Sunday, December 07, 2008

"Trust Me" said the VC

Someone very close to me was very excited to close funding of a new concept company. The technology her team was creating was going to revolutionize health care for a significant segment of the population and had many follow-on applications. She had a term sheet from top quality VC's. She had a high powered team with amazing researchers from all over the country. The market was a concern, but apparently these investors were well-financed. They repeated consistently that they had money in the bank for tranche 1, tranche 2 and wanted flexibility in the terms, because they felt more money was required in tranche 2. They had daily conversations with the CEO which were described as open, honest and helpful. Some issues did come up, but they always do. The VC asked if the CEO "trusted" them when typical founding team protections were requested. Their reputations were so solid, the VC said, that this was nothing to worry about. They only invest in 1 deal a year, so they back their teams to the hilt.

Everything was moving quickly, final papers were in the CEO's mailbox, the money was about to be wired, then Friday at 4 PM....

...the bottom fell out. Apparently "market conditions" was affecting the bigger brand name of the 2 venture firms. They were going to have a meeting on Monday, but they would not be going forward. It was nothing the team did, it was just "market conditions." This was not a term sheet falling apart in diligence. Everything form of diligence was done - management, technology, market, IP, and on and on. This was final paperwork. The deal was going to close on Friday, but the opposing counsel was not available for a couple of days, so Tuesday was the date. Well, at least the CEO thought it was.

Later we find out, the firm has been under incredible disarray for months. It's clear "the denominator effect" was impacting them. That, and the inability of limited partners to cycle funds through hedge funds. This was one of the most powerful and well known funds on Sand Hill Road. A friend of mine who runs a late stage fund told me, "Rajiv, don't believe anything a VC tells you today. When there's no money for the next couple of years, you'll see all kinds of strange behavior. It's going to be ugly."

Luckily, the CEO-to-be and her team are able to get their jobs back. Though they have to deal with the fact that everyone knew they were leaving, but they are needed.

So a fundamental innovation that would improve healthcare and reduce cost is delayed. The uncertain financial market has created even more victims.

Of course, what this VC has done is unforgivable. This will definitely be called out in the It's one thing to pull out during term sheet diligence, it's another to bail at the close. Frankly, there should be a financial penalties for bailing out. Trust goes both ways - the more protection you want, the more you should be willing to give. There's no free ride, my friends.

Note: I decided not to name names to prevent unintended consequences - at least for now.


akulkarni said...

Wow. Its the stories like these that make you realize how bad it really is out there. Thanks for taking the time for sharing this anecdote. Best of luck to your friend - hopefully she can get things going again when the market picks up.

Rajiv Parikh said...

It's the denominator problem...

I'm getting a whole bunch like this. Today, heard that a CEO just got approval for insider round at 1/10th the previous post-money. This is after making tremendous progress. For founders, a wipeout. For everyone else, a chance to keep going for a while. The CEO felt he failed, when he really succeeded in helping the company live for another day.