Nivi · April 1st, 2007
“Having information that the other side doesn’t have gives [VCs] an advantage… they take advantage of entrepreneurs who haven’t been through this before… they were totally willing to take advantage of us.”
“Knowledge is Power.”
In this series of articles, we’re going to explain how to negotiate a great deal with your Series A investors. We’re calling this series Term Sheet Hacks.
The VCs know more than you do.
You, the entrepreneur, negotiate a term sheet once every few years. You negotiate your most important term sheet (the Series A) when you have the least experience. You negotiate against a VC firm that issues two to three term sheets per month. You negotiate against a “standard” term sheet that encapsulates decades of combined knowledge from hundreds of venture firms.
Like a good chess player, your prospective investors know what the game looks like many moves from now:
- Their term sheet foresees the Series B, possibly terminating you, selling the company, and more.
- Their term sheet anticipates those events and includes terms like ‘protective provisions’ and ‘election of directors’ that create the best future outcome for their firm.
- They employ a full-time CFO or general counsel who ensures their firm is cutting good deals. And his shelf is filled with books on the hilarious topic of term sheets.
On the other hand, you probably have a basic understanding of a few simple terms like ‘valuation’ and ‘vesting schedules’. You barely know what the game looks like right now, let alone at the Series C.
Your investors can take their time – they have years to invest their money – but you’re under pressure from your employees and co-founders to deliver the money that will keep your company alive. The clock is ticking…
Good companies get bad deals all the time.
Many of the successful companies that we all read about in the news didn’t negotiate good deals simply because they didn’t get good advice. Consider Jim Clark‘s (founder of SGI and Netscape) account in The New New Thing:
“At [SGI] board meetings… Jim’s face would get red and he’d start shouting that [an investor and board member] had cheated him and his engineers.”
Or ask a friend who has taken money from investors.
Whether these stories are true is irrelevant. Like any negotiator, your prospective investors are not in the business of giving you a good deal. They are in the business of making money for themselves and their investors (their limited partners).
Isn’t this what my lawyers are for?
In principle: yes. In practice: no.
With few exceptions, most law firms advise their clients to accept “standard” terms.
Most law firms do a lot more business with VCs than they are likely to do with you. VCs refer new clients to the law firms, hire the law firms regularly, and know the attorneys socially. Where do you think the law firms’ loyalty lies?
The basic incentives between you, your law firm, and your prospective investors are not in your favor. Your lawyers make money by executing transactions and your investors simply bring more transactions to your lawyers than you do.
You can’t hack a term sheet without leverage.
Don’t bother trying to apply any of these term sheet hacks if you don’t have leverage. You can’t negotiate at all without leverage. Roughly speaking, leverage is power.
Alternatives are the most basic type of leverage in any negotiation. Fancy negotiators call their best alternative a BATNA (Best Alternative To a Negotiated Agreement). If you’re negotiating a term sheet with the famous Blue Shirt Capital, your BATNA may be an independent term sheet from the renegade Herd Mentality Management.
A BATNA is just one type of leverage and it is possible to negotiate effectively without a good BATNA. Hostage negotiators do it all the time. But if you’re not in the mood for a hostage negotiation, get multiple offers before you apply any of these hacks. Don’t let anyone tell you that creating competition to invest in your business is a bad thing.
Let’s get this party started.
Our goal here is to give you the knowledge to effectively negotiate against the experts. We don’t have all the answers but we’ve negotiated enough term sheets, started enough companies, and learned from enough entrepreneurs, lawyers, and VCs to understand how this game can play out. Term Sheet Hacks is a work in progress and we’re looking forward to learning more from your comments and emails.
These articles assume that you either have a term sheet in-hand or are anticipating one. If you need a basic understanding of term sheets, read Brad Feld’s term sheet series and hire a lawyer.
Before you go on, please read our disclaimer:
This site provides information. Use it at your own risk.
Information is not the same as legal advice – the application of information to an individual’s specific circumstances. This site does not provide legal services or legal advice.
Although we try to make our information accurate and useful, you should consult a lawyer to interpret and apply this information to your particular situation.
We are not lawyers and we do not take any responsibility for rashes, financial ruin, or anything else that follows from applying this information.
Our first two hacks show you how to create a board that reflects the ownership of the company and why you should make a new board seat for a new CEO. We also maintain a list of all the term sheet hacks. Please do read on…
Topics Launch · Lawyers · Negotiation · Term Sheet
Thanks! Keep ’em coming. Even the nicest VCs can’t help themselves, its in their genes.
That’s just a stupid comment about law firms. We represent the company, which generally means we report to the board of directors. And we make it painfully clear that we are not representing the founders as individuals. Most of the time, I go so far as recommending and even pushing founders to get separate counsel to represent them if I think they are getting bad terms. And I think this is representative of all of the major Silicon Valley firms.
Prior to Series A funding ‘the company’ and very likely the board is severally the founders. So, prior to a series A closing and a board with external investors being formed you, Mr. Silicon Valley Lawyer, effectively and materially represent the founders who are the owners of the company. Your argument in this case is nothing but an example of legal sophistry.
