Lesson 5: The Negotiation Process

Negotiating Back and Forth with Investors

Going back and forth with investors is a natural part of the negotiation process to wrangle out the terms of your deal with them. VCs know what is important to them on a term sheet, and they want to see you stand up on the important issues. It shows them that you recognize what the important issues really are. Investors observe how founders acts in this negotiation, as it usually reveals things about the people.

If you do not negotiate back and forth on the significant items on the term sheet, you can lose credibility in the eyes of the investors. They also want to know whether you will fight for what you believe. In this module, we will cover what the most important issues are in negotiating an agreement of terms with investors. But first, here is a snapshot of some rules of thumb as you approach a negotiation:

• Try your best to have more than one VC showing interest in you when you go into a negotiation with an investor about terms, putting you in the best possible negotiating position.

• Three issues are typically worth wrangling over on a term sheet
  
  

• Hire a lawyer that already has experience with VC financing.

• Work with your lawyer and advisors ahead of time to identify what is most important to you and your start-up, as well as map out desirable terms.

• It is your job as the founder to negotiate the terms, not the responsibility of the lawyer.

• Avoid a “no shop” clause.

• Understand how VC ownership will affect your current equity position.

• Before going into negotiation, determine what you really want/need (non-negotiables) and what you can be flexible on

On a term sheet, high priority items of high importance outweigh lower priorities. Below is a quick “cheat sheet,” followed by explanations of the important ones. “Lower Priority” simply means to spend less time wrangling about it.  

High Priority / High Important

Low Priority / Lower Importance

• Valuation

• Liquidation Preference

• Make Up of the Board of Directors

• Protective Provisions

• Founder Vesting

• Anti-Dilution Protection

• Exclusivity

• Information rights

• Conversion rights

• Registration rights

• Standard conditions to the investment

• Rights of first refusal

• Co-sale and tag along rights

Valuation

You will need to negotiate a “pre-money” valuation with VCs – calculated on a fully diluted basis. This value includes all issued stock and anything that could be converted into common stock, including a stock option pool. Make sure you understand the effect of including the option pool in the fully diluted, pre-money valuation. Pre-money valuation includes a large, unallocated option pool for new employees. Don’t let your investors determine the size of the option pool for you. Sliding the option pool into pre-money valuation lowers the valuation of your company, decreasing the share price. When negotiating valuation, you should keep your eyes on the option pool. You should meet the investor in the middle. Negotiate price after determining a realistic figure for the option pool.

For example, if your company is valued at $2 million with one million shares already outstanding, and the option pool is 25%, then it means that the VC is determining a stock price based on a company value of $1.5 million (not $2 million) because the 25% is $500k, which is subtracted from the overall valuation when figuring out the price per share. In short, you lose when the option pool is too high. So, if you don’t negotiate it, a VC could just slip into the term sheet; you will feel the pain later. But you can avoid it altogether through negotiation.

Liquidation Preference

Liquid preference defines the return than an investor receives in the sale of the company. So that you understand the actual dollar differences between the liquid preference formulas, you should model out expected exit values. Terms that are established in Series A usually carry over to Series B and later rounds of fundraising.

Make-up of the Board of Directors

After an initial equity financing round, a usual arrangement for a board of directors is a three-person board – one investor representative and two founders, who have common stock. They should reflect the relative control of the cap table. When you are negotiating with a VC, you need to have a meaningful and productive conversation about the formation of the board. You and the VC should be aligned on the governance of your company. Control of the board can impact big decisions and affect significant issues in the future, including vesting of stock.

Protective Provisions

Don’t be surprised when a VC wants to have a set of protective provisions, which are essentially “veto rights” over specific actions. Veto rights on future financing of a sale of the company is a big deal. Less controversial are veto rights related to declarations of dividends or the modifications of the rights of the stock issued to the investors. You should talk to your lawyer and advisors about protective provisions early in the negotiation.

Founder Vesting

Here are the most basic things you need to know about founder vesting, but you should also talk to your lawyer and team of advisors. Be ready to negotiate these terms if they are not in the middle ground, putting you at a disadvantage.

• When does vesting commence?

• Upon termination without cause, does vesting accelerate?

• Upon change of control or upon termination without cause within a specified time, does vesting accelerate? 

Put a limit on shares that would be forfeited and make the buyout price as high as possible.

Anti-dilution Protection

To protect VCs from future sales of preferred stock at a lower valuation, most deals – at least in the United States – have some sort of anti-dilution protection. At a basic level, if you see the term “broad-based anti-dilution protection,” you should be fine. However, if you see the term “full ratchet,” you don’t need to run for the hills, but you should go talk to your lawyer.

Exclusivity

It is reasonable for a VC to ask you to not talk to other investors for a period after you sign the term sheet, especially since the VC is paying money to have professionals draft paperwork and doing due diligence on your company. The reasonable timeframe is 30-45 days. If a VC asks for more time than that, it is okay for you to push back and limit it to 45 days, which is enough time to complete a VC investment.

Now, you are better equipped to go back and forth with VCs, but we still highly recommend you get your own professional support of an experienced lawyer and advisors, if you haven’t already.