Negotiation Posts

Spearhead asked me to write a post on angel investing when they first launched. Here’s a slightly updated version—most of the wisdom is from Naval.

Charlie Munger says investing requires a latticework of mental models. Here are 11 lessons for your angel investing lattice:

  1. If you can’t decide, the answer is no.
  2. Proprietary dealfow means ‘they want you’.
  3. Investing takes years to learn, but improves for a lifetime.
  4. Valuation matters: you will have to pass on future greats.
  5. Back $0B companies.
  6. Judgment is important but overrated.
  7. Invest only in technology.
  8. Some of the best investors have no opinions.
  9. Incentives make for bad investing advice.
  10. Play fantasy football.
  11. Power beats contracts.

1. If you can’t decide, the answer is no

If you can’t decide on an investment, the answer is no. For all practical purposes, there are an infinite number of investments out there, so pass. 

That doesn’t mean you won’t regret it. But the next investment is just as good a priori.

Your experience and judgement is only going to get better by the time you see the next deal.

2. Proprietary dealflow means ‘they want you’

Nobody thinks they have a shortage of dealflow. The hard problem is getting your money into the startups you want. The company has to want you over other investors.

Without ‘they want you,’ you will get cut out of good investments and end up with adverse selection of weaker companies. It’s okay to pass on investments, but you don’t want them to pass on you.

Missing out on a few investments can mean losing all your money because of the power law returns of investing: the top deal in a good portfolio returns as much as deals 2 through N combined. If you miss out on the top deal, you’re going to miss out on most of your returns.

You never want to hear, “I will come to you if I don’t get money from Sequoia.”

3. Investing takes years to learn, but improves for a lifetime

Get started with angel investing now. It takes years to learn and longer to see returns.

You want to invest in 30 companies at a minimum–that takes time. Start with small investments because your later ones will get better as you gain expertise and brand. So your returns will take even longer.

Investing takes a long time to learn, but it is one of the few professions you can improve until the day you die.

4. Valuation matters: you will have to pass on future greats

You can’t build a portfolio of pre-traction companies at $8-10M pre-money and expect to make a venture return. On occasion, you can make an exception, but you can’t do all of your investments at this price.

You will have to pass on great teams because the valuation is too high. You will have to pass on future iconic technology companies because the price is too high. But passing at a $40M pre-money lets you take 10 shots on goal with unknown companies at $4M pre-money.

You can’t negotiate valuation unless you’re investing 1/3 to 1/2 of the round. Or if you’re the first check in the company. Start the negotiation by saying, “I like you but I can’t make the valuation work, but I would invest if the valuation were X.”

Despite high valuations, it’s still possible to make money in angel investing. If you can’t make money in tech, you can’t make money anywhere. 

Anecdotal valuation data

Valuations for pre-traction companies between 2005-2010 were $1-5M pre-money for the first non-friends-and-family round. Funds that invested during this time period made 4x-100x returns.

These valuations moved to $4-6M pre-money after 2010, with some demo days in the $8-10M range. This likely cut returns by 2/3 or more.

Play with valuations tool on AngelList.

5. Back $0B companies

To quote Vinod Khosla, invest in “$0B companies” that could be worth $1B tomorrow.

Focus your attention only on companies with the potential for a 100-1000x return. Otherwise, pass.

Without these large exits, your portfolio will not achieve a venture return. 

6. Judgment about markets is important but overrated

Some markets are obviously bad and should be avoided. But judgment about markets is less important than you think, because there is so much luck and randomness involved. Companies can do hard pivots into new markets (Twitter, Slack and Instagram).

Judgment is not about doing a lot of research, digging and homework. By the time you figure it out, you will have missed the deal. Instead, learn a few markets really well.

Of course, you will learn about new markets over time. But learn a few markets really well. Buy all the products and try them.

Find the best scientists in the market and invest in them. They can help you with research on your next investment; this is an unfair advantage. 

Read research papers then call the grad students who wrote them. Waiting to learn about new markets on TechCrunch is too slow.