Maybe dont have the guts, nor the moral fibre, to do your fudiciary duty and go to bat for founders because you know you’ll be black balled in future by the VC firm concerned for being too founder friendly.
Bottom line, you represent the interests of the guy/s that sign your engagement letter. They count on you to represent them. They are the incumbent shareholders of the company. The company board, which is not a human being, is nothing a representation of an aggregate of those founder shareholder interests other prior to series A funding.
You do not report to the board that is formed after closing but the one that exists before it. The board prior to funding represents the founders. Therefore, you represent the founders. Kapish?
Congratulations for starting this site! I am sure you will have a grateful following in no time. Also, fyi, Business Week just posted an article that talks about the changing dynamics of VCs investing in angel rounds and mentions my startup jaxtr as an example.
Your comment about lawyers hit the nail on the head. Some time ago, I was an inexperienced enterpreneur. We had hired a Silicon Valley law firm, who drafted the Series A agreements. I asked the lawyer, should I sign these in my best interest? She said yes. I signed. I was fired from the company within one month by the “professional” CEO! DO NOT TRUST THE COMPANY’S LAW FIRM EVER!
There are plenty of lawyers who know VC terms and VC deals very well, yet are not in the VC’s back pockets. Ask around your business community — you will quickly learn which lawyers you can trust as being more company/entrepeneur focused, and which ones will be good VC lawyers but too cozy with VC’s for a smart entrepeneur to really trust. Doing VC deals on the investor side is a low-margin business given the severe downward fee pressure from the VC’s — some firms stock up on VC deals and go for quantity over quality; others will do a VC deal *for the Company* but will generally only occasionally work with VC’s. Also, many VC-back-pocket lawyers will sell themselves to you as having all the connections to the VC’s and can get your company in front of all the big players, but that should be an alarm bell. There is a difference — ask around with people who have been there and whose opinion you value and trust, and you will find it.
Help! Hurry up with the rest of the hacks, its urgent here 🙂
(very urgent)
Zeon, if it is urgent, send us an email at nandn at venturehacks.com.
As a VC, and a fellow boardmember of Naval’s, I’d say this is all good advice, especially if you don’t trust your prospective investors.
One thing ALL entrepreneurs should do is to reference check their investors in the same way that those investors are reference checking you. That way you hopefully won’t be going into a very close partnership with people that you don’t trust…
Excellent… Great perspective. Many of these guys (investors) will fleece you like the sheep that you are if you’re inexperienced or otherwise let them… and they’ll do it with a smile… and laugh about it back at the office. I’ve seen it many, many times in my previous life on the buy side at a venture debt firm. Cheers, chrisco
Interesting contrast of time constraints for entrepreneurs and VCs. Yes, entrepreneurs endure more pressure on the monetary side, but VCs are entitled to provide the resources to lessen the burden. Look forward to reading more Hacks.
The only group that gets “worked” more than the entreprenuer is the VC fund’s limited partners. You are swimming with the sharks here. Get some protection.
Great site.
Great site. I am in the middle of trying to find an investor and this advice is really great. One other alternative for bootstrapping a company is a government program called the SBIR. They give you enough untethered capital to get a product development lifecycle going, although navigating through the program is a pain….
You know something they don’t. You know your business:
http://www.conquistador.org/newsletterissue?newsletterIssueEntityId=1120
Good advise. The basic take away is that while an entrepreneur might be doing things the first time, the VCs, lawyers and other people in the start-up ecosystem have been there and done it before. Naturally they have more experience and know more about how to protect themselves when the tide turns. An entrepreneur should not be afraid to ask “what-if’ questions to his lawyer when he doesn’t understand anything in the term-sheet.
Some part of the term-sheets is like negotiating “pre nups”. You are basically negotiating the framework to follow when things go wrong or you end up in disagreement in future, just at the point where you are agreeing to work together in present.
One thing the article should expand upon is how to negotiate without scaring of the VCs. An entrepreneur has to balance protecting his interest with not coming across as someone that might be a “problem founder”. No VCs like to work with someone they perceive as a problematic founders. It is a tight rope walk !
We have always said at our firm that you can represent VCs or entrepreneurs, but not both, for the very reason you identify. You can’t aggressively protect a founder if you are concerned that it might cost you the legal work for raising a VC’s next fund. The VC community is simply too small, and business matter are too personal. You hit the nail on the head, regardless of what my colleagues say.
I’m wrestling with the granddaddy of these questions – VC or not VC?
Personally, I’ve heard three basic arguments:
1. The Jonathan Abrams / Friendster lament – decrying VC as know-nothing velociraptors. I don’t buy it. There are many sides to that story, but if they couldn’t get their shit together to deliver a working product, then it makes sense that KPCB pushed him out, and from there the revolving door of CEO’s was a tailspin to the ground.
2. Smart people saying: “VC’s add no-value; even the best of them. If you can, keep your overhead low, and fuel from sales. The days of huge Oracle licenses and building a data center are a thing of the past.”
3. On the other side, there are all those testimonials on the VC web sites that say: we couldn’t have done it without them. And there are many stories of entrepreneurs that have made significant money, yet they go back to raise VC instead of fueling it with their own money.
