How to Create the Next Facebook: Seeing Your Startup Through, From Idea to IPO (13 page)

In the next chapter, we look at the nitty-gritty of negotiating an offer from investors. It’s an intense process, but I’ll show you some ways to get your footing.

My father said: You must never try to make all the money that’s in a deal. Let the other fellow make some money too, because if you have a reputation for always making all the money, you won’t have many deals.

—J. Paul Getty

When an angel or VC wants to make an investment, they issue a
term sheet
. This is a short document—one to four pages or so—that sets forth the amount to be invested and the valuation. There is also an array of protections that are heavily legalistic and technical. Often these are the most critical part of the document, yet investors tend to focus instead on the valuation. It can be a huge mistake.

Mark Zuckerberg agreed to his first term sheet back in 2005, which came from Peter Thiel. Mark had the help of counsel and key advisors like Sean Parker, who understood the nuances of the deal terms. Although the valuation was important, it didn’t become an obsession. Consider that an important focus was for Mark to maintain control of Facebook, which would prove critical for the company’s success.

All this required hefty legal fees, which were the company’s responsibility. And did you know that general practice is for the company to also pay the VC’s fees? It’s true. But these come out of the financing.

This chapter shows many of the types of provisions you see in a term sheet and how to negotiate them. After this, you will look at how to manage the due-diligence process, which can have its own landmines. But first let’s cover some time-honored approaches to smart negotiation.

Before getting into the negotiating process, make sure your team is on the same page. This includes not only your co-founders but also your advisors and attorneys. Decide on things like the ideal term sheet you want, deal killers, the minimum levels on key points, and terms that don’t matter much.

You’ll be glad you vetted these issues. Keep in mind that VCs are pros at negotiation—it’s part of their job description—and are not afraid to pounce on inexperienced entrepreneurs.

Let’s say one co-founder blurts out that an anti-dilution clause is important, but a few days later another co-founder mentions the opposite. The VC will smell an opportunity to kick out the clause.

Yes, it can be brutal.

It’s common for entrepreneurs to talk too much in negotiations. This may be due to nervousness, or it may be a way to create rapport.

Don’t fall into this trap. You may talk too loosely about certain terms, such as inadvertently volunteering your minimum deal points on the valuation or the liquidation preference. It’s almost impossible to undue such a move.

What about Zuckerberg? By his nature, he is a quiet person. He reflects much on ideas and what people say. The silent approach has also been a great negotiating technique. Despite his young age, he was able to effectively go up against some of the world’s best dealmakers.

If you read the literature on negotiation—and there are many books on the topic—you’ll notice myriad approaches. One is to be Mr. Nice Guy and not get too aggressive. The belief is that you’ll reach a better deal if you’re collaborative.

There are merits to this technique, but it has its problems. Investors want to know that an entrepreneur is tough and willing to fight hard on material points. If you roll over on major issues of the financing, you’ll probably lose the confidence of your potential investors. They will wonder: Are you too wishy-washy? Will you be up to the task of getting strong terms from customers and vendors? Probably not. Consider that investors, such as Peter Thiel, have passed on investments because the entrepreneurs were not willing to get aggressive on their negotiations.

On other hand, some entrepreneurs go to the other extreme, taking a no-prisoner’s approach. The premise is that a negotiation is a war, and every point must be won.

The most notable example is Steve Jobs, who was a relentless negotiator. Somehow he was able to get his way with mega companies.

But of course, Jobs was an outlier. He had an innate sense of timing and immense charisma. Chances are you don’t. So if you are too hostile in your negotiations, you’ll likely wind up with little to nothing to show for it. It’s also important to remember that during the negotiation process, you are in the early stages of building a relationship with the VCs. They will be part of your company for years.

The best negotiating approach is to maintain a balance between collaboration and aggression. It’s not easy, but it gets better with experience—and as an entrepreneur, you will have many opportunities for practice. It’s key to be mindful of the balance and keep finding ways to improve.

You should also be wary if the VC uses hostile tactics. Is this approach the typical way they conduct business? Might this bode ill for a long-term relationship?

One bad sign is if the VC offers an
exploding term sheet
, which means you must agree to it within a short period of time (say, 24 to 48 hours). This high-pressure technique is a major red flag. Probably the best thing to do is walk away.

You also should not agree to a “representations and warranty” clause that makes you personally responsible for the company’s results. This could be devastating to your personal finances. It also shows that the VC is overreaching and you should probably look elsewhere for an investor.

If a VC gives a low-ball number on your company’s valuation, it feels like an insult. You may want to lash out or tank the deal. Don’t they know this company has huge potential?

This may be the case, but you need to realize that VCs are taking a big leap of faith. Most early-stage ventures fail for a host of reasons, such as timing, competition, and bad execution.

It’s amazing that VCs are willing to invest in such ventures. Doesn’t it seem nuts to put $5 million into a company that has only a prototype, no sales, and a young management team?

So when it comes to the valuation of your company, you need to have thick skin. Expect the low-ball offers—and don’t be surprised if the valuation goes even lower as the negotiation progresses! It’s all part of the not-so-glamorous journey for an entrepreneur.

