Nivi · January 29th, 2010
Actually two dueling inspirational speeches. Very NSFW — contains, as they say, “strong” language.
Actually two dueling inspirational speeches. Very NSFW — contains, as they say, “strong” language.
Thanks to Walker Corporate Law Group, a boutique law firm specializing in the representation of entrepreneurs, for supporting Venture Hacks this month. This post is by Scott Edward Walker, the firm’s founder and CEO. If you like it, check out Scott’s blog and tweets @ScottEdWalker. – Nivi
It’s a new year — which means it’s time to make resolutions. Rather than write about my resolutions, I decided to put on my lawyer hat and advise entrepreneurs on what I think their New Year’s resolutions should be. During my 15-year career as a corporate lawyer (including nearly eight years at two major law firms in New York City), I have seen entrepreneurs make certain fundamental mistakes over and over again. So what better way to welcome in the new decade than to recommend the following resolutions to entrepreneurs…
There is nothing that will give an entrepreneur more leverage in a negotiation than a competitive environment (or the perception of one). Every investment banker worth his salt understands this simple proposition. Not only does competition validate a firm’s interest, but also it appeals to the human nature of the individuals involved. Competitors can be played off each other and, as a result, the entrepreneur will be able to strike the best possible deal.
I learned this important lesson as a young corporate associate in New York City. As I discuss in my video post, Lessons Learned in the Trenches of Two Big NYC Law Firms, I recall having two M&A transactions on my plate: one was a divestiture — i.e., the sale of a division of a multinational corporation being auctioned by an investment bank; and the other was the sale of a private company to a competitor (with no i-bankers involved). In both deals, my firm was representing the sellers but, as we worked our way through the negotiation process of each deal, we ended-up with two completely different acquisition agreements with respect to the material terms.
In the auctioned deal, because the i-banker was able to play the prospective buyers off each other and create a competitive environment, the final agreement was extremely seller friendly and included broad materiality qualifications, a huge basket/deductible and a cap on seller’s liability of 10% of the purchase price. In the private-company transaction, however, there was only one prospective buyer — and the buyer’s principals knew that the seller was anxious to sell and thus were playing hardball. The deal terms ended-up being extremely buyer-friendly and included a large portion of the purchase price being escrowed and a cap on the seller’s liability equal to 100% of the purchase price.
The lesson learned is that you must create a competitive environment (or the perception of one) in order to have strong negotiating leverage. There is, however, one important caveat that entrepreneurs should keep in mind: this game must be played carefully and is better handled by someone with experience. The last thing an entrepreneur wants is to end up with is no deal at all.
You have to think with your head, not with your heart — particularly when you’re doing deals. The best deal guys are masters at taking their emotions out of transactions and being extremely disciplined. They will just walk from a deal if they get out of their comfort zone (e.g., with respect to the price, risk profile, etc.), regardless of how much time and money they have spent.
On the other hand, most entrepreneurs become emotionally wedded to a particular transaction and are unable to maintain their objectivity as they move further along the deal process. They get all excited as soon as someone waves some money at them and allow themselves to get drawn into the money guy’s web. It is critical that entrepreneurs understand this dynamic. Entrepreneurs will generally be negotiating with guys on the other side of the table who are far more deal savvy than they are – venture capitalists, private equity guys, etc. – guys who are masters at playing on their emotions.
This is why it is so important for entrepreneurs to establish a game plan (i.e., dealbreakers) before the negotiating process begins and to have the discipline to stick to the plan and be willing to walk, if necessary. If an entrepreneur is seeking venture capital financing, he should sit down with his transaction team before reaching out to the VC’s to establish his dealbreakers with respect to key terms, such as valuation, the liquidation preference, board composition, etc. The same approach should be followed if he’s interested in selling his company: What’s the lowest purchase price you’ll accept? What’s the highest cap on liability you’ll agree to? Will you agree to escrow part of the purchase price? If so, how much and for how long? Once you establish the dealbreakers early on, you can take your heart out of the equation and think with your head.
