Negotiating With Investors – Focus on What Really Matters

Negotiations with investors are tough – especially when you’re not accustomed to these kinds of discussions and the party across the table engages in them on a regular basis.  What’s the most important advice (right after hiring a good/experienced lawyer who understands your business) – focus on what’s important – economics and control.

Having stated that you must understand and try to aggressively protect, retain and preserve economic/financial upside and control, it’s also essential to understand that the investor has something you need – money – and it’s inherently reasonable for that investor to expect in return for providing you with that money that he or she will receive both (a) substantial economic upside in the event the company is successful and downside protection if it’s not, and (b) a degree of control in order to protect that investment.

Unfortunately, I can’t provide a detailed explanation in a blog post of all of the terms and variables that arise in negotiating economics and control, but here are a few you must understand (Note – if you don’t know what these terms mean, find out before negotiating):

• Valuation – what ownership share will the investor get for invested dollars?

• Dividends – if the investor is to receive dividends, how much, when, who decides, and are they cumulative?

• Preference – assuming the investor gets paid first upon a liquidity event and that payment is more than the initial investment (i.e., a preference), how much more?

• Participation – after receiving the preference, does the investor get to “participate” in the remaining proceeds, and if so, to what extent?

• Dilution – how can various parties be diluted (including by an employee incentive pool), and what impact will this have on distribution of proceeds?

• Board Seats – who fills the Board seats, and what is the “balance of power”?

• Voting Rights and Protective Provisions – what issues does the investor get to vote on and/or veto?

• Conversion Rights – assuming investors receive preferred stock, when can they convert to common, and what impact might that have?

• Tag-Along and Drag-Along – under what circumstances can parties force others to participate in a sale or allow them to participate in a sale?

The above list is, admittedly, abbreviated, but it should give you an idea of the most important issues in negotiating with investors – everything else pales in comparison.

Strategic Alignment Goes Beyond Your Workforce

Business consultants frequently discuss the importance of having an aligned workforce – one with an identified and accepted culture, common values, a shared vision for the future, and a uniformly adopted strategic plan for getting there.  I would suggest for businesses of all shapes and sizes the need for alignment extends beyond your workforce to include, at a minimum, your legal counsel and other important advisers.

Why, you might ask, is it important that your outside advisers be “aligned” with you and your business?  In the simplest terms, having aligned advisers results in: (i) less wasted time; (ii) less wasted money in both consulting fees and lost opportunities; (iii) less frustration and misunderstandings; (iv) more productive negotiations and transactions; and (v) more meaningful and direct accomplishment of your business goals.

So, what does it mean to have aligned advisers, and how do you get them?  Here are a few thoughts:

•         First, choosing the “right” advisers is critical – different advisers have different personalities, approaches and philosophies – choose those that share yours from a big picture perspective.  But understand that this alone is not enough.

•         Remember, you set the course – not them.  Aligned advisers adopt your approach, not theirs – so they need to know what your approach is and what your objectives are.

•         In addition, your advisers must know what tactics and methods you want to use to achieve your objectives – overall and in each transaction or circumstance.  Make sure your directions are clear in this regard.  Think joint venture versus distributor, or even 50-page agreement versus handshake deal.

•         Make sure your advisers are informed as to changes in culture, philosophy, tactics, objectives, budget, etc.  They can’t execute what they don’t know.

•         Finally, periodically evaluate your advisers and their alignment.  If they don’t get passing marks, make a change.

The value of alignment cannot be overstated.  Make it part of your consulting and advisory relationships.

Sometimes You Really Can Do It Alone

One of the most common questions asked by startups and more mature businesses looking to grow is – how do I raise money from outside investors?  There are a number of answers to that question.  However, before you ask yourself that question, I would suggest there is a more important one – should you raise money from outside investors?  The answer to the second question, in turn, requires you to ask yourself some others.  Don’t worry – eventually you’ll get to answers, but the point is, the decision to raise money from anyone other than yourself (even friends and family) should not be made lightly.

Some of the questions you need to ask are as follows:

  • What do I need the money for?
  • How much do I really need?
  • When do I really need it?
  • Do I have it on my own; and if so, why would others put their money at risk if      I won’t?
  • Are there grant funds or other public or private assistance available?
  • Can I borrow the money rather than diluting my ownership?
  • Am I comfortable with all that accompanies outside investment (e.g., loss of      control, dilution, etc.)?
  • And . . . only after answering all of those questions and determining that you      need outside investors – who are my ideal investors?

The point is, the most expensive, complicated, intrusive and dilutive money that you bring into your business is outside equity investment.  So, when you ask and answer the above questions, consider what you can do to structure your company and business plan to maximize the growth you can achieve with your own dollars before bringing in outside investors.  While it may seem more expensive and risky in the short term, you may find the opposite to be true in the long run.

Subtlety Has Its Place

As the title to this post indicates, subtlety has its place – just not in business negotiations or contracts.  This is not to say that people shouldn’t be tactful, courteous and professional in these contexts – of course, they should be.  I’m not talking about manners; I’m talking about clarity, precision, directness and transparency – i.e., the things that avoid uncertainty and minimize the risk of disagreement (and litigation).

Occasionally, clients will ask me to word a provision in a contract so that it isn’t as clear or explicit as it might be, so that it’s “less conspicuous,” or in a way so that “later, we can take the position that it meant X. . . .”  This is almost always a bad idea.  After all, a contract is meant to be a clear and complete expression of the parties’ mutual intent and agreement – trying to “finalize” the deal while simultaneously avoiding clarity and completeness in order to avoid points of disagreement is NOT a recipe for success; to the contrary, it is a recipe for future disputes.

