Mastering Negotiation Tactics with Startup Investors
Written on
Chapter 1: The Challenge of Negotiating with Investors
Negotiating with startup investors can be quite daunting. I vividly recall a moment during the negotiation of our first $12 million funding round when "Raul," the leading venture capitalist from "Donald Ventures," bluntly stated, "there is no negotiation." That’s certainly not the kind of feedback you hope for.
The reality is that securing funding can be incredibly tough. In our case, we faced significant obstacles. By the time we received a term sheet from Donald Ventures, 63 other venture capital firms had already opted out. In fact, we were left with only two firms on our list when we reached out to Donald Ventures.
Receiving the term sheet from Donald Ventures at 5 PM on a Friday was nerve-wracking. Like most term sheets, it had a deadline—5 PM on Saturday, giving us just 24 hours to finalize an agreement. I managed to schedule a call with Raul for Saturday at 4 PM. Although the terms were far from favorable, I understood that accepting this deal was our only option. It was either accept these terms or face the end of our company.
Despite the unfavorable terms, the potential success of the company meant that my team and I could stand to gain significantly. At exactly 4 PM, I called Raul to initiate negotiations. However, he reiterated, "There is no negotiation on this term sheet." No matter how hard I tried to persuade him, he remained unyielding.
After about twenty minutes of back-and-forth, Raul reminded me that it was 4:20 PM, and the term sheet would "explode" at 5 PM. He left me with his number and ended the call, leaving us without any negotiating power.
You can't negotiate effectively without leverage. After discussing with my advisor Dave and our investor Gill, I ultimately agreed to the terms presented.
Section 1.1: When You Can Negotiate
Your negotiating power is virtually nonexistent when the only option is to accept the deal. However, leverage comes into play when you’re not dependent on outside funding.
Take "Bill," for instance. His company was cash flow positive, boasting annual revenues exceeding $10 million. He sought funding to bolster his cash reserves and accelerate growth. While his cash position was not ideal, Bill's financial stability provided him with the leverage to walk away from unfavorable terms.
Conversely, what if you find yourself in a position where survival hinges on securing funding? In such cases, you could follow Kevin's example. He was looking to raise $20 million in a Series B funding round and, although his company was thriving, it needed additional funds to sustain its growth trajectory.
Kevin wisely began seeking funds 18 months before running out of cash, which positioned him similarly to Bill. He didn't desperately require the money, giving him leverage in negotiations. With substantial interest from investors—twelve out of twenty pitching firms expressed a desire to access his data room—Kevin anticipated receiving multiple term sheets.
To maintain his negotiating advantage, Kevin instructed interested investors to submit their term sheets by the end of the month. Sure enough, three investors complied, allowing him to negotiate from a position of strength.
However, a word of caution: Kevin's strategy only works when there is considerable interest in your deal. Attempting this with limited interest will likely backfire.
Section 1.2: Key Terms to Focus On
When evaluating a term sheet, two critical terms deserve your attention. First and foremost is the valuation of your company. It’s crucial to understand that investors, particularly venture capitalists, often require a specific ownership percentage in your startup to justify their investment.
If you’re securing funds from angel investors, they might accept a SAFE note, which postpones the valuation discussion until the next funding round. Conversely, when dealing with friends and family, it's advisable to establish the valuation yourself, especially if they lack investment experience.
The second significant term is the liquidation preference. This could even outweigh valuation in importance. Liquidation preferences dictate how proceeds from a company sale are distributed among investors and founders.
Here are two aspects to consider regarding liquidation preferences. Firstly, aim for a 1X preference, meaning investors recoup their investment amount before you receive any payout. If the preference is set at 2X, they will receive double their investment before you see any return.
Secondly, determine whether the preference is non-participating or participating preferred. Non-participating preferred is more advantageous for founders. For example, if investors hold stocks worth $10 million and own 20% of the company, selling the company for $20 million results in different payouts based on the type of preference.
With participating preferred stock, investors first receive their $10 million, and then they get 20% of the remaining amount, totaling $12 million. In contrast, non-participating preferred stock allows them to reclaim their $10 million, leaving you with the remaining value based on your ownership percentage.
Chapter 2: Seeking Professional Guidance
Negotiating with investors can be complex. While I don't believe that most investors aim to deceive entrepreneurs, having a knowledgeable attorney experienced with investor term sheets is invaluable. Their expertise will guide you through the intricate details and protect your interests.
The first video titled "How To Negotiate With Startup Investors" delves into effective strategies for approaching negotiations with investors, highlighting key tactics and pitfalls to avoid.
The second video, "A Startup's Guide To Negotiating With Investors," offers a comprehensive overview of the negotiation landscape, emphasizing the importance of preparation and understanding investor motivations.