Lesson 3: Negotiation Rules

Contact and Rules During the Negotiation Process

The following is a snapshot of rules that we believe you need to adhere to in the negotiation process with investors.

Rule #1: It is okay for you to say “no” to an offer.

Analysis: This may be the most important rule during the negotiation process because if you believe you only have only one option and you “cannot say no,” then you have undermined your own ability to negotiate. Remember that there is always another option, even if you don’t see it clearly in the moment. Even if an investor tries to lowball you based on a projected lower valuation, you can just say “no.” Don’t’ sweat it.

Rule #2: Negotiate the important Issues.

Analysis: When negotiating, get with your team and figure out what are the most important issues and then focus on them. Show the investor that you will take a stand for the important issues. If your positions are fair, the VC will accept that you are negotiating important issues, which he/she likely knows already. Ultimately, you need an alignment of interests with the investor.

Rule #3: The more investor firms interested in your company, the more leverage you have.

Analysis: The leverage you have is based on the strength of your alternatives, which you can use to negotiate the terms you want for the term sheet. But you should also be careful not to over-extend your leverage to get the highest valuation when a VC could also other non-monetary value, such as connections, political capital, strategic counsel, and mentoring.

Rule #4: You should determine the size of the option pool, not the investors.

Analysis: When you are negotiating valuation, do not take your eyes off the option pool, which is a collection of unallocated options for new employees. If you do, you may find out later – when it’s too late – that an investor has slipped in a clause about the option pool that effectively lowered your company’s valuation. Just make sure you understand the impact that the size of an option pool will have on your company’s fully diluted pre-money valuation.

Rule #5: The investors and the common stockholders’ representation of the board should reflect the relative control of the cap table.

Analysis: This rule, which is particularly relevant for early-stage boards, should motivate you to have a good discussion with the VC about makeup of the board of directors. You want to make sure that you are all aligned on corporate governance. Control of the board can become an important issue in the future.

Rule #6: Know the founder vesting arrangement before finalizing the deal.

Analysis: Generally, there are three questions that you want to have answers to: (a) on what date does vesting begin? (b) does vesting accelerate upon termination without cause? And (c) does change of control or termination without cause trigger an acceleration of vesting within a certain period?

Rule #7: Honor an investor’s request for you to refrain from talking to other investors after signing a term sheet.

Analysis: It is a common and reasonable request for an investor to add a restriction to an agreement that you don’t talk with other investors for a set period (usually 30-45 days) after you sign the term sheet.

Rule #8: Make sure that the anti-dilution protection is broad-based.

Analysis: It is common for virtually all VC deals in this United States to have anti-dilution protection to protect VCs from future sales of preferred stock at a lower valuation. You will want it to say something like “broad-based anti-dilution protection.” If it says, “full ratchet,” then you should be concerned and should talk to you lawyer with VC financing experience.

Rule #9: Fully understand the interests of the investor, not just your own interests.

Analysis:  When you can really understand the long-term interests of the investor and find a solution that serves their interests, then you have leverage, even when you don’t have strong alternatives. Try to avoid just focusing on your own interests in a negotiation. The VC doesn’t necessarily care about your interests.

Rule #10: VCs value trust

Analysis: As much as untrustworthy behaviours can ruin a negotiation, honest, ethical behaviour, including full disclosures of “bad news,” builds high trust in the eyes of the investor. If you have the courage to tell the truth – even when it hurts – then the VCs will trust you more. Consider this a rule because the opposite of honesty will almost always do damage to the relationship with the investor.