VCs Charging Fees

I got a question via email yesterday that I'd like to address and then add some additional thoughts on the topic of VCs charging fees to the companies they invest in.

Our startup company recently started seeking funding and the first firm we presented to has shown some interest. However, they have now sent us a Due Diligence Agreement and are requesting a "one time good faith due diligence payment of $9,000".

Is it standard industry practice to charge the entrepreneur a fee for the due diligence? We are obviously short on cash - paying $9k to every VC who shows an interest in us sounds counterproductive.

As I told the person who sent in this question, I believe most high quality venture capital firms would not request a due diligence fee as part of signing a term sheet. Most VC firms are paid a management fee by their investors that is designed to cover the basic due diligence efforts.

However, if there is some particular diligence issue that is not usual, like a dicey patent situation, some arcane tax issue, a lawsuit, some highly technical diligence that requires an expert to weigh in, I have seen and have even asked the company to cover those costs out of the proceeds of the financing.

Also, most VC firms ask the companies to pay the legal expenses associated with closing the transaction. Those fees are often taken out of the proceeds of the financing. I know of a few entrepreneurs, like my friend Steve, who find that very distateful and I certainly understand why, but it is customary and has been the industry practice for years.

So my point of view is this. You should not feel like you have to pay a fee to a venture firm to get a term sheet signed or even close a deal (like is customary in the buyout business). But you should be prepared to pay for the VC's legal fees and if there is something unusual that the VC cannot get comfortable in the normal course, you may end up having to cover that cost as well.

All of this begs the question - what happens if the deal doesn't close? If the entrepreneur raises a significant amount of money it's not so hard to cover these fees. But what if the deal goes bad?  Who is stuck with the fees?  My feeling is that the VC firm should bear the cost if they walk away from a signed term sheet and the entrepreneur should bear the cost if they walk away. Of course there are times when it's not even clear who walked away from whom. Fortunately, those are few and far between.

UPDATE: Click on the comments and read what Shivering Timbers has to say about this. He's even more outraged by the request for $9k than I was.

Comments

[Shivering Timbers]

You should have mentioned the very high probability that this is not a legitimate VC fund at all, but a scam artist.

I would take every instance of the phrase "out of the proceeds of the financing" and put it in boldface type. That's a key difference between a scam artist and a legit financier.

There really should not be any circumstance where a (presumably well-funded) investor would be asking the (presumably not so well-funded) entrepeneur to pay upfront expenses in order to get financing.

It stinks to high heaven, and is the classic setup for a fraud.

[Brandon Watson]

I would print up the term sheet, attach it to a bag of sand and send it back to the "VC" firm with a small mallet. The note attached should say "have a nice summer pounding sand."

Like Fred said, there are very, very rare and arcane reasons to ask for this fee, but tell them they can have it as a condition of close. Even then, management fees cover this sort of thing.

[Alexander Muse]

Charging for diligence is almost as bad as charging to listen to a pitch. There is a company in Utah that charges companies a fee to present their pitch to a group of investors.

[Charlie Crystle]

Run.

[Jeff Clavier]

I got the same email, and essentially replied:

It is the first time I hear about a VC asking to cover their due diligence cost upfront. The only practice I also implement is to get a portion of the legal costs related to the investment covered by the company AFTER closing.

I would definitely refuse to pay, and most likely would stop discussions with that firm.

[You Mon Tsang]

Amen to all the commenters so far.

I think your post should advise huge caution with the very slight possibility that it is legit. You implied in your update note that you were "outraged." The outrage did not come through.

That said, I'm bummed that that my first post on your blog is "constructive," so let me say that I am a avid and loyal reader. Keep up the hard work.

[steve]

the problem i have with VCs charging their portfoloio companies for the funding deal legal fees is, there is nothing to stop the VC from abusing the privelege.

heck, if i'm not paying my own attorneys to get a deal done -- if in fact the other guy is paying my attorneys! -- i would crank up my attorneys every which way, trying to gain every possible advantage i can. which VCs do, all the time. who wouldn't? i mean, why does the chinese government charge the family of an executed prisoner for the cost of the bullet used in the execution? because they can.

the way i resolve that tension is by asking for a cap on legal fees allowed. and before i do the cap, i ask my own attorneys -- or anyone who has experience with doing similar deals to the one I'm doing -- to give me an idea of what it should cost to get such a deal done -- after all, VC funding deals in particular are all pretty cut and paste.

with a cap in place, you'll be amazed and delighted how quickly and easily things get processed and completed.

[Hooman Radfar]

Fred, I agree with your point, "You [entrepreneurs] should not feel like you have to pay a fee to a venture firm to get a term sheet signed or even close a deal." Moreover, I think that Jeff is 110% right that if an entrepreneur is in a situation where a VC requires these types of "fees" in order to close a deal they [the entrepreneur] should walk. I have not heard of any top-quartile firms that require you to pay this type of upfront cost.

