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Negotiating with VCs: Navigating the Founder’s Dilemma

The 'Founder’s Dilemma’ is a concept attributed to Harvard Business School professor Noah Wasserman
His award-winning program and best-selling book discuss the fundamental problems faced by founders of startup companies, most notably the dilemmas related to funding.
Key Points:
  • Understand the Founder's Dilemma and its inherent trade-offs
  • Concentrate on intrinsic value, rather than valuation
  • Communicate – it's more personal to discuss issues, and often more productive
  • Match your Goals - know your investors and their intentions
  • Don’t Ass-u-me
  • Don’t delay consolidating terms as you might lose the deal

As a start-up begins to grow, founders face a difficult decision: how much control are you prepared to concede to a third party in order to make the business profitable? It's possible that with the right investors a startup will achieve fantastic financial gains and business success, however, you may have to part with more equity than you expected.

Wasserman's research revealed that founders who surrendered more equity in the startup with the purpose of attracting co-founders, investors and employees are more likely to end up with a more valuable business, and ultimately a more profitable shareholding. It's all about giving something to get something back – if you don't give enough, then what you get back is less valuable in terms of overall growth. So how much are you prepared to concede?

Capitalists and Kings

Wasserman described the fundamental trade-off between the wannabe 'rich' -v- the wannabe 'king'. In the 'king' model, some startup founders will bootstrap their funding in order not to cede control over company decision-making. In the 'rich' model, founders may be wholly motivated by profit and in order to obtain appropriate funding, will be obliged to accept a proportionate loss of control.

The get-rich-quick option is more likely to lead to a profitable startup with a valuable exit, while the king-of-the-castle option offers founders a greater control over what may turn out to be a less profitable but longer-term venture. In the overall scheme of things, neither option is necessarily better than the other – it all depends on what your vision is and what will work best to bring that vision to fruition.

Wasserman's research indicated that sharing equity is a more successful gambit in the long run because it builds better relationships and a stronger overall business venture. VCs don't only invest money; they invest in the whole business. They can also bring to the negotiating table considerable expertise, such as network resources, strategic advice, project mentoring and even political influence, so consider your choices carefully before making a decision. Some angels and VCs may not even consider a venture that's not wholly aimed at profit, so it pays to know who you're dealing with.

Matching Goals

You need to be honest with yourself so you can identify your primary motivation for starting a business. Once you have done this, you can choose the VC or investor who best fits your particular bill. This is a complex and time-consuming process for which you are best advised to consult an experienced lawyer, as negotiations can be extremely nerve-wracking. One point often made by investors and VCs is that founders focus too heavily on the valuation of their business (what it's worth before their investment) rather than its inherent value.

The value of a business may be a more nebulous concept for both parties, as some early stage investments are more like a true partnership that you'll build together. Bear in mind that you're entering into a relationship that might last ten years or more, and you will realize that both parties have as much to gain by fair negotiation as one another. While it may be essential to determine who has overall control, it is equally important to share that control so that your investor has confidence and some say in the outcome.

Nuts and Bolts

Once both parties have indicated their agreement, VC negotiations are likely to center around price and terms. It's unlikely at this point that there'll be fundamental disagreement, but a bit of flexibility may be required to ensure your mutual agreement. A Term Sheet will typically be issued, outlining the main areas of negotiation.

Term Sheets

A term sheet is a non-binding summary of the conditions a VC will require for funding a startup and it is legally similar to a Letter of Intent. Term Sheets mostly consist of three key areas: financing, corporate governance and asset liquidation, and include such terms as:

  • the amount to be invested
  • registration rights
  • voting rights
  • price per equity share
  • pre-money or investment valuation
  • liquidation preference
  • anti-dilution provisions

Once a Term Sheet is issued, it is advisable to move quickly, so that everyone gets back to doing what they're best at. For this reason, most Term Sheets will be drafted with an expiry date, so that both parties maintain a sufficient pace in the deal process for the terms to remain valid. Don't dilly-dally, or you might jeopardise the deal.

Communicate, Negotiate, Validate

The key word in any investment funding round is 'negotiation'. In order to gain a better understanding of what each party is looking for, you must have clear lines of communication which allow you to speak with potential investors frequently about different aspects of the negotiation. Be up-front and honest with your decisions, your queries and your concerns – if you don't understand something, say so. If you deem it appropriate, call your investors out with a request for complete candor.

Bring up your concerns, ask for answers and satisfy yourself on all points before making a formal commitment. Don't continue in the half-dark with an incomplete understanding of terms, in case they come back to bite you in the future. If both parties aren't on the same page, misunderstanding can lead to mutual mistrust, which is no foundation at all for a successful venture.

Above all, don't wait for formal meetings to bring up any issues: 21st-century comms enable frequent face-to-face discussions, and you should aim to develop a close relationship with any VC or investor before you make any final decision. Sometimes a ten-minute chat is worth a thousand words of legalese.

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