This is the advice a senior partner gave me when I was a young corporate associate at a major New York City law firm: “If you want to be a great lawyer, you have to work your balls off and make practicing the law the number one priority in your life.” He explained that this means everything else in your life has to be pushed aside, and you need to “work, work, work.” And when you’re not working, he added, you need to be reading treatises and articles discussing the deals you’re working on to get a deeper understanding of the significant issues. When I explained to him that, after three months, I had been working nearly every weekend and that my girlfriend was ready to leave me, he told me that I need to get a new girlfriend.
I received similar advice from Harry Hopman, my old tennis coach (and the winningest coach in Davis Cup history), when I was playing tennis in the minor leagues after college. He preached to me that: “It all comes down to one word — desire. How badly do you want it? How much are you willing to sacrifice?” And he was right. When I was traveling and playing tournaments in Europe and South America, I noticed that the best tennis players were generally the hardest working; the qualifiers were the ones going out drinking every night, not the top seeds. Sure there were exceptions — like John McEnroe — but the exceptions were rare.
I have seen this same pattern during my legal career: the most successful clients tend to be the hardest working. The private equity guys and hedge fund guys I represented in New York City were animals; working around the clock and cranking out deal after deal. I attribute a lot of their success to just plain hard work. In 2005, I moved out here to California to help entrepreneurs, and it’s been a mixed bag in terms of the work habits that I’ve seen. Some of my clients are intense and put in the long hours; others, however, are just dreamers — and they are the ones who struggle. In short, there are no shortcuts to success.
Here’s the advice I give all my clients to avoid getting screwed by their investors: do your due diligence prior to accepting any money. The number one mistake I have seen entrepreneurs make in any deal is the failure to investigate the guys on the other side of the table. Remember, you will, in effect, be married to your investors for a number of years. Accordingly, entrepreneurs must do what any bride or groom does prior to tying the knot — date for a while and, of course, meet the family.
What does this mean in practical terms? It means surfing the web and learning everything you can about the particular firm making the investment and, more importantly, the particular individuals with whom you are dealing (and who, presumably, will be sitting on your board for a number of years); it means breaking bread and having a couple of beers with the potential investors; and it means getting references and talking to other entrepreneurs and founders who have done deals with them. Issues to address include: How have they treated their other portfolio companies? Are they good guys or jerks? Can they be counted-on and trusted? Do they share your vision for the venture? Will they add significant value (e.g., through contacts, domain expertise, etc.)?
There is an outstanding video discussion on Mixergy.com between Brandon Watson, a smart entrepreneur (currently at Microsoft), and Andrew Warner, the founder of Mixergy, as to what could happen if you don’t adequately diligence your investors. Brandon is extremely candid and discusses how he got “bullied” by his board. Moreover, he expressly notes in the comments to that post that, “the diligence factor was that I knew them, but had never taken money from them. It’s hard to know how people are going to react when they are at risk of losing money because of something you are directly responsible for until you are actually at that point.”
This is obviously a bit self-serving, but every entrepreneur needs a strong, experienced lawyer to watch his back. There is just too much at stake for entrepreneurs to be (1) using sites like LegalZoom, (2) pulling forms off the web and trying to play lawyer, or (3) retaining the cheapest lawyer to save money. And as the Madoff affair and other recent high-profile cases demonstrate, there are a lot of unscrupulous characters out there trying to take advantage of unsophisticated entrepreneurs.
There are also more subtle potential problems entrepreneurs need to be protected from, including the inherent conflict of interest that certain service providers have. For example, entrepreneurs need to be careful with investment bankers, who generally only get paid if a particular deal closes. Indeed, a middle-market i-banker’s entire year can be made or broken based on whether or not he can close one or two deals.
Unfortunately, I experienced this issue first-hand shortly after moving to California when I got pulled onto an M&A deal in which an i-banker stuck his finger in my chest and warned, “We’re going to get this deal done despite you fucking lawyers.” He then later complained to the managing partner (who had the client relationship) that I was blowing up the deal because I had retained special environmental counsel from my old NYC law firm and we were pushing too hard on the environmental indemnity. Good work by the i-banker (and cheers to my former managing partner) for getting the deal closed by watering down the environmental indemnity: less than six months later our client’s company was indicted for environmental problems that it inherited as part of the acquisition.
