions with existing investors or strategic partners.
    • Respond to truly unsolicited inbound inquiries (without actively soliciting or negotiating).
    • Continue filling out the current round with other investors, especially if the lead investor isn’t funding the entire round.
  5. Be Wary of Vague Language: Ambiguity in the clause can lead to disputes down the line. Ensure that terms like “solicit,” “negotiate,” and “entertain” are clearly defined or understood by both parties.
  6. Understand Consequences of Breach: Know what happens if the clause is violated. If a break-up fee is involved, ensure it’s reasonable (typically 3-4% of the deal value at most) and clearly defined under what exact circumstances it would be triggered.
  7. Maintain Communication: Even with a No-Shop clause in place, open and honest communication with the negotiating investor is vital. If you receive an unsolicited offer, it’s often best to inform your current negotiating partner transparently, adhering to the terms of your agreement.
  8. Consult Legal Counsel: Always have experienced legal counsel review the term sheet, especially binding clauses like the No-Shop provision. They can help you understand the nuances, identify potential red flags, and negotiate terms that protect your interests.

The No-Shop clause, when thoughtfully negotiated, can provide a framework for focused and efficient deal-making. By understanding its purpose, common variations, and potential pitfalls, founders can confidently navigate this critical part of the term sheet and work towards a successful funding round.