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June 26, 2011

Leveling The Playing Field When Negotiating With Venture Capitalists

A venture capitalist is looking for one thing from a prospective investment: a large return in a short time frame. They’re looking for the best possible ROI in five to seven years and that’s exactly what they try to ensure themselves when they offer you a term sheet or stock purchase agreement.

Although they are looking for a return on their investment and a healthy one at that, they understand that you also want to make a profit and can be some of the best allies you could have in growing your business. At the same time, once you sign a term sheet which lays out the terms of ownership of the company (even though they are non-binding), the venture capital firm now has the upper hand in negotiations. A term sheet is where factors like control of your board of directors, valuation, liquidation preferences and so on are detailed.

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Normally, getting a term sheet is cause for cautious optimism, if not necessarily celebration. Generally speaking, this is a step which means that a venture capital firm is seriously considering investment in your venture, since the term sheet is the first step in the process of stock negotiation. In case you were wondering, yes, this is when you need to call a lawyer, at least if you want the negotiations to be fair. Otherwise, you’re operating at a disadvantage and investors know it.

The next thing to do is sit down with your lawyer and look over the term sheet before actually negotiating with the venture capital firm to come to a final stock purchase agreement which is as favorable as possible to you.

The best way to level the playing field during negotiations is to get a little competition going. If you can get term sheets from more than one venture capital firm at the same time, you’ll be able to create a sense of urgency and with any luck, carve out a stronger negotiating position for yourself. You can do this by contacting multiple firms close to the same time; your teasers should not that you’re looking to close the current round of funding at some stated amount and on a stated date.

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It’s all about supply and demand. There are hundreds of venture capital firms out there in the US alone and of course, there’s just one of you. Being in limited supply, your company’s value is higher the more venture capitalists are interested in you. If one venture capital firm tries to lock you into a term sheet with a “no shop” clause which keeps you from pitching your company to other potential investors while they think about whether to offer you funding, this method can work especially well.

Getting multiple term sheets makes the negotiation process easier for your company by minimizing or eliminating one or more of the biggest problems entrepreneurs face. By creating competition for your company, you’ll give yourself more leverage in negotiations and ultimately get better terms in your final stock purchase agreement.


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