Handshakes, Term Sheets and Trust

I read this story yesterday about a failed startup acquisition. It’s one of the big nightmares of an entrepreneur: Big Company shows interest in Startup. Acquisition talks go well. Handshakes and gentlemen’s agreements happen. Startup day-to-day is disrupted during the lengthy acquisition process. For whatever reason, acquisition falls through. Startup is now much worse off than before: less money, low morale. This paragraph stuck with me:

As I look back on it, there were a few things we could have done differently, although I suspect we’d have gotten the same result. We could have insisted on a term sheet, even though term sheets are non-binding. Maybe we could have negotiated a breakup fee in case the deal fell through, although I don’t think we had the leverage to force them to agree to one. Ultimately, the real lesson learned is this: get your business to a level of success where you don’t care if the deal falls through.

In my opinion, this is not the best lesson to learn from that experience. Sure, if you build a successful business then you’ve won. Become Facebook, go public, write posts like “hey, look at our beautiful desks.” That much is obvious, but these guys are a little startup. There are other lessons here, one of which is about the art of trust. The “art of trust” you may say? Just sign contracts, and don’t believe in any words anyone says. Trust but verify. No need to ever blindly trust anyone.

If that were the case, businesses couldn’t function. In the world of business you trust people every day who (in game theory parlance) could defect at any time. Your employer can fire you for no reason. A big customer can stop paying a bill on which your livelihood depends. Ah, but you have a contract so there are penalties. Right? Let me tell you a short anecdote.

Many years ago I was running a consulting business, and one of our customers was a famous internet company at the time. We had a contract, they were paying us 20k per month on an indefinite basis. The contract stated that they had to give us a 90-day notice before canceling it. Of course, the day came that Company no longer needed our services. The new person in charge had no idea about this clause in our contract, so I brought it up. “Let me think about it, and I’ll get back to you tomorrow.”

The next day, Person In Charge tells me “you’re right, we cannot cancel the contract without 90-day notice. This is your 90-day notice. For the next 90 days, here’s what we want you to do.” This was followed by a description of the most horrendous task the company could think of, the software equivalent of the escape scene from The Shawshank Redemption. At that point I conceded, we shook hands and parted amicably.

So contracts between a small company and a big one are mostly a psychological anchor. It comes down to who’s willing to sue, or who can afford it. Contracts assume everything goes well, and more than anything they spell out in writing what the parts are supposed to be doing so there’s no confusion.

What does this have to do with the story above? I believe the startup should have pushed for the term sheet as soon as possible. Either the acquirer would have said no (end of story right there), or the sheet would have been signed. A term sheet increases the likelihood that the acquisition will go through, even if it’s non-binding. This is because putting it together and agreeing to it takes a serious amount of work. As the acquirer puts work into the deal, biases like the Endowment effect and sunk costs start kicking in. This makes it psychologically harder for them to back out. 

The bigger question: who to trust and when? Maybe there is a formula for that, but I don’t know it. Experience certainly helps; the more you’ve been exposed to bullshit, the sooner you recognize the smell. Of course, in an ideal situation both parties work hard to align interests so there’s little need for trust. The challenge in that case is to periodically verify that the interests are still aligned, because they can drift apart very quickly. If you happen to be working with a party that has a public reputation, you want to try to set things up in a way that betraying your trust would hurt that reputation. Of course, sometimes you can’t do any of those things, and all you’re left with is your intuition. Well, at least you can study the history of the other party, and ask other people who have dealt with them. That’s why it’s so hard to get business when you’re a startup: you have no history.

The gist of this meandering post, if any: in business sometimes you have to trust others even though they could defect. That can be especially costly in a startup, but those are the breaks. May The Trust Be With You.

2 thoughts on “Handshakes, Term Sheets and Trust

  1. Great post Diego. The sooner the term sheet, the earlier you end up knowing if it is a long shot or not. Something very distracting for startups is also when they are focusing on developing specific products/services to target certain customers… and suddenly a very large customer appears asking for something that is not aligned with the current product development and willing to pay good $. Many startups end-up diverting their efforts to serve a customer that might at some point during the process go backwards and the startup spent precious time and money on other than the original product roadmap. On these cases, instead of asking for a term sheet something similar is to ask for a signed LOI or proposal. You might end up with nothing as well, but if the customer is doubtful about the service/product they will probably try to avoid signing anything.

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