7. Invest only in technology 

The best returns come from investing in technology companies. Avoid companies that don’t develop meaningful technology (either software or hardware).

The 5 largest companies in the S&P 500 (Apple, Google, Microsoft, Amazon, and Facebook) are all technology companies. The largest private companies are also technology companies. 

There are exceptions like Dollar Shave Club. Their early investors had good returns. But, as a rule of thumb, you should only invest in technology.

8. Some of the best investors have no opinions

“I have no idea what’s hot. But I’m certainly always listening. Big Dumbo ears. Just listening.” – Doug Leone, Sequoia

Some of the best investors on the planet have no strong opinions about a particular business. They try not to project into the future, so they can listen intently in the present.

Almost any entrepreneur will be smarter than them in their market. The investor’s job is to listen and decide whether the founders are smart, honest, and hard-working. 

These investors don’t fall in love with a business. When it comes time to do a new round, they re-evaluate the business from scratch and ignore sunk costs.

If you’re thinking about all the great things you could do if you were running the business, you’re going down the wrong path: you’re not running the business.

If you are telling the entrepreneur what to do, don’t invest. Thinking like an investor is different than thinking like an entrepreneur who is determined to make a business work.

9. Incentives make for bad investing advice

Incentives influence the advice you get from VCs, lawyers, incubators, and everybody else. Everyone serves their own interests first. The best source for angel investing advice is other angels and founders.

People are generally well-meaning but, in the words of Upton Sinclair, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!”

10. Play fantasy football

Build your instincts by looking at startups without investing. This will build your instincts, which is what you really use to make investment decisions.

In the old days, you had to work at a VC firm to see dealflow. You had to make a few investments and lose money before getting good judgment. John Doerr called this “crashing a fighter jet.”  First you lose $25M, then you have some judgment.

Now you can get judgment without crashing the fighter jet. You can see dealflow from your friends, your incubator, demo days, and AngelList.

You need a lot of data to build up your instincts. Track your fantasy portfolio and anti-portfolio. Write down what you like and dislike about each deal and see how your judgment develops over time.

11. Power beats contracts

Contracts can be renegotiated. You will be pressured to renegotiate your investment by founders and VCs. If you’re alone, you won’t have the power to fight back.

Contracts are written for worst-case scenarios, so people can’t outright steal your money. Suing people is bad for your dealflow. So real-world decisions are usually based on power.

If you’re the only seed investor in a round, you can get screwed. There aren’t enough co-investors to make a ruckus if the company wants to:

  • Recap and start over
  • Raise the cap on your convertible note
  • Give your pro rata to a new investor

If you’re alone, you won’t have the power to fight back. The startup and their new investors can pressure you to renegotiate. So don’t be a herd animal when making an investment decision, but move with a pack when you do. 


“Every time the other party says ‘I want’ in a negotiation, you should hear the pleasant sound of a weight dropping on your side of the leverage scales.”

– G. Richard Shell, Bargaining for Advantage

Most entrepreneurs don’t understand the power of positive leverage. Here’s a typical situation:

After weeks of fund-raising, you find a brave investor who says “Yes, I want to invest.” He says he will give you an offer soon. You’re excited. A few days later he delivers a term sheet that you don’t like. The valuation is really low. Or the non-economic terms aren’t favorable. Your excitement turns to disappointment and frustration. This is the only offer you have so far. What do you do?

First, we hope you’ve been talking to several investors at the same time and creating a market for your shares. With an adroit touch, you can use this first offer to create the scarcity and social proof that drives other investors to say “yes”. At a minimum, you can use this offer to drive investors to make any decision at all — up or down. And keep improving your alternatives until you’ve a signed term sheet.

But let’s assume you don’t have any other offers and you have to negotiate with this investor. Or that this investor is your first choice — whether or not you have alternatives.

Positive leverage

This type of negotiation is similar to a hostage negotiation because you can’t walk away from your opponent. You can’t say, “Yeah, it’s okay, go ahead and kill the hostages, we’re not interested in your demands.”

