This article is the thirteenth in an ongoing series on Deal Leadership. To learn more about leading a deal efficiently, download this free eBook today: Lead, Follow Or Get Out Of the Way -The Art and Science of Deal Leadership or purchase our books at Amazon.com.
Imagine you’ve always wanted to own a second home, but weren’t sure you should buy one. You hem and haw and agonize about the decision, but then one day you finally decide to go for it. There is a brief moment of joy and excitement, but it is quickly followed by a great soberness as the reality sets in. You will have to figure out what to pay for it, get the purchase and sale done, maybe arrange all the paperwork for a mortgage, and find some way to care for it and maintain it in the off-season. This mental process is a lot like what you go through when you decide the diligence on a company is positive enough. At first you are like “OK, let’s do this!” and then you realize you’ve got to set terms, actually make the deal happen, and live with the downstream consequences.
As a deal lead, once you conclude that there is enough of an opportunity to merit potential investment, and around the time you start drafting the final report, you can push through the temporary euphoria and begin negotiating the termsheet. In some cases this will be driven entirely by the deal lead, while in investor networks with dedicated management, it might be led by a manager with the involvement of the deal lead. In either case, it is a vitally important role which is informed by the learnings of the diligence process.
Start-ups have a lot of risk, and the diligence process is really about documenting those risks so that investors can make informed decisions. As we’ve pointed out in our eBook on Due Diligence, you are not looking for a deal with no risk. You are looking for a situation where you know roughly what you are getting yourself into. (Kind of like the house inspection and budgeting process for that second home!) A termsheet negotiation is about acknowledging all those risks and allocating them between the two sides of a deal. So, it is natural that the negotiation would be informed by the learnings of the diligence process.
Christopher spent the majority of his career in roles where negotiation was a key part of his responsibilities. And a lot of that time has been spent in early stage investing. So let’s put him on the spot to see how he thinks about it.
Christopher, how do you approach the negotiation process when you are leading a deal?
My approach reflects the fact that I lead a large network of investors and tend to be working with really terrific deal leads. I will almost always set myself up to serve as the point person for the negotiation for four reasons:
It’s a huge convenience if the process is led by someone who does a lot of these and is very facile with the terms and terminology and can write a termsheet himself.
You need someone who has a good sense of what’s market and what terms will be acceptable to the investors in the deal.
It’s important to have someone in the discussion who is willing to be be the “bad cop” and hold firm on key terms, like valuation, and not be swayed by pressure or worried about the working relationship with the entrepreneur.
You want to protect the person who is going to join the board and work closely with the CEO from having to be the heavy in the negotiation.
What is your starting point for the process?
It is important to keep in mind your role in the big picture financing life-cycle of the company. Some inexperienced investors might come into this situation with a scorched earth approach, looking to drive the best possible bargain and the toughest possible terms for themselves. The problem with that approach is two-fold:
The toughest set of terms is not necessarily the best bargain for investors.
The working relationship with the team can affect your outcome and returns as much as the deal terms.
If you go in looking to ram a greedy set of terms through, not only will you potentially cause mistrust and harm the working relationship with the founders, but you may also saddle the company with terms that make it very hard to raise money in a future financing. Subsequent investors may not want to put money into a deal with ridiculous terms for prior investors, or they may insist on the same terms for themselves. Your job as the architect of the first termsheet with the company is not to drive the most aggressive bargain. It is to come up with an acceptable set of terms that is as “vanilla” as it can possibly be. Once you are an investor, you don’t want any wrinkles or friction, particularly of your own making, to cause issues with bringing in subsequent financing.
So with that philosophy in mind, I always start off with a standard set of template terms that our investors, lawyers and syndicate partners are used to, and then tweak them and customize them for the specific deal situation. Usually, it is just a handful of routine terms which need tweaking, but other times special issues in the diligence or special aspects of the company’s situation require heavier customization. Once I have a draft termsheet to propose, I need to get it in front of the company for reaction.
At this juncture I have a choice. There are two ways to go about forming a termsheet:
Before sending it, you can walk the entrepreneurs through the concepts and your thoughts on each key term, or
You can send them a proposed draft termsheet.
I generally base my approach on the sophistication level of the founding team. If they are very experienced and familiar with early stage investing terms, I will generally just prepare a draft termsheet and send it to them. But if they are newer to the whole investment process, then some context and education and perspective might help them better understand the termsheet and react to it more constructively. In this case, I will generally have a conversation and explain the various issues and where I am coming from on each point before sending it over. That way they know roughly what to expect and are not surprised by the harsh black and white of the terms on paper.
