is the discussion, sometimes lengthy, of the terms of investor financing. It begins when management makes its first contact with an investor.
Whether that contact is face to face or made through the mail, the first impression management makes sets the tone for the dialogue with the investor. A solid presentation by management sets the groundwork for a positive exchange with the investor by improving the investorís perception of the company and its management. This, in turn, can help reduce a companyís cost for funds and improve the terms of the companyís deal.
Most venture capitalists prefer to make a funding proposal to management rather than react to a proposal prepared by the company. Their proposal is made only after they complete their due diligence, during which managementís opinions and expectations about financing are solicited. Usually the proposal is specific as to amount of money, timing of investment, and the number and types of company securities the investor desires.
Once a proposal is made, managementís negotiating position is reduced to that of reacting to the proposal and trying to convince the investor to modify those terms that are unacceptable. This can prove difficult, especially when a companyís need for money is acute and there are no other offers on the table. Therefore, one good strategy for improving managementís bargaining position and the results of its negotiation is to begin the search for money early and to approach several investors simultaneously. The entrepreneur who waits until the last minute before he approaches investors seriously compromises his ability to negotiate effectively.
Another good strategy is to convince the investor that the company presents an exceptional and extremely rare opportunity. (This too is usually best done before the investor makes his funding proposal.) The care management takes in preparing its plans and presentations to investors pays off in better financing packages and easier negotiations. An investorís impression of the company and his judgment as to its value usually have more to do with the price he requires for his funding than all the persuasion attempted during the negotiation of the actual financing agreements. As a result, much of managementís most effective negotiation occurs when it is selling its concept to the investor, long before formal negotiation of the terms of that financing begins.
That is not to say, however, that management should relax once a funding proposal is made and accept whatever price and structure an investor proposes. Most investors are interested in getting the best deal they can and will propose a price and structure very favorable to themselves. Managements should expect this and analyze the investorís proposal carefully, using the analysis as the basis for its negotiation with investors.
Most investors expect a reasoned, issues-oriented negotiating approach from management in which management and the investor openly address the concerns of both parties and search creatively for solutions that build a workable deal. Negotiating effectively in this context requires an understanding of venture capital deals and structures, of the needs and concerns of the company and its management, and of the perspective of the investor.
A major purpose of this book has been to provide entrepreneurs with more knowledge about the venture capital deal structuring process so that they can understand better the compromises and concessions they are asked to make. A better understanding helps management identify and articulate its concerns with objectionable parts of an investorís proposal, which, in turn, makes it easier for the parties to discuss the open deal points and arrive at acceptable compromises.
Obtaining a better understanding of a proposed deal and its short-term and long-term effects involves more than just reading one book and looking closely at the investorís proposal. It also involves getting qualified professional help from someone who has done venture deals before and can give management an independent appraisal of the proposed deal. This person should be able to guide management in suggesting effective solutions to many of the problems identified in the deal proposal. He should be conversant with the applicable securities laws so he can direct the dealís structure in a way that avoids securities problems for management and the company.
In most cases this person should be a lawyer. It simply is not true for most entrepreneurs that they can negotiate a commercially reasonable financing package without the help of a qualified professional. In most cases, the professional investor has vast deal-making experience, while the entrepreneur has little or none in structuring a funding. This, coupled with the far-reaching and often prejudicial effects of many common venture deal provisions, makes it almost foolhardy to complete a venture deal without qualified professional help.
And, while it is true that most venture investors use a reasoned analysis approach in their negotiations, entrepreneurs should not be so naive as to believe that investors will not also use deceptive tactics and pressure strategies to get the deal they want. While most effective deal makers find that an open, analytical approach makes for the best deals, some also view games and pressure tactics as a legitimate part of the negotiating process. Many of these investors mix these tactics into an otherwise straightforward negotiation. They may include delay, refusals to discuss reasons (See: We Always Do It This Way), and last-minute demands for concessions to "get the deal done." An adviser who is practiced at venture deal making usually can distinguish these tactics from the heart of the negotiating process so they can be dealt with effectively.
The discussion in the Equity Penalties entry describes one last-minute demand tactic that occurred in an otherwise open negotiation with one of the senior fund managers of a nationally prominent venture capital firm. In that case, the entrepreneur received a phone call late Friday night from the fund manager saying he could not close the deal on Tuesday unless the entrepreneur agreed to give him significantly more stock if the company did not meet its plan. The deal had been negotiated at length and was ready to be closed. The investor had numerous opportunities to raise this issue before but waited, instead, to bring it up at the last minute, to couple it with a threat not to fund, and to do so in a manner that made it difficult for the entrepreneur to get his counselís advice.
The entrepreneur should have called his lawyer at home. Instead, he worried all weekend about his deal dying. On Monday morning, when he called his lawyers, he had convinced himself to make the concession in order "to get the deal done."
The investorís proposal was absurd, particularly in view of the manner in which it was made. It smacked of bad faith. The entrepreneurís lawyers counseled him to reject the proposal in a way that showed how ludicrous it was. The entrepreneur contacted the fund manager and told him he could not go forward with the equity penalty proposed, that it was unfair, and that if an equity penalty was critical, the parties would also have to discuss an equity bonus to management (and corresponding dilution of the investorís interest) if the company met its plan. The investor promptly dropped his demand and closed the next day.
There are several good books on negotiation. Two good examples are Getting to Yes by Roger Fisher and William Ury and Getting Together - Building a Relationship that Gets to Yes by Roger Fisher and Scott Brown. Both books are a result of research conducted by the Harvard Negotiation Project and describe a constructive, issues oriented approach to negotiation. See: Deal Breakers, Financing Agreements, Golden Rule, K.I.S.S., Letters of Intent, Lawyers, Pricing, ROI (Return on Investment), Shopping, Structure.