Valuation and Negotiation
I was thinking about Rob Go’s post on valuation which makes one of those great points that fit in the category of common sense that people in my end of the business often feel intuitively but don’t articulate. With respect to the valuation of early stage VC investments (where there is no cash flow), he says:
The answer is that vc rounds are priced by the market - by supply and
demand. I once met an experienced VC who admitted to me that he didn’t
actually know how to do a DCF. But he did know where a deal would
likely close at based on pattern recognition.
From my point of view, since I am neither a buyer nor a seller of rounds, this is about as accurate a description of how pricing actually works as I have seen. For so many early stage technology companies there is no DCF analysis that can be done (or that isn’t transparently a work of fiction).
So, the discussion should really be about the kinds of things entrepreneurs can do to improve their negotiating position. There is a mountain of advice around the basic things entrepreneurs should do in preparing their slide deck, approaching VCs etc. A personal favorite is Naval’s post on Presentation Hacks.
I am not even going to try to list ten things that entrepreneurs can do to enhance their bargaining position, but I do want to talk about the imbalance of information between VCs and founders. VCs do lots of deals, they hang around with their partners who also do lots of deals, they sit on boards with other VCs who do lots of deals, they use lawyers who do lots of deals, they follow the venture industry (of which doing deals is a huge part) through conventions like the Nantucket Conference and publications like Dow Jones VentureSource. They have a pretty good, albeit impressionistic, sense of what is going on in the market – way better than you do.
This brings me to the “facts.” Entrepreneurs should get to know what is going on in the market. There are probably comps of some sort for any given company; find out about their valuation and terms. Some time ago, I wrote a post titled “Do the facts matter when you are negotiating with a VC over financing?” The thesis of this of this post was that it did not matter what was going on in the marketplace some entrepreneurs were going to get good deals and others not so good deals.
Nivi did not agree and wrote the following comment:
This post seems to imply that BATNAs are the only leverage in negotiations. They're not. Having access to a database of deals and their terms is great normative leverage. Humans are susceptible to a host of psychological principles (consistency, reciprocity, etc.) and normative leverage exploits them.
So the non-rock star in this post can and should use norms to get a better deal.
Upon reflection, I agree with Nivi. Go find the facts. No real need to state the obvious, but what you negotiate in the A round is very important because, after the A round, founders only get diluted (in terms of percentage ownership) and (God forbid) if there is a down round founders can get washed out.
Consider this: In connection with follow on rounds (B rounds and later) VCs are often (almost always) refreshing the option pool. Why? Because even they recognize that management (i.e. the people who will make it happen) have too small a stake in the business going forward. In effect, the investors have already taken the maximum percentage of equity they can out of the business. If you are a founder and no longer in management (for any reason) where are you going to be?
As another entrepreneur pointed out to me, from the founder’s perspective, small percentage differences at the front end can have large cash consequences at the exit. Now, let’s not lose sight of practical reality. Often, unless you are a rock star, you are going to have to take what you can get – that is to say there will be limits to your leverage and you don’t want to set an unconstructive tone with your potential investor (who, after all, is about to become your business partner and, probably, your biggest stockholder).
Another huge driver of negotiating leverage is the quality of the management team. Great sounding ideas are good, but there are quite a few of them out there. A management team led by someone who has delivered a nice exit in the past, is a rare thing that VCs (rightly) treasure. Here is what Naval’s interview on a variety of topics related to entrepreneurship has to say on this point, and I think this is an exact quote, “It’s the people, stupid.”
Now, not everyone can get a rock star to lead their venture, if they could rock stars would not be so rare. But, a compelling team will make a significant difference to an investor. VCs will be skeptical about a first time entrepreneur’s ability to be CEO. If this is a role you insist upon, you may scare off a lot of investors. Where there are weaknesses in the management team, they need to be recognized and addressed in a sensible way. Demonstrating common sense and good judgment will help you in your negotiations.
Having said all this, you have to be realistic, you are not going to “win” every point, nor should you. Remember negotiation is a lot about what you get now, but it is also a lot about the relationship going forward.
If Rob go is right and I think he is, there are a lot of things out side of the usual slide deck, elevator pitch type advice that will affect your ability to obtain financing as well as the terms you get. I will try to comment on them from time to time as I see them arise.