[JayR]

The market standard for as long as I have been around is that in institutional VC deals, if the deal gets done, the VC's legal expenses get covered up to a capped amount, and if the deal doesn't get done then each party covers its own expenses. It's the same in most other types of institutional financing - commercial lending, buyout transactions, etc. It's not as standard for strategic investors to get their expenses covered, particularly if the strategic is represented by in-house counsel, although some strategic investors insist on an allocation to cover the overhead associated with their internal review.

I have encountered the VC upfront fee payment issue twice in my fifteen or so years of papering venture deals. Both were in the last six months. In both instances, the "fund" involved wasn't really a fund and wanted to use the money to travel around to find a syndicate. It was effectively the same as the company paying a finder to go look for investors (except that the payment wasn't tied to success in finding money). I don't know of any respectable VC that would ask for this kind of fee, and I wonder if a respectable VC would co-invest alongside a VC that would ask for this kind of fee.

You see a lot of angel groups that charge companies to pitch - as much as several hundred dollars. I've heard all sorts of justifications for that. I don't buy into any of them.

[Jeff Clavier]

In the current market where there is a lot of venture and angel capital available, imposing upfront fees in "hot" sectors like consumer Internet would lead to dealflow drought IMHO.

Though getting entrepreneurs to pay $1K to attend a one hour pitch meeting sounds pretty good as an eyeball monetization strategy (eh eh).

On the issue of reimbursing the legal costs of the lead investor, as long as there is a reasonable cap ($25K is really the max), it is a market practice I don't have an issue with. And remember that if multiple firms are involved - which is almost always the case with Series Bs and up, only the lead investor gets to claim its fees back.

[Michael Cooper]

Sound like extortion.

[ivan]

I would guess that, in any industry, when something becomes 'custom and practice' (or as Fred writes, "Also, most VC firms ask the companies to pay the legal expenses associated with closing the transaction ... it is customary and has been the industry practice for years") it is time for a shake up. Why would a company pay the legal expenses of the VC that is investing? Surely that is a legitimate cost of business for the VC. Do no VCs see these sort of things as competitive advantages to offer companies. After all, if it's not that much from the funding round, it's not that much from the VCs income either.

[Alexander]

My first thought wasn't that the VC was a scam artist (though that seems more likely to me now) but that the VC was testing the entrepreneur at the start to see how knowledgeable he was about the process. :)

[reader]

If I was an investor (LP) in this VC fund, I'd cancel my investment immediately.

The main reason startups work is that all parties (employees, founders, VCs) are forgoing some cash compensation to align their interest in the equity value of the company. That's what the LPs are investing for.

I've spoken on this subject before about "consultants", "advisors" and "venture catalysts" charging cash to startups with the promice of success. terrible idea. VC firms are getting more than their fare share of cash in management fees.

[Matt Lyon]

Reminds me of a local "rental agency" in our highly-impacted college town that charged $100 application fees to consider you for renting their apartments -- the clincher is that they made more money collecting fees than they would from actually renting the place out, and therefore never found anyone 'suitable'.

Fortunately a few smart people caught on eventually and alerted the state housing commission, which in turn shut them down.

[Charles F. Bacon]

This fee request looks like an up front fee scam. I have seen a ridiculous number of such scams. However, to be fair I have not seen any of the bigger venture capital firms charge such a fee. (If you have, please email me right away!) You should NEVER pay an upfront fee to a capital source, such as a venture capitalist.

Now of course there is the investment banking route, which is an entirely different story. The poor entrepreneur gets poorer until the deal is done, by paying up front for practically anything the investment banker can think of.

This brings up one of my pet peeves. Financial houses are really good at adding more and more charges to the deal post-financing. I have a rather strong opinion about this practice. Over the years, capital sources, typically the VCs but practically everybody, have created a myth that all this falls under the heading, 'a standard industry practice.' Baloney! There are no standards here at all! Every year they try adding new charges and categories, and when no one successfully challenges these, they build it in as if it were part of the foundations of every deal.

I have seen some absolutely outrageous fees. Probably the most outrageous of all time is the 'non-accountable expense allowance.' Let's play that back. The entrepreneur pays a fee for something that is nothing, just a number pulled out of thin air!

Make no mistake. All these charges and of course their fees do not benefit the entrepreneur at all, and in fact, come right out the entrepreneur's pocket. So, the financial houses deduct all the fees and charges, and the entrepreneur ends up with far less than their requested capital!

I suggest an industry-wide practice change. Add all the fees and charges on top of the requested capital and raise that amount, so that the entrepreneurs receive what they actually need vs. a watered-down remainder! Just one man's humble opinions. Charles F. Bacon, www.duediligenceguru.com.