Any thoughts from the community on choosing the right path?
Nattybumpo,
If you think capital can make your business move faster and let you test hypotheses faster or more effectively, consider raising money. Angels are another source of capital for your business.
You should also consider whether you have the type of business that VCs are looking for before you start spending your time raising money from them: e.g. great, relevant team with a great product chasing a huge market.
The primary value of most VCs is adding money. Would you work with them if they didn’t give you money? If the money makes sense for your business, consider it. You can get good advice and intros from advisors, you don’t necessarily need VCs for that. Unbundle the money-add from the value-add.
Wow, I found your site just in time. I got a term sheet a few days back that seemed a bit agregious and after reading your hacks I’m in awe over it. Keep it up, thanks!
Howdy. What are your thoughts on hiring a boutique investment firm to help raise a VC round?
Nattybumpo,
On one hand, it makes all the sense in the world that entrepreneurs who need expert help should be able to hire somebody to help them raise money.
On the other hand, there’s already tons of biased but still good advice from VCs on the web on how to raise money. My guess is that most of the placement agents you can hire are going to give you worse advice than you can get from a few blogs. For example, I constantly refer people to David Cowan’s How To NOT Write A Business Plan.
There there is the adverse selection signal you send by going to a boutique firm. e.g. if you are good you don’t need the help, if you are bad you do need the help. (I hate adverse selection arguments but you should be aware of this signal).
I don’t want to say that it isn’t that hard to get intros to VCs but I will: “It isn’t that hard to get intros to VCs.” In general, they’re looking for companies that are already succeeding in huge markets. Nothing succeeds like success and VCs invest in success. They’re not entrepreneurs with a passion. If you’re succeeding, you should be able to get the meetings.
Angels are more relevant if you are early or you are looking more for a passion investor.
Most VCs, especially early stage ones, hate it when you come knocking with an investment bank. You look too weak and unconnected to get an intro on your own, it looks like you have bad judgement paying the bank a % of the round to shop you around, they don’t like their money going to the middleman, and the whole thing smells like a pure price auction (most investors like to believe that they and their money is special).
I wouldn’t do it except for a very late stage company being shopped to purely financial or to corporate investors.
Thank you, fellas. Another broader question on the VC process: What is a win????
In other words, VC’s like to say that they are looking for 10x their money. Yet many know that if they make 3x their money, they are happy.
So….imagine that one has the opportunity to take $5M at a pre-money of $15M, or take $2M at a pre-money of $6M. Arguably, the expectations from the VC firm are significantly different. ie: in the $5M scenario, the VC expects a $200M liquidity event, whereas in the $2M scenario, the VC expects an $80M liquidity event.
From the entrepreneur’s perspective, this is confusing. On one side, for the same dilution, the more cash the better. On the other, if the entrepreneur and VC are mis-aligned in terms of what constitutes a “win” I’ve heard horror stories in which the VC vetoes a sale and then market conditions change. ie: if a buyer comes along with a check for $50M and this is a win for the entrepreneur, but not for the VC, this could be a problem, that could potentially have been mitigated in how much money to raise.
Any thoughts, O’ sherpas of the VC world?
A few thoughts:
1. Ask the firm what they consider a win. See how aligned you are. Check this when you do reference calls on your investors.
2. Pare back protective provisions so the investors lose their right to veto a sale if the share price hits a threshold. We’ll cover this in a future hack.
3. You can always re-negotiate with your investors if you have an offer to buy the company.
Unfortunately this is one of those “it depends” answers. The major factors are time to liquidity, size of the fund, success of the VC, and success of the fund.
1) The faster you get to liquidity, the smaller it needs to be to count as a win. 3x in one year is a win. 3x in 10 years is not.
2) Biggest factor is size of the fund and how much the investment returns relative to that size.
3) The more successful the VC historically, the bigger the win they need (Sequoia may want 50x while no-name VC might be happy with 5x)
4) The more successful this particular fund is so far, the more anxious the VC is to get this fund done, closed, and move on to the next one. Late in a successful fund’s cycle, the VC is looking to liquidate companies and move on to the next and usually larger fund…
I’m looking for any general rules of thumb that may explain what is reasonable when it comes to determining the ownership for the Founder and ownership for the investor. I’ve created one company fully finance by one VC, who in my opinion took advantage and 2 years into the business cheated me out of half the founders shares. Now they have decided to sell the company. I have been approached by other investors to back a bid to buy the company. Gross sales are $60 million per year. EBITDA is $7.0 million. Original investors will more than double their initial investment (maybe even triple) they made 5 years ago. Founders share is 5% (was 10%).
I’m looking for idea of what to ask investors who back the purchase and further growth of the company.
Thanks,
AG
A new CEO would get 5-10% of a financed startup.
Since you’re providing access for your new investors, engineering the deal, and generally making the deal possible for your new investors, you should probably receive what a CEO would get in an LBO. I understand that is in the 10-20% range.
Either way, this assumes that you are joining the company and vesting for 3-4 years.
Best way to get good legal advice: make friends with a sharp lawyer.
Second best way to get good legal advice: refer clients.
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