When you have to negotiate without good alternatives, the tools of positive, negative, and normative leverage are essential. Positive leverage is your ability to provide things that your opponent wants. You have positive leverage when your opponent says, “I want to buy your car”, “I want you to release my friends from jail” or “I want to buy your shares”.

As soon as your opponent says he wants something from you, you have some positive leverage. You control what they want. You can grant them access or deny it. That’s why experienced opponents delay making offers — they don’t want to give you leverage.

In practice

How does positive leverage work in practice?

First, positive leverage should improve your psychology during the negotiation. You’ve gone from a situation where you want something from the investor to a situation where you both want something from each other. Your psychology is critical in a negotiation because “leverage often flows to the party that exerts the greatest control over and appears most comfortable with the present situation.”

Second, you can now identify other things that your opponent wants and deliver them. Maybe you’re working with a partner who is trying to get his first deal done at the firm. Help him succeed and help yourself in the process. Maybe you’re working with a firm who is excited about stealing a deal from a top-tier firm. Help them succeed. Maybe you’re working with a firm who wants to co-invest with a top-tier firm so they can show off to their LPs. Help them succeed.

Third, even before investors makes an offer, you gain a little bit of leverage every time they ask for something. Don’t try to use it after the first meeting. But if you’ve been talking to them for three weeks and they’re getting deeper and deeper into diligence, you should recognize and use your leverage. At a minimum, you should ask for information about their process and thinking at every step of the way.

The prime time to negotiate is when your opponent says, “I want.”

“If they’re talking to you, you have leverage.”

– Christopher Voss, FBI Negotiator

Here are the latest videos from Venture Hacks TV (the best startup advice you can get while you’re folding the laundry). You can subscribe to VHTV via RSS, email, or Twitter.

1. John Doerr: The salesman for nerds

 


 

Video: Charlie Rose interviews John Doerr 

 

 

I’m going to keep my eyes on the videos coming out of TechCrunch Disrupt this week. The best talk on Monday was Charlie Rose’s interview of John Doerr.

I’ve always thought of John Doerr as a salesmen for nerds. And Doerr always looks at the big picture — I remember him talking about how the browser was going to be important again, well before Firefox emerged.

2. Gates convinces Jobs to give him 3 pre-release Macs

 

Video: Pirates of Silicon Valley

 

Watch how Gates manipulates Jobs hatred of IBM to get his way at 6:45.

Every entrepreneur should see Pirates of Silicon Valley. This made-for-TV movie from 1999 is amazingly well-done. It’s a dramatization of Steve Jobs and Steve Wozniak starting Apple; Bill Gates and Paul Allen starting Microsoft; and how Jobs and Gates collided.

The script and acting ring true. Wozniak writes that “the personalities were very accurately portrayed.” Steve Jobs actually invited Noah Wyle, the actor who portrays Jobs, to impersonate him at Macworld. And the negotiations are pretty realistic.

Watch the clip above and rent the movie if you like it — it’s cheesy but good.

3. This Week in Venture Capital with Jason Calacanis

 

 

Video: This Week in Venture Capital Episode 6 (Download) 

This Week in Venture Capital is a combination of startup analysis and startup advice from Jason Calacanis’ burgeoning ThisWeekIn empire. Mark Suster is the host. Jump to 33:05 for a solid block of startup advice on:

  1. Your deck getting in the wrong hands @ 33:05.
  2. If this is your first time raising angel money… @ 38:13.
  3. “VCs—when we fund raise—never ever are raising money. We’re pre-marketing until the round’s closed.” – Mark Suster @ 44:34

If you’re into startup analysis, check out the deal of the week, Stack Overflow, @ 1:00. Jason’s Q&A expertise shines through here. And here’s Mark’s recap of the episode.

Subscribe to VHTV via RSS, email, or Twitter. Do so immediately and without hesitation. How else are you going to get startup advice while you do the dishes.

… a founder, a VC, and his Associate negotiate a down round. Very NSFW.

