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March 29, 2010

How to Negotiate With Venture Capitalists

After a venture capital firm makes an investment decision, there are a number of critical issues that must be worked out contractually to ensure a good relationship between investor and investee.

Valuation. This is the most important issue to negotiate with venture capitalists. The outcome of this decision determines the valuation of your company—how much the investor pays for what percent of your startup. It works in your favor to give away a lower percentage for a higher dollar amount.

Timing. In order to minimize the risk of their investment, many venture capitalists provide their funding in stages. Installments of capital might come after specific time stages or operating landmarks.

Stock Issuance Timing. In some cases, it is preferable for investors to see that ownership stock comes in waves (“vesting”).

Company Management. Venture capitalists invest in people as much as they do in companies. In many cases, the investor will mandate that specific people be placed in key positions in the company, or that you hire certain individuals at certain stages. This is often a good thing, because venture capitalists and their networks tend to be very capable and knowledgeable. However, it affects compensation and stock options, and may dilute the holdings of the founders.

Employment Limitations. Generally, venture capitalists dislike contract clauses that prevent the firing of employees, or set compensation levels too high. These types of investors also may require non-compete agreements that limit what types of work you can do after your time of employment at this particular startup.

Proprietary Rights. Venture capitalists invest in technologies. They want to ensure that these technologies are bound, by law, to the company they fund, and not to any individual. Individuals move around and therefore represent a risk to the investment. Furthermore, investors usually want to see that any new innovation remain with the funded company as well. Confidentiality agreements are not uncommon.

Lock-up period. A common issue in negotiations is the lock-up period, a specified time period where this specific investor is the sole entity allowed to make the investment. This time period, often 30-60 days, is used to conduct due diligence on the company to be invested in.

Liquidity Events. The single most important part of an investment is the investor’s exit strategy; how are they going to get their money back, plus a return, at some point in the future? It generally occurs in a “liquidity event,” an acquisition or public stock offering. This issue will deal with registration rights, rights to sell stock, and forced redemption of stock. It is essential to seek the counsel of a qualified third-party professional to ensure that these terms are fair.

The results of negotiations on these issues will have tremendous impact on the future of any firm or entrepreneur who receives venture funding. It is critical that entrepreneurs seek the services of reliable, professional advisors to assist them through this process.

Click here to learn about a proven, step-by-step method for raising venture capital.

All the best,

Amir

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