Earlier this week, I had the pleasure of participating on a panel on term sheet negotiations at this year’s edition of the Wisconsin Early Stage Symposium in Madison, Wisconsin; an annual event that brings together several hundred entrepreneurs, investors and what are gently referred to as service providers interested in growing the high impact business community in Wisconsin and the upper Midwest. It’s always a great event, bookending as it does the annual Wisconsin Early Stage Conference, a gathering of similar folks with similar interests (i.e. mostly the same folks with mostly the same interests) that takes place early each summer.
The term sheet negotiations panel is always a lively event, and one that I have been a part of at both of the Wisconsin conferences for several years running. Basically, the four panelists role-play a venture capital negotiation session based on a term sheet advanced by a venture capitalist and available to the audience to peruse during the session. This year, I played the part of the guy with the black hat (literally, in this case), which is to say the venture capitalist. The term sheet was more or less from the lower reaches, which meant my hat’s color was quite appropriate. The entrepreneur, the guy with the figurative white hat, was played by serial entrepreneur Robert Hopton of Idle Free Systems, and he played the part with admirable passion and conviction. Joe Hildebrandt, of DaneVest Tech Fund, played the part of the angel investor who had led the seed round, and Ed Maginot, of Grant Thornton, played the part of the company’s accounting adviser. My partner at Michael Best, Greg Lynch, tried, with more or less success, to keep the negotiations from getting physical.
As noted, I have been a part of this panel multiple times over the last several years. While some of the details change every time we do this exercise, having been through the process something approaching ten times at this point, what strikes me are a few of the consistent themes that keep reappearing. Themes that, entrepreneurs thinking about venture funding as a possibility for their new businesses should seriously reflect on before they get too far into the venture capital courtship process. Herewith, those themes…..
- Valuation is in the eyes of the beholder and if you, as an entrepreneur, want the best valuation you had better make sure there are at least two independent pairs of eyes doing the beholding. The fact is, for pre and most early revenue high impact start-ups, the valuation of the enterprise is, if not arbitrary and capricious, at best loosely tied to any wholly objective analysis. What matters is what a particular investor is willing to pay, and if you want to have any real influence on a particular investor’s thinking the only real leverage an entrepreneur has, short of being willing to walk away from the deal, is to have more than one investor in the hunt.
- Don’t confuse the list price with the actual price. List price, in the venture capital world, is usually an objective number based on how much capital buys how big an ownership position in the business. Figuring out the real price is a subtler and subjective exercise. Some of the important deal terms that can seriously undermine the list price include cumulative dividends, redemption rights and participating liquidation rights. In terms of valuation, the devil is often in the details.
- If, as an entrepreneur/founder, you are not willing to give a substantial amount of control to prospective venture investors to effectively make them partners in your business, you should not waste your time courting venture capital investors. Good venture investors are not micro-managers, but they are active investors, and for a variety of reasons (including their fiduciary obligations to their investors) they will insist on a variety of investment terms that will give them not only input on critical business decisions but absolute veto authority over a number of major corporate decisions. If you can’t live with that, don’t waste your time courting professional venture capitalists.
- If, during the courtship of a particular venture investor, including the term sheet back and forth, you find yourself thinking of the investor as the bad guy, step back and ask, per item three above, if this particular venture capitalist is someone you want to partner with. Entrepreneur/VC relationships can be, and usually are at some point, very stressful, even when the entrepreneur/VC “fit” is solid at the outset. If, on the other hand, the fit going in is uncomfortable, the likelihood is that when the going gets tough, as it almost always does at some point even in the best deals, the entrepreneur/VC relationship will become dysfunctional. And, having been there and done that on several occasions and witnessed it on many more, that is a place where even good deals go to die. Better to bail during the courtship then sign up for a likely very stressful divorce.
Of course, the above list is far from comprehensive. Term sheets, and term sheet negotiations involve a myriad of issues, and those issues can interact in unexpected ways. So, (self-serving note here) as an entrepreneur you should work with experienced advisers during term sheet negotiations. But whether you do that or not, you should keep the thoughts noted above close to heart. Or, just live and learn. It works for teenagers, right?© MICHAEL BEST & FRIEDRICH LLP