Video: Old Face Andre talks economics with Omar

Another business lesson from The Wire — about intellectual property: “It ain’t about right, it’s about money.”

Mark Suster, entrepreneur turned VC at GRP Partners:

“When I was at BuildOnline (my first company) and things went ‘pear shaped’ we called all of our customers and said, ‘I know that we signed contracts with you. The reality is that the market has changed and I need to change to the new realities. We committed to product features. I can’t ship those as promised. I’m sorry. Do you like our product & service? Yes? Ok, thank you. Listen, I know that if you like what we do then you’ll want a healthy supplier/partner. I need to be able to earn a profit and with the contracts we’ve signed I cannot. I either need to cut product development staff (and therefore can’t ship products as promised) or I need to be able to charge you slightly more for our service or for features you want to see so that I can make ends meet. Help me understand which you prefer.’ I lost zero customers. In fact, we built tighter relationships. I had no choice and as they say, ‘necessity is the mother of all invention.'”

From What Makes an Entrepreneur (2/11) – Street Smarts. You can also find my favorite negotiation book, Bargaining for Advantage, in our bookstore.

Thanks to Atlas Venture for supporting Venture Hacks this month. This post is by Fred Destin, one of Atlas’ general partners. If you like it, check out Fred’s blog and tweets @fdestin. And if you want an intro to Atlas, send me an email. I’ll put you in touch if there’s a fit. Thanks. – Nivi

In Part 1, I discussed a few of the term sheet clauses that entrepreneurs should absolutely avoid; the wrong tradeoffs which later expose them to really “losing” their company. There are rational explanations for all of these, but, as we know, hell is paved with good intentions. Here are some more pathways to hell…

“Thank You and Good Luck” for options: Limited exercise period

I am going to get some of my colleagues mad at me here. I see many stock options plans where, when employees leave the company, they have a short time window (usually 3 months) to exercise the options they have vested. This means they have to pay the strike price that the options were issued at and acquire the shares (strike price could be $3 for shares valued at $4 at the last round).

That forces startup employees to fork out cash and often crystallizes tax liabilities. It feels harsh to me. I think options should be exercisable over long periods of time, so people who have contributed to the wealth creation process can exercise when the value is realized (i.e. the company is sold) and it becomes a cash-less exercise for them.

Things I cannot get too excited about

Multiple liquidation preferences: This means investors get a multiple of their money back before you see anything. I don’t like these conceptually, they feel very un-venture to me, but they are only part of the deal. If you push super hard for a $100M valuation but have to accept multiple liquidation preferences as a trade-off, it’s your call. If the company goes public (at which point preferred shares convert into ordinary shares and the liquidation preferences disappear), you win. If the liquidation preferences are negotiated away in a subsequent round of financing, you win. Personally, I have a strong preference for simple terms at the right price from the outset.

Cumulative dividends: Sometimes an 8% dividend is slapped on, and it accrues over time when it isn’t paid. Again, this is not appropriate for most venture deals, but it may be part of an acceptable trade-off.

The trap of complexity

More than anything else, I find the real danger is complexity. When you need 3 full days of modeling to come to grips with a cap table, or when no-one can agree anymore on how clauses should be applied, you are in trouble. You will spend more time discussing internally how clauses should be applied than focusing on that critical acquisition you should be closing. I have seen cases where you needed robust macros to model outcomes. How about adding an exit-value-dependent management carve-out to a participating liquidation preference reverting linearly above 3X return on top of a French legal requirement that the first 10% gets distributed to all shareholders equally ? I have modeled this and it’s simply not worth it.

Value is not created by arcane legal language but by nailing business execution and growth. Keep it simple and keep yourself focused on the right elements.

Get good advice (duh!)

I was at Seedcamp on the VC panel with Fred Wilson and a few others recently and there was a lot of talk about terms and how not to get screwed (evil evil VCs…). I will repeat the advice I gave then: you want to protect yourself adequately, get a good lawyer. You will not out-compete us on terms negotiation. I use Tina Baker at Brown Rudnick in the UK and Karen Noel / Olivier Edwards at Morgan Lewis in Paris; they are great, go talk to them.