The bottom line is that a strong, experienced corporate lawyer will sober the entrepreneur and lay out all of the significant legal risks in a particular transaction; he will then push hard to negotiate reasonable protections. If the deal sours and lawsuits are filed, well-drafted documents with appropriate protections become a kind of insurance policy to the entrepreneur.
If you like this post, check out Scott’s blog and tweets @ScottEdWalker. If you want an intro to Scott, send me an email. I’ll put you in touch if there’s a fit. Finally, contact me if you’re interested in supporting Venture Hacks. Thanks. – Nivi
“Some managers are uncomfortable with expressing emotion about their dreams, but it’s the passion and emotion that will attract and motivate others.”
– Jim Collins
“People will forget what you said, people will forget what you did, but people will never forget how you made them feel.”
– Maya Angelou
(Both quotes are from The Presentation Secrets of Steve Jobs by Carmine Gallo.)
I’ve started reading Emotions Revealed by Paul Ekman, a consultant to the television series Lie to Me. It’s an excellent and accessible catalog of emotions. For example, Ekman describes the differences between 10 or so different kinds of enjoyable emotions: sensory pleasures, contentment, excitement, relief, wonder…
In 1936 (!), old-school economic giant John Maynard Keynes described the spontaneous optimism that drives startups:
“A large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.
“Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die—though fears of loss may have a basis no more reasonable than hopes of profit had before.
“It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death.”
(Via: Mavericks at Work)
“Over the past few months, I’ve witnessed the experts and the media bemoan and belabor the “tough economy.” My attitude in times like these is to stay focused, stay optimistic, ignore the media and operate as normal. We’ve done a great job of doing these at Infusionsoft and it’s paying off. We had our best quarter ever in Q3 and we’re on track to blow that away this quarter…
“Sequoia Capital is well respected. [But] they blew an opportunity to remain optimistic and they succumbed to the fear that’s swirling around. In the process, they spread their negativity to a bunch of smart people who really ought to know better.”
In The Psychology of Entrepreneurial Misjudgment, part 1: Biases 1-6, Marc Andreessen kindly interprets an essay from Charlie Munger‘s book, Poor Charlie’s Almanack:
“Mr. Munger’s magnum opus speech, included in the book, is The Psychology of Human Misjudgment — an exposition of 25 key forms of human behavior that lead to misjudgment and error, derived from Mr. Munger’s 60 years of business experience. Think of it as a practitioner’s summary of human psychology and behavioral economics as observed in the real world.
“In this series of blog posts, I will walk through all 25 of the biases Mr. Munger identifies, and then adapt them for the modern entrepreneur. In each case I will start with relevant excerpts of Mr. Munger’s speech, and then after that add my own thoughts.”
I started making a cheat sheet of Marc and Charlie’s key points—I thought I would share it with you. It’s a handy reference once you’ve read the full article.
(For another great article on cognitive bias, see Cognitive biases potentially affecting judgment of global risks.)
Once you realize how much incentives influence human behaviour, you need to assume their influence is even bigger than you think. Never think about something else when you should be thinking about incentives.
“If you would persuade, appeal to interest and not to reason.”
Incentives are so powerful that every incentive should have a counter-incentive to restrict gaming of the first incentive.
Liking and loving something conditions you to (1) ignore faults of and comply with wishes of the loved, (2) favor people, products, and actions associated with the loved, and (3) distort other facts to facilitate love.
Wanting to be liked by your teammates impedes you from firing people and making unpopular but good decisions.
Disliking or hating something conditions you to (1) ignore virtues in the disliked, (2) dislike people, products, and actions associated with the disliked, and (3) distort other facts to facilitate hatred.
Startups should focus on their customers, not their competition—whom they may dislike.
