Thursday, October 25, 2012

Negotiating with Investors: How far is too far?

When an investor presents a company with a term sheet we enter the exciting realm of negotiation. Much can be, and I am sure has been, written on this topic. But perhaps not in our context. How far should a founder push the envelope with his investors on deal terms? I even posted a question on Quora to get testimonials about some wacky things that founders have tried and succeeded on.

In the meantime, I wanted to share my thoughts on this more generally:

  1. Being Reasonable. During the term sheet negotiation process, the investors are watching the founder. After all, an investment into a company is the beginning of a long road. The investors will have much interaction with the founder over the years after they invest, so at a basic level they have to like the founder enough to look forward to that interaction. And they must believe that the founder is someone capable of succeeding in making them a lot of money. Someone who is unreasonable, irrational, and who handles negotiation like a selfish five year old, is generally not likely to pass that test and get to a signed term sheet, though I am sure there are some exceptions.

    What is reasonable and rational, of course, varies by culture and context. But I would posit that being reasonable in a term sheet negotiation means picking one or two terms that are deal-breakers, and arguing calmly and persuasively for those terms, in a substantiated and thoughtful manner. If there are other terms that are more investor-friendly than is the market practice, a founder may use them as leverage, trading chips, to get the terms important to the founder. Investors respect an entrepreneur who has a solid grasp of the deal terms, who can evaluate the relative importance of those terms, and who is willing to engage in a give and take process during negotiation.

    Attorneys can actually be helpful here--a startup attorney who sees a lot of term sheets can work with an entrepreneur to help him assess which of the terms offered are "market" and which are not. Knowing industry standards, even when one is arguing for structuring deal terms differently, goes a long way to sounding reasonable in a negotiation.

  2. Being Strategic. If you have to pick only one or two terms to really focus on, which ones would you pick? Frankly, there are only two important concepts in a financing -- price and control -- though these are expressed in a number of ways through a number of different terms.

    • Price. You could argue over price. For instance, you could try for something trite, like asking for a higher valuation than originally offered or for a smaller option pool reserve, which effectively gets you a higher price (less dilution for the founders). Or you could get creative. As an example, to bridge a wide gap in valuation you could set milestones and provide for warrant coverage to the investor in the event the milestones are not met. Or you could play with the conversion price of the Preferred Stock to overcome valuation differences. But frankly, unless you have a lot of leverage (e.g., competing term sheets and investors falling over themselves to invest in your hot company), there is unlikely to be much give here from the investors.

    • Control. Control is more promising. It can't be measured in dollars, so it is easier for the investors to give this, if they like and trust the founder. There are many control terms. I have seen a deal, for instance, where angel investors gave the founders a proxy to vote their Preferred shares. That's an outlier, but some of the more typical control terms that do get negotiated are (a) board control -- who the board seats are allocated to between the founders and the investors; and (b) stockholder control -- what blocking rights an investor, either alone or in concert with other investors, has on specific actions by the company.

      Since control and voting are intimately tied, a lot of thought (and negotiation) goes into whether voting will be done by class or by series and what the percentage threshold will be per such class or series. While the number of shares held by an investor or a group of investors is tied to the price, the law allows flexibility for unequal voting by different classes of shares. These mechanisms are not frequently invoked beyond protective provisions that run into several pages in length, but can be, and sometimes are, under the right circumstances.

  3. Cost. Legal innovation is expensive. A road well-traveled, otherwise known as "market terms", is going to come with the lowest legal price tag because there will be established forms which need little customization and not a lot of negotiation. Your attorney will not need to conduct legal research to tell you the ramifications of a particular provision because they will be well-known to him or her.

    Conversely, be prepared that innovative legal solutions will be expensive. They will require more time to prepare and analyze by your attorney. They may require specialists (like tax or executive compensation attorneys) or senior partners to get involved, which will increase your legal bill. You will get pushback and arguments from the attorneys on the other side of the table, and your lawyers will have to convince the lawyers on the other side that your solution works. Negotiations, too, will add to your legal bill.

    It may be that your proposed terms, which require the innovation, will ultimately result in a significant financial benefit to you, to the tune of millions of dollars. It has certainly happened before. So by no means do I wish to discourage you--for me as an attorney it is a lot of fun to work on innovative solutions. But I do want to set your expectations--custom solutions come with a higher price tag, that's all.

Happy company making!


White Summers  Inna Efimchik at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

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