Having said that, it is completely your responsibility to understand what you are signing, and it is up to you to push back. Read the documents, ask questions about everything you do not understand. Ask your lawyer: where does this document create risk for me, both on my income stream and my ownership. How does this go wrong and how do I protect against it? This is advice you are seeking, not an outsourcing service.

And remember, there is no such thing as standard terms. May the force be with you.

If you like this post, check out Fred’s blog and his tweets @fdestin. If you want an intro to Atlas, 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

Last week, I spoke to a startup that was in discussions to license one of their products to a competitor. The competitor asked for historical sales data about the product, and the startup was wondering whether they should share that information with a competitor. Our conversation went like this:











The book I mentioned in the conversation is Bargaining for Advantage. It answers almost every negotiation question. I read the book cover-to-cover — that’s rare.

The answer to this particular problem starts on page 68 of Bargaining for Advantage and there’s a good summary on page 72:

“The solution here is to take your time and build trust step by step. It helps if you can use your relationship network to check the other party out. If that is not possible, take a small risk before you take a big one. See if those on the other side reliably reciprocate in some little matter that requires their performance based on trust. If they pass the test, you have a track record on which to base your next move.”

Almost every problem you run into in a startup is not unique. Someone else has had the same problem and knows how to solve it. With the right advisors (books, blogs, people), you can solve it the easy way, instead of the hard way (experience and failure). Save the risk and innovation for the important stuff.

P.S. If you’re sharing secrets with VCs, read these posts: Three things you should never tell a VC when fundraising and How to Deal with Skeletons in your Closet (and my comment).

This is the first in an ongoing series called Books for Entrepreneurs. We’ll use these posts to recommend books that we’ve found useful as entrepreneurs (duh).

Our first book is Bargaining for Advantage by G. Richard Shell. Richard is a professor at Wharton and this is my favorite negotiation book period. It synthesizes the principled negotiation of Getting to Yes with the psychology of persuasion in Influence.

Jim Pitkow recommended this book while we were raising Songbird‘s Series A. Since then, I have referred to it again and again while writing posts for Venture Hacks and answering questions from entrepreneurs.

Make sure you don’t read this book if these questions are irrelevant to you: Should I be the first to open? Should I open optimistically or reasonably? What sort of concession strategy works best?

Here’s a small sample of what you’ll find in Bargaining for Advantage:

What is leverage?

Everybody talks about leverage in negotiations but very few people know what it means. My favorite chapter, “Leverage” defines it (emphasis added):

A better way to understand leverage is to think about which side, at any given moment, has the most to lose from a failure to agree… the party with the most to lose has the least leverage; the party with the least to lose has the most leverage.

“Leverage often flows to the party that exerts the greatest control over and appears most comfortable with the present situation.

“To gain real leverage, you must eventually persuade the other party that he or she has something concrete to lose in the transaction if the deal falls through.

Positive leverage: Every time the other party says “I want” in a negotiation, you should hear the pleasant sound of a weight dropping on your side of the leverages scales. [Positive leverage is the ability to provide things your opponent wants.]

Negative leverage: Threat leverage [that] gets people’s attention because… potential losses loom larger in the human mind than do equivalent gains. But a word of warning is in order: Making even subtle threats is like dealing with explosives. [Negative leverage is the ability to hurt your opponent.]

Normative leverage: [Normative leverage is the ability to apply general norms or your opponent’s standards and norms to advance your position.] You maximize your normative leverage when the standards, norms, and themes you assert are ones the other party views as legitimate and relevant to the resolution of your differences. Attack [your opponent’s] standard only as a last resort.

This way of thinking about leverage also points to more sophisticated ways of enhancing your leverage that go beyond just improving your BATNA. Your goal is to alter the situation (or at least the other party’s perception of the situation) so you have less to lose, the other side has more to lose, or both.”

Bargaining for Advantage includes detailed examples that make the theory of leverage concrete.