So, what does this mean for your negotiations and contracts?  Quite simply, items of potential disagreement should be identified and discussed (and hopefully resolved) early on, just as items on which the parties agree should be discussed.  Dispute resolution at the point of negotiation/deal-making and as part of the contractual process is healthy and productive.  It generally leads to one of 2 outcomes – either the parties ultimately reach agreement through compromise, concessions, etc., and they move ahead with the deal; or they don’t, and the deal doesn’t get done.  Either result is far better than signing a contract or entering into a relationship only to end up in the other kind of dispute resolution – the kind that comes after the contract is signed and involves 2 teams of lawyers, a judge, jury or arbitrator, and words like injunction, breach of contract, damages, and legal fees.  Don’t be subtle . . .

Nice to Meet You – Let’s Get Married

Only fools rush in.  We’ve all heard that expression many times and probably think we’re far too wise and experienced to be such a fool.  However, you’d be amazed at how often businesses and individuals rush headlong into business relationships or contracts only to find out they should have used more discretion, patience and judgment.  Remember, before you date someone, you usually want to know at least a little bit about them; before you go steady, you want to know a little more; and before you get married, you really want to know them well.

Consider applying some of these dating lessons and clichés to your business and legal relationships and contracts, and you may find you have fewer emotional breakups or (more importantly) fewer bad marriages that end in messy divorces:

  • Ask around (a/k/a, do your due diligence) – learn all you can about a person or company before you engage them, become partners or enter into a long term binding contract.
  • Trust your instincts (a/k/a, if it doesn’t feel right, don’t do it) – unless there’s some compelling reason you have to work with a specific person or company or you have to jump into a deal with both feet, if you’re getting a bad vibe, don’t proceed.
  • Go slowly (a/k/a, – start small) – whenever possible, start with a smaller project or a short term relationship and see how it goes. There’s usually time and there will almost always be more opportunities to work together if the first one goes      well.
  • Build in an escape hatch (a/k/a, don’t put all of your eggs in one basket) – even if you’re ready to hire someone or enter into a contract, make sure you have the ability to terminate or get out of the relationship.
  • See other people (a/k/a, avoid exclusivity) – exclusive relationships are serious commitments and have high risk (and potentially, high reward); take your time.
  • There are more fish in the sea (a/k/a, know when to say when) – ending a bad relationship is always hard – whether personal or business – but when your gut tells you it’s not right, then it probably isn’t. Cut your losses and end the relationship (in the right way, of course).

The bottom line is, business and legal relationships resemble personal relationships – with the same types of risks and rewards.  Look before you leap.

Raising Outside Capital? Know the Basics – Part 1

So your company is doing well and has great growth potential, but the banks won’t loan you money to grow, you’ve exhausted your personal resources, and you’ve run out of friends and family willing and able to write checks to your company – what does that mean?  It probably means it’s time to raise outside capital – perhaps angel or venture capital.  Here are some considerations before raising outside capital and some of the key points you’ll likely be negotiating:

Dilution/Loss of Control:
First, consider whether you’re prepared to own less than 100% of your company, and if so, whether you’re also prepared to have less than 100% control over business decisions.  If the answer to either of these questions is no, you should not raise outside capital.

Capital Need – Sources and Uses:
Second, carefully consider how much money you need and what exactly you’re going to do with it.  The reason is twofold – first, no experienced investor will take you seriously unless you have a detailed and well thought out strategy; and second, the more you raise, the more ownership and upside you give up.  Raise just what you need to execute your business plan (with the caveat that everything generally takes longer and costs more than planned).

Strategic Investors:
Third, consider what qualities, skills, connections, experiences, etc. you would like your ideal investor to bring to the table.  After all, a dollar is a dollar, but these other strategic offerings are what differentiate one investors’ dollars from another’s – and make them more valuable to you.

Valuation:
Valuation will be key.  At the risk of stating the obvious, the higher the valuation you can justify, the lower the interest the outside investors receive for each dollar invested.  And be prepared to justify your valuation – this company is your baby, not theirs.  What you see as a cute dimple, they may see as an ugly scar.  In the end, the value of the company becomes what you and your investor(s) agree it is.  Make sure you’re prepared to make the strongest case for your valuation – and understand that to the investor, it’s just business.

Stay tuned for “Know the Basics – Part 2.”

Angels and Opportunities – What a Concept!

One of the biggest challenges facing angel investors is access to good deals. One of the biggest challenges facing early stage companies is access to capital; another is access to experienced, strategic investors who bring more to the table than money. There’s no real mystery here – we need to go beyond ad hoc networking to connect angels to investment opportunities for their mutual benefit and for the benefit of the start-up and entrepreneurial ecosystems inIowaand beyond. We’ve known this for a long time, but now we’re finally doing something about it – enter “The Plains Angels.”

 The Plains Angels is the brainchild of Mike Colwell at the Greater Des Moines Partnership and will be led by Mike, Christian Renaudand Tej Dhawan with support from BrownWinick. It is not an investment fund, but rather a group of angel investors looking for a reliable and consistent source of high quality deals that have been vetted by experienced consultants. That’s the mission of The Plains Angels – to connect angels with opportunities.

This is not a new model – it’s proven successful in Omaha, Austin, Denver and elsewhere, and it will succeed in Iowa. And the beauty of it is, it need not and should not be limited to Iowa companies or Iowa angels. In fact, in order to develop the synergies and diversity of opportunity that we’re looking for, it’s essential that The Plains Angels cross pollinate and be cross pollinated by other like-minded groups.

This is an exciting time to be involved in the start-up/entrepreneurial and angel groups in Iowa and more broadly.  The Plains Angels is what we’ve needed for several years to put us over the top locally and make an impact regionally and nationally. This is going to be a lot of fun – join us for the ride!