A big fear of entrepreneurs is a massive dilution of their ownership stake. It could mean the difference between being mega-wealthy or moderately wealthy or merely content. But there is no way around dilution; it’s part of the game. As for Zuckerberg, he had only 28.1% of Facebook’s ownership when the company came public in May 2012. But it was still enough to make him one of the world’s richest people.

There are several approaches to valuing a company. They include looking at comparable transactions, coming up with the market values of the assets, and evaluating a company’s cash flows.

But for early-stage ventures, none of these methods work. Even if there are similar transactions, they won’t have been disclosed. An early-stage company has few meaningful assets, and cash flows are years away. So throw away your Excel spreadsheets—they’re useless and will muck things up.

Perhaps the only quantitative standard is that an investor generally takes a minority stake in an early-stage company, say 10% to 40%. By doing so, they make sure the entrepreneurs have enough incentive to create a breakout company.

The ownership percentage varies based on a variety of factors. One is the general funding environment. If it’s robust—like the late 1990s or 2010 to 2012—then expect the ownership percentage to be 10% to 15%. But if the market is in a nuclear winter, such as during 2001 to 2003, then it could be 30% to 40%. This is assuming any investors are willing to write a check.

The other critical factor for the valuation of the company is its hotness. If you have what appears to be the next Facebook, then expect multiple term sheets, all with minimal valuation percentages (they could easily be below 10%). But for this to happen, you need to have tremendous traction in the marketplace already.

The more likely scenario is that there will be naysayers. VCs will try to get a better ownership percentage by highlighting the risks. This is why you need to constantly find ways to hit milestones and show ongoing progress. It’s the only way to get a blow-out valuation.

To negotiate the valuation, you first need to understand the lingo. Keep in mind that there are two types of valuations: pre-money and post-money.

The
pre-money
is the valuation of the company before any capital is added. Suppose you start a company, and, based on your analysis, you think it’s worth $5 million. This is the pre-money valuation.

Let’s say an investor agrees to this amount and is willing to invest $1 million. In this case, the
post-money
valuation is $6 million, which is the pre-money valuation plus the investment amount.

As you can see, the difference between the pre- and post-money valuations is $1 million, which is significant. This is why you need to be clear with the VC about which one is being discussed. If not, you may wind up with less equity. VCs understand this and are not afraid to confuse matters to get an edge.

But there is another wrinkle—and this is mostly for Series A deals. An investor will require that a certain amount of equity be set aside for options for employees; this is called an
option pool
.

Again, make sure you and the investor are talking about the right valuation. Is it before the option pool is added or after? If it’s the former, you will suffer from dilution over time as you grant options. This can be a big deal, because option pools typically range from 10% to 20% of the outstanding shares. In the case of the Series A funding of Facebook, the company and the VC agreed to share the dilution of the option pool. It was a reasonable approach.

If this is not possible, you can try to get a higher pre-money valuation. But this has its limits as well. Unless you have a red-hot startup, you may not be in a position to get aggressive about the valuation.

Finally, you need to understand that there are valuation differences for the types of securities involved in the financing. In general, common stock is valued at 10% of preferred stock, because the preferred stock has more power. Although this may seem a bit unfair, it’s actually a benefit to the company. A lower valuation on the common stock makes it easier for employees and founders to buy shares, because they are much cheaper.

The 10% rule is also a way to avoid tax problems. For example, let’s say the common stock is sold at 1 cent per share to the founders. Six months later, they sell shares to angels at $1 per share. In this case, the IRS will wonder if the original valuation was too low, and the founders may have to pay a huge tax bill. By having separate valuations for the common and preferred stock, you can avoid this problem.

Don’t get deeply mired in all of a term sheet’s clauses. Many are not particularly important and are a waste of time. When getting funding, you want to maintain momentum and close the deal quickly so you can begin the next phase of the company’s growth.

Speed is also important because the funding environment can freeze in an instant. Take the example of PayPal. The company’s CEO, Peter Thiel, rushed to close a $100 million funding in March 2000 because he thought the dot-com bubble would burst. He turned out to be prescient: the market collapsed in a few days. Without the funding, PayPal would have been out of cash in about two months.

There will inevitably be disagreement, but the most important clauses in a term sheet include the liquidation preference, the board slots, anti-dilution, pay to play, and drag-along rights. Let’s look at each in more detail:

The liquidation preference gives priority to the investor when there is a liquidity event, such as an acquisition. The most basic is a
1X preference
. This means the investor gets up to 1 times the investment back before anyone else gets any cash.

This is a reasonable provision. To understand it, here’s an example. Jack raises $5 million for his startup. After a few months, he gets bored with the venture and shuts down operations. He walks away with a big chunk of the money because he owns more than a majority of the stock. It’s sounds awful, but it’s perfectly legal.

Because of this potential scenario, you have no choice but to accept a liquidation preference. Even Facebook had to.

The good news is that you can soften the impact. If an investor demands a 2X or 3X or even 4X preference, push back hard. It could mean you wind up with absolutely nothing even if your company turns out to be a success.

For example, suppose you get a $10 million investment, but there is a 3X liquidation preference. If you receive a $30 million buyout, all of it goes to the investors. In the end, you will have been an employee, not an entrepreneur.

A VC may try to extract even more with something called a
participation
, which gives them part of the upside as well. Let’s take another example. Suppose you raise $10 million for your venture, but the investor gets a 1X liquidation preference and participation. His ownership percentage is 30%.