How To Negotiate A Term Sheet Against A VC
Startup founders have to be great at many things — building, recruiting, managing people, raising capital — negotiating isn’t always at the top of that list.
Investors have more experience negotiating, but steamrolling an inexperienced founder doesn’t meet anyone’s goals, and might cripple a startup and keep the team from getting what they need to build a viable business.
Since I’ve been in venture, I’ve learned a lot about how to negotiate in a collaborative way. Before I was a venture investor, I was a litigator, and spent a lot of time in tough negotiations with opposing counsel with the goal to win. Negotiating in venture capital isn’t about winning or losing. Ideally, making an investment in a company aligns incentives for all parties.
So I was excited at the opportunity to participate on Andrea Minkow’s and Amy Jin’s Straighten Your Crown podcast series about demystifing negotiation where we discussed some best practices that are hopefully helpful for people who don’t negotiate on a regular basis. We covered a range of topics from how to prepare for a negotiation to communicating to be heard, and how to be flexible and creative when situations are tricky.
For a quick guide, here are five practical tips founders can use as they prepare to negotiate with venture capitalists.
1. Know your bottom line before you start
Before you walk into any negotiation, have a sense of what your bottom line is. Know both what outcome you’d love to achieve and where you would walk away.
During a negotiation, your bottom line might move. But, defining it upfront gives you a good gauge of where you stood at the beginning, not diluted by manipulation or negotiation. Later, that benchmark will help remind you why you started from that position, your reasoning, and your motivation. It’s also important to revisit your bottom line before you accept any offer.
Are you willing to walk away? If the answer is no, then you know how hard you should push and when you need to start capitulating. Unfortunately, if you aren’t willing to walk away, it is hard to maximize your outcome.
2. Remember: You have more leverage than you think
While it may seem like investors have more leverage because they are bringing the capital, start-ups actually have a ton of leverage even if you don’t have another term sheet. Once an investor has decided they want to invest in your company, you’ve already won. Most institutional venture capitalists only make one to three investments per year and making it to that point is most of the battle. The investor also doesn’t want to start a relationship with you on a bad note, so there is probably some room for negotiation.
I recommend gaining more information about the venture firm you are speaking with by doing reference checks. Ask for more time to decide and do your own due diligence. You can gain some leverage and be more informed to make the right match for you and your company.
In the current market, many investors believe that entrepreneurs are in the power position. Many companies are receiving multiple term sheets. If this does not apply to you, there is still the threat of other suitors coming in that you can leverage. Moreover, even if you only have the one offer or no offers, there are still options — you can continue to try to raise from other investors, enter an incubator program, try to operate the business profitably or delay your fundraise.
3. Know what matters most to you and the investor
Here is a short list of what startups should care the most about: 1) dilution (valuation + option pool size + investment amount), 2) liquidation preference, and 3) board composition.
It’s hard to negotiate on several fronts at once. I suggest picking one or two key points to focus on. For example, if you want less dilution, you can ask for a higher valuation. Or you can go about it another way and outline the hiring plan with equity compensations to demonstrate how a lower option pool will be sufficient to get the company to the next round of financing.
What matters to investors is that founders are clear about their goals, thought processes, rationale, and plan. For instance, if more or less capital is needed, be tight on the operating model, and be ready to show the expected growth you expect from the capital over time.
Doing your own reference checks and diligence on the investor will also help you determine what matters most to them. Do they have ownership minimums? Do they insist on having a neutral board?
And the single most important thing you can do is ask a lot of questions at the start of a negotiation. What you hear might surprise you, and it’ll certainly help you understand someone’s motivations and rationale. What you learn by asking may help give you the leverage you need to negotiate to meet your bottom line.
4. Be creative
Negotiation outcomes are rarely binary — there’s usually no clear winner or loser. An agreement can only be reached if it’s mutually beneficial. Even though it is a negotiation, you’re trying to reach a solution that everyone understands and feels comfortable with and sometimes you have to work with each other a bit and be a little flexible to make it happen.
For example, if an investor insists on a board seat and you feel uncomfortable with that, ask if they would be willing to step off the board at the next round of financing, if the company hits certain milestones, or if an independent board member is identified who could add more value.
Similarly, investors often ask for certain protections — like a blocking right over future rounds for instance — that set bad precedents and that won’t matter if the company is doing well. Consider asking to put those promises into a side letter with a solid expiration date.
5. Have conviction
Finally, it’s important not to confuse being flexible with weakness or lack of confidence. During a negotiation, you might need to make some sacrifices based on the competing priorities of investors.
There are certain issues that may be non-negotiable for you. If you disagree with an investor on a certain point, clearly articulate the reason for that disagreement. Having conviction around a set of circumstances — as long as they are explained — is a trait of a strong leader.
We want our founders to have conviction about their product, their business, and their talent. Ultimately, if we decide to work with you, we’re investing in the judgment of the founding team, and the negotiation process is a great way for us to get to know each other.