It might sound patronizing at first blush, but the reality is that education is a huge part of the early stage negotiation process. Active investors negotiate termsheets all the time and are very comfortable with the concepts. But entrepreneurs have a lot of anxiety and uncertainty, as well as a lot of hot button issues. So it can be really helpful to take the time to explain the logic behind key terms. For more on founder and investor concerns and a good overview of early stage deal terms, see our eBook on Understanding Early Stage Deal Terms.
What areas merit special attention?
There are a great number of sticky issues in termsheets, but when I am starting a negotiation, most of my thinking and effort goes into:
Figuring out the right valuation,
Making sure the option pool is the right size,
Considering how to construct the board,
Determining how to structure the founder vesting terms,
Sizing of the round and the minimum needed to close, and
Deciding how to structure the liquidation preference.
Vesting for founders and early employees is very important in early stage deals. There is nothing worse than a co-founder of a company owning 20% of the company’s stock after working for the company for a year or two. You want all key employees to have two or three years of vesting left, even if they have been involved with the company for quite some time. This may require a restructuring of the cap table.
Governance is a very important part of all our deals. In addition to financial capital, we invest a fair amount of human capital into our deals. In most cases, the deal lead will take either a board seat or board observer seat with the company. This is a key role and requires a fair amount of the deal lead’s time over the years when we are active with the portfolio company. For early stage deals, we do not expect to control the board, but we will have a strong voice.
Pre-existing investors are also an area needing attention. One goal of completing a financing is often to clean up the balance sheet, and we need to be certain that any convertible bridge debt is brought over to the equity side of the ledger. In negotiating the termsheet, we need to be mindful of the thresholds and discounts applicable to any outstanding convertible bridge debt. Often upon conversion, bridge debt will entitle holders to a discount off the purchase price in an early stage round, and will require that such round be of a specific size before conversion is mandatory. These terms can be and often are negotiated as part of a round of financing. We need to consider what leverage might exist, in any given situation, before taking the terms of existing convertible debt at face value.
Because securing an exit is important, but can sometimes be at odds with the founders of the company or other legacy stockholders, we require drag along rights. These require all stockholders to approve or otherwise agree to sell their equity in a transaction receiving the affirmative vote of a majority or two-thirds of the shareholders. This becomes an important tool to prevent minority shareholders from threatening to exercise dissenters’ rights in a prospective deal or otherwise seeking to gain leverage in an exit transaction by signaling that they will not proceed.
Another important right to secure for our investors is the right to participate in future rounds of financing – sometimes called pre-emptive rights or rights of first refusal. These rights entitle investors in the angel round to participate in any future financings of the company up to their pro rata share of the financing in order to maintain their percentage interest. Sometimes a company will seek to include a pay-to-play provision that requires investors to exercise this right upon each future financing or otherwise lose pre-emptive rights altogether.
And finally, a key toggle point in any angel financing is whether we will be seeking a straight liquidation preference or a participating preferred structure. Upon a liquidation or sale of the company, a straight liquidation preference entitles the holder to receive either their investment back as a priority to the common stock (and any junior classes of preferred stock) or that which they would otherwise have received had they converted into common stock prior to the transaction. A participating preferred gives the holder the benefit of both worlds: a priority payment equal to the amount invested plus a pro rata amount of any remaining value. Weak liquidation preferences may not be attractive to investors because they feel they are not being adequately compensated for the early risk they are taking. But overly generous liquidation preferences can turn off later investors or contribute to a massive preference stack that greatly diminishes the early investors returns in weaker exits.
All in all, there are a lot of issues to consider, and getting a termsheet that is going to work for a large investor base can be a pretty tricky process!
So, do you always prepare the first draft?
Yes, it is traditional for investors to prepare the first draft of the termsheet and get it over to the company. That is certainly my strong preference, because if the company does the first draft there are usually a lot of things missing and a lot of wacky off-market terms. When I am drafting and thinking about the termsheet, I will involve the deal lead in the process, if he/she wants to be involved.
Do you deliver it in person and sit right down and negotiate?
No. As noted above, I will sometimes talk with the CEO before sending it over. But once I send it, I recognize that companies generally need time to confer with their attorney before responding. So a redline of their thoughts and issues is generally a good next step before sitting down.
How long does that take and what else is going on at that point?
We discussed in Forks In The Road: The Importance of Interim Checkpoints, that in the background, the deal lead is typically marshalling his or her troops to finish the diligence report, and I am simultaneously giving some thought to issues like potential board and observer appointees and what the best syndication strategy might be.
What happens next?
Once I have comments back from the company we try to hash out an agreement. The goal is to get a mutually acceptable termsheet done right at the same time the final draft of the diligence report is finished. Once the termsheet is done and signed, we publish the diligence report and the termsheet to our investors and begin to syndicate the round.
Want to learn more about leading a deal efficiently? Download this free eBook today Lead, Follow Or Get Out Of the Way -The Art and Science of Deal Leadership or purchase our books at Amazon.com.