Joe Johnson, Ph.D.
Entrepreneur. Investor. Startup Expert.
The experience of negotiating a deal with a startup can run the gamut from smooth to difficult. The factors affecting the process include: the valuation of the company, the terms specified in the term sheet, and the personalities of those individuals conducting the negotiations.
Negotiation occurs during the entirety of a potential deal’s evolution as angel investors continuously gather information to help increase their likelihood of a successful outcome. Throughout that period, the company founders and the potential investors are becoming better acquainted. Since it’s obviously essential to have access to the best possible information prior to presenting a term sheet, be alert throughout the due diligence process and every time you meet with the company principals. Having an intimate familiarity with the other party’s expectations can be of invaluable assistance when it comes to negotiating a deal that leaves both parties happy and ready to work together going forward.
Dealing With Valuation Disagreements
As covered in a previous post, valuation can be an awkward and touchy subject. Since it’s essentially a subjective measure of a company’s pre-revenue worth, the principals may disagree (sometimes quite strongly) with an angel investor or angel investing group over the valuation. The valuation process is, by nature, inherently adversarial given that the parties each have a vested interest in reaching opposite conclusions.
Despite this fact, valuation is an essential aspect of the negotiation process since it directly affects the investment’s financial details. An investor’s ownership and stock positions are defined by the size of his investment and the company’s pre-money valuation. For investors, a lower valuation equates to receiving more stock for a given investment size. Those involved with the company may desire a higher valuation for multiple reasons, including wanting to ensure that they maintain a sufficient ownership stake, as well as the simple, ego-based desire to have their company viewed as valuable. Oftentimes, the egos involved on both sides of the table can present a significant hindrance toward arriving at an honest – and mutually agreed-upon – valuation.
Running multiple valuations and having ready access to information about comparable companies can help investors during the valuation negotiation process and ensure that both parties can eventually agree on the company’s initial value. That said, it’s sometimes impossible to come to an agreement on valuation. If the company founders refuse to accept the valuation and you aren’t inclined to amend it in their favor, negotiations will very likely stall. Failure to accept your valuation may signal an inability to compromise or to see their company clearly and is an investment red flag to which you’ll do well to pay attention. Beyond that, since many of the terms outlined in the term sheet are based upon a valuation agreed by both parties, it’s pointless to continue absent that agreement.
Presenting the Term Sheet
The term sheet, while not a legally binding document, outlines the possible terms of a deal and functions as a sort of blueprint. It generally contains supplementary legal documents such as a non-disclosure agreement, but the investment terms themselves are not binding and are open for negotiation by both parties.
The term sheet’s specific contents define the deal’s structure. A term sheet that clearly details the investors’ expectations signifies a desire for openness and assurance that everyone involved is content with the proposed terms.
These items are often found on term sheets and are usually regarded as negotiable:
- The amount of investment
- The amount of ownership
- A board seat (or partial board seat shared with other investors)
- Share types
- Conversion of shares
- Redemption of shares
- Antidilution measures
The definition of any non-negotiable factors is up to the parties involved. If you, as an investor, have particular criteria for your investments, they’ll likely inform your expectations with respect to deal terms. For example, perhaps you require preferred stock and antidilution measures to ensure that the proportion of your investment to company value (vis-a-vis outstanding stock shares) remains constant following any possible future rounds of funding. Be open about your requirements and, should the other party be unwilling to meet them, consider your level of belief in the company’s future vs. the value of your investment and decide whether to continue or to walk away.
Series Seed provides an easy-to-understand term sheet template that’s been stripped of some of the legalese encumbering traditional term sheets.
How to Negotiate
In order to ease the term sheet negotiation process, it helps both to have been transparent to that point and to have an unambiguous term sheet ready to present. Being open about how you arrived at your valuation figure can help to elucidate your thinking for the team. Their being aware of your reasoning may help to reassure them of your fairness or it might even inspire an awareness that they’ve somehow failed to present pertinent information that would directly affect their valuation.
Prior to presenting a term sheet, be completely familiar with the specific items on which you’re willing to negotiate, how much flexibility you’re willing to grant, and which items are entirely non-negotiable. Having this detailed knowledge ahead of time will enable you to enter the room with a superior plan of action. Everyone wants to secure a good deal. The challenge is for all parties to leave the room feeling as though they’ve secured the best deal possible. To preserve the valuable company/investor relationship, neither side should feel as though it “lost”.
Negotiations should always be an emotion-free zone. It’s a business deal and the principals may already be emotional, as they’re trying to secure funding for their company. By ensuring that you’re level-headed and willing to discuss your thought processes when necessary, you’ll contribute to a calm and thorough negotiation process that will also serve to illustrate the added value you’ll bring to the company.
What’s the ‘Right’ Deal?
The ‘right’ deal will vary from investor to investor. Most angel investors would love a large ROI – really, who wouldn’t? – however, that isn’t always the primary goal. For angel investors aiming to promote growth in their communities or valuing the concept of mentoring like-minded entrepreneurs, antidilution measures may not be as important as access to the principals or a board seat.
Negotiating the ‘right’ deal, then, requires that an investor remain consistently aware of his goals and criteria – and to clearly share that information when necessary to secure favorable terms.
When to Walk Away
After having completed the due diligence process and having decided to invest in a company, there may yet come a time when you ought to walk away. Should negotiations stall due to personality conflicts, issues with the valuation, or a refusal to accept the term sheet, it’s necessary for you to consider whether continued involvement with that company is a good idea. By having a clearly articulated set of personal investment criteria and an understanding of the deal components you’re willing to negotiate prior to entering discussions, you’ll be better able to make a determination of when walking away is your optimal remaining course of action. When your criteria are no longer met, the terms don’t show signs of improving, or the other side is unwilling to compromise, it’s time to tally the lessons learned and move on to the next target company.
The techniques endemic to negotiating the ‘right’ deal do become simpler with time. Familiarity with the process and experience gained in dealing with entrepreneurs will buttress your negotiation skills and assist you in scoring a beneficial investment deal. Throughout the process, it’s imperative to remember that an ongoing relationship is being established. There should be no ‘losers’ exiting the deal room. Everyone should feel as though the deal was successful. The company is receiving important investment capital and has a bright future ahead. You’re receiving a valuable ownership stake and are excited to support the company in accordance with the terms detailed in the term sheet.
Negotiations should be win-win and leave everyone excited for the next stage of business development.
About the Author
Dr. Joe Johnson is an entrepreneur, investor, and startup expert. He is the founder and principal of GoodField Investments and the GoodField Foundation (www.GoodField.com).
Joe has a Ph.D. in Entrepreneurial Leadership and an MBA. He is the author of the upcoming book on The Science of Why Most Entrepreneurs Fail and Some Succeed.
Most importantly, he is the incredibly blessed husband of one amazing wife and father of six wonderful children. He resides in Bradenton, Florida. For more information on Dr. Johnson and his work, go to www.JoeJohnson.com.