Execution is often better than further contemplation:
“A good plan, violently executed now, is better than a perfect plan next week.”
Believing that something will happen, and convincing others that it will be so, makes it more likely to happen.
While a hypothesis is still doubted, wise entrepreneurs know whether (1) persistence and iteration will prove the hypothesis, or (2) the hypothesis will not be proven and additional testing is a destructive waste of time—a new hypothesis is required.
Have strong opinions, weakly held. New and correct ideas may not be accepted simply because they are inconsistent with existing ideas.
Your existing ideas may be unknown to you. They may be hidden assumptions. We often make hidden assumptions about unknown unknowns.
If existing customers in the market aren’t ready for a product that is inconsistent with their behaviour, go after customers who aren’t in the market because they can’t afford the existing product or don’t have access to it. See The Innovator’s Dilemma and The Innovator’s Solution.
“Things are worth what people pay for them.”
Summary: You need strong alternatives to hack a term sheet. Create alternatives with focus: pitch and negotiate with all your prospective investors at once. Focus compounds scarcity and social proof, which closes deals. Focus also yields a quick yes or no from investors—either way, you will soon get back to building your business.
The simplest type of leverage is a great BATNA. A great BATNA might be a term sheet from another investor, an offer to buy your company, or an investment from angels instead of VCs.
Hostage negotiators learn how to negotiate with awful BATNAs where people die in a hail of bullets. If you’re not in the mood for a hostage negotiation, get a great BATNA by creating a market for your shares.
Many entrepreneurs wonder what their company is worth. The incredible answer is: companies are worth what people pay for them.
There is no right or wrong price. The market clearing price is determined by supply and demand: how many shares you’re selling, your team, your product, your revenue, your salesmanship, et cetera.
The market determines your value, but there is no market for your shares—you must create it. How? At a minimum, get two independent, competing offers from investors who make it a habit to invest in startups at your stage.
Pitch all your prospective investors at the same time. Negotiate with all interested investors at the same time. You can’t clear the market in series, you can only clear it in parallel. Learn from Adam Smith at Xobni:
“Our series A didn’t happen quickly. We excited the people we met with, but we were timid about getting started having recently closed a $100k angel round. One firm had interest, so we thought “We better talk to someone else to make sure we’re getting a good deal.” That incremental approach went on for a few months. We were always in late stages with one investor but just beginning the dialogue with another. Deciding to raise money should be an atomic decision; don’t try to just dip your toe in.”
Jump on your desk, kick something, and declare a start to your fund-raising. Don’t negotiate consecutively, negotiate concurrently—you can’t create a market by meeting investors one-at-a-time. The only way to clear the market is to focus on fund-raising and talk to a lot of investors at once.
On eBay, everybody bids at the same time, over a short and arbitrary period of time. That drives the price up. They don’t bid one-at-a-time over a timespan of ‘whenever’.
The next few hacks will cover the five major milestones of fund raising:
Your leverage goes up at each milestone—that is, your interest in new prospective investors goes down at each step.
Investors move in herds that are steered by scarcity and social proof. Scarcity is “hurry up or the deal is going to disappear.” It engenders urgency. Social proof is “everyone else wants to invest, don’t you?” It engenders validity.
Scarcity and social proof make people crazy. Scarcity and social proof close deals. Focusing on fund-raising creates a positive feedback loop of scarcity and social proof:
If one investor wants to invest, you get a little bit of scarcity and social proof. That raises the interest of a second investor and creates more scarcity and social proof. Which raises the interest of a third investor…
Learn more about the psychology of negotiation in Bargaining for Advantage. It combines the negotiation principles of Getting to Yes with the psychological principles of Influence. Chapter 6 of Bargaining for Advantage, “Leverage”, is free money.
Focusing your fund raising on a short period of time (about 4-8 weeks) means you will raise money quickly. Or you will fail quickly and start working on getting past no. Either way, you’re no longer raising money, you’re back to building your company and serving your customers.
Related: You can’t clear the market in series.
Image Credit: Noah Angeja