Read the book to learn about opening, making concessions, closing, the rogue’s gallery of tactics, …

Related: The Monk and the Riddle, Inside Intuit.

“We took the approach of wanting to get to know the different partners and the different possibilities and to see where there was the best fit. Partnerships take a lot of work—you want to go out on a few dates before you get married. Yes, we dated a few people but didn’t get married… and so there were a few unhappy girlfriends out there. The choice wasn’t an economic choice, it was a customer choice.”

Steve Jobs

Summary: A deal is only as good as its best alternative. Keep improving your alternatives until you have a signed term sheet. And keep developing your current offers or they will die. Finally, don’t say “shopping around”, it puts investors off their stroke.

A reader asks:

“I have spoken to only one person regarding an investment, and they immediately said they would back my company. Should I contact more than one potential investor, i.e. shop around for someone who has experience in this space, and might be capable of injecting more capital for bigger goals? The product looks good, so I’m confident I can successfully engage other potential investors.”

In your mother’s womb, you learned that a chain is as strong as its weakest link. Now, in the awesome womb of Venture Hacks, you learn that,

A deal is as good as its best alternative.

Receiving a term sheet is a significant milestone. Receiving a verbal offer or an indication of interest is also a significant milestone.

But you should keep engaging alternative investors until you sign a term sheet. Sometimes, you should keep engaging alternative investors until you close (assuming the term sheet you signed doesn’t have a no-shop).

shopping.png

Improve your alternatives to get a better deal.

Create a market that is filled with alternative buyers. Without alternatives, you will be stuck in a hostage negotiation with a single prospective investor. With alternatives, you will do well. In Bargaining for Advantage, G. Richard Shell writes,

“Research has shown that, with leverage, even an average negotiator will do pretty well while, without leverage, only highly skilled bargainers achieve their goals.”

Spending time developing alternatives is as good as spending time developing your current offer. It increases the chances of closing your current offer. It closes your current offer faster. And it improves the terms of your current offer. Keep this in mind if you “don’t have time” to develop alternatives.

Develop your current offers or they will die.

Keep developing your current and pending term sheets while you engage alternative investors. If you sit on a term sheet for 2+ weeks, there’s a good chance, say 33%-50%, that the offer will disappear because the investor will move on to a shiny new company and his enthusiasm for your company will wane. Not to mention that most term sheets expire after a couple weeks.

Don’t let offers cool while while you warm up alternatives. Shopping around for Gucci underwear is effective as long as stores have it in stock. It’s not effective if each store runs out of inventory while you’re visiting its competitors.

The best way to keep investors warm is to focus on fund-raising so you can (1) get all your offers at once and (2) pick the best one before any of them cool down.

Buy a little time after your first offer.

When you receive your first offer, you can buy 1-2 weeks of time by saying,

“We’ve promised to close out conversations with a few investors and we need to honor our promise.”

“We’ve committed to a partner’s meeting next week and we need to honor our commitment.”

No investor is going to ask you to break your previous commitments. This little tactic buys you time and increases your social proof and scarcity.

You only need a few offers to clear the market.

How do you know if you’ve cleared the market? You need two or three offers from investors who make it a habit to invest in startups at your stage. These investors should create enough demand, social proof, and scarcity among themselves to improve your terms and clear the market.

Finally, receiving more than two or three offers means you will have to disappoint more investors. Turning down investors is surprisingly hard.

You’re not “shopping around”.

Finally, don’t use the words “shopping around” or “auction” with investors. Their reaction to these terms is,

“What am I, a bag of money? I can only get in this deal if I pay the most?”

You’re not “shopping around”, you’re “looking for the right partner”. While you’re talking to investors, you can define the right partner in terms of domain experience, or someone who wants to invest more/less money, or someone who has a history of backing the founders, or anything but: the guy who will pay the most.

Image Source: Visit Chandler.

How many similarities can you find between hacking fund-raising and hacking a car purchase? Watch this video:

The best answer gets a coveted Venture Hacks mug.

(Via Lifehacker.)