5 tips for negotiating with VCs
By Will Elton, Last updated: 2021-05-26 (originally published on 2017-07-19)
As an entrepreneur looking for funding, it might seem that you are the one at the mercy of all your potential funders out there – banks, angel investors, venture capitalists, and the lot. While it is true that the process of securing funding is a competitive one that requires you to be at the top of your game, this does not mean that you have no bargaining power at all.
In the case of obtaining venture capital, this is an important business deal that will have significant implications on how you grow your startup and seek more funding in the future. As a startup founder, you need to realise that there is a point beyond which the deal is no longer beneficial to you. Here, we give you five tips on how to negotiate with VCs so that you can strike a deal with makes sense for both parties:
Tips for Negotiates with VCs(venture capitalists)
1. Deliver a solid pitch
After spending time building relationships with VCs and securing meetings with them, the next important step is delivering an executive summary that will clearly articulate your business plan and address all the concerns on the VC’s mind. This can be an intimidating process so it is crucial that put yourself into the VC’s shoes and ensure that you cover all your bases. Beyond the relevant financial projections that shows you know the market size and scalability of your startup, VCs also care about the more intangible elements, such as the credibility of the founders. All these contribute towards their assessment of whether your startup is a right fit for their investment portfolio.
According to Zegal mentor Emmanuel Pitsilis, there are nine key elements you should include in your executive summary:
- A clear simple hook.
- A problem you are addressing.
- A tangible solution that strikes the imagination.
- A well-thought through business and economic model.
- The size of the business opportunity.
- Distinctiveness and defensible differentiation.
- Intellectual property & protection.
- Your team & your passion.
- Funding required.
2. Get into the VC mindset
As in every negotiation, it’s all about getting understanding the goals of both parties. On your end, make a list of what you want from the negotiation. Have in mind what your boundaries are so you know what will cause you to walk away. In turn, make sure that you understand the VC’s motivations, obstacles and goals. This will allow you to frame your goals as solutions to a problem VCs are trying to solve.
According to Asia’s most influential VCs, such as Golden Gate Ventures and Sequoia Capital, these are the top things they look out for:
- Walk the talk
- A focused leader & a coachable team
3. Know the terms of the Term Sheet
Once you’ve gotten a VC interested in your startup, the next step would be to sign a Term Sheet. The Term Sheet sets out the offer from the investor to a company to purchase shares in the company. While the Term Sheet itself is not legally binding, it serves as an essential document that helps both your startup and the VC reach preliminary and conditional agreement on key terms of the investment during the negotiation stages. It is thus important to look out for the following key clauses in a Term Sheet:
- Type of share – the voting and financial rights the investor’s shares have;
- Power for the investor to appoint a director to the board;
- Valuation of the company – the “pre-money valuation” will usually determine the price per share that the new investor will pay and the “post-money valuation” is the valuation of the company after the investment has been completed;
- The fully-diluted number of shares in the company. This will usually include shares that have been issued, shares allocated to an option pool, and any other shares which the company could be required to issue through options, warrants, convertible debt, or other commitments;
- Option pool of shares – whether there are shares set aside for employees or other investors;
- Full investment on completion date versus the investment being made in stages over a period of time (tranches), and any technical and/or commercial conditions (milestones) to be met for each tranche;
- Anti-dilution provisions to protect the value of the investor’s stake in the company;
- “Tag-along” and “drag-along” rights;
- Liquidation preference – if the company is liquidated, whether the investor receives an amount from the proceeds before other shareholders;
- Restrictions on how shareholders can deal with their shares if they leave the company within a certain time, and non-competition restrictions on founders; and
- Who pays the investor’s costs.
It is important that you understand what all these clauses in a Term Sheet mean. For instance, a “drag-along” right means that minority shareholders are required to join the deal when a majority shareholder sells his stake. In contrast, a “tag-along” right means that where a majority shareholder chooses to sell his share, minority shareholders have the right to join the deal and sell their share at the same terms and conditions as the majority shareholder. In order to be best prepared, it is a good idea to define your optimum, desirable and essential output in advance.
- Optimum: This is the best outcome of the negotiation and should be your opening position.
- Desirable: This is the outcome you expect to obtain from the negotiation.
- Essential: This is the bare minimum outcome you are ready to accept from the negotiation.
Source: The Startup Factory
A comprehensive understanding of the terms of the Term Sheet will allow you to appreciate the interest the VC is protecting when pushing for a particular term, and easily assess whether the term is favourable to you.
Related reading: Funding via Convertible Note, Explained
4. Size up the VC
As much as the VC is sizing you up to determine whether to take the risk on you, the negotiation process is also an opportunity for you to evaluate the VC firm to determine whether it aligns with your goals and anticipate potential challenges in the future. There are four key questions you should pose when evaluating a VC:
What is the VC’s track record?
While many entrepreneurs treat a VC firm’s brand as a proxy for performance, you should look at the actual performance to evaluate its track record. VC funds should be able to generate minimum venture rates of return. Also, look out for the timing and size of the last fundraise.
How much money is the VC personally investing?
When VCs increase the amounts they invest in their funds, this signals more personal confidence in their own performance and generates better alignment with their investors and portfolio companies.
How big is the VC fund?
At larger VC funds, partners get high salaries from fixed management fees regardless of their investment performance.
Do you have a list of portfolio company CEOs?
Do a reference check by talking to three to five other CEOs the VC has invested in. Ask about the VC’s level of involvement, contribution to Board dynamics and whether they were helpful to the company’s growth.
Source: Harvard Business Review
In your preparation for negotiations with VCs, it is crucial that you go through this due diligence process even though it is tedious.
5. Build trust before you ask for money
At the end of the day, securing funding from VCs is an imperfect science. Beyond evaluating how sound your financial proposition as a business is, VCs are also evaluating the business acumen and personal characteristics of the founding team. Having a VC make an investment in your startup is like formalising a relationship that has gradually been built over time. As in any relationship, it is thus crucial to start building trust early. According to a VC in San Francisco, the formula of trust comprises three parts: sincerity, reliability and competence.
Here are some tips for building trust with potential VCs:
- Ask for advice. Seeking advice from someone signals that you are humbling yourself while elevating them to a position of authority, while subtly letting VCs know that you are raising capital without directly asking for it.
- Establish common relationships. Look up shared relationships on Facebook, Twitter and LinkedIn and use this as a chance to build rapport.
- Be conversationally humble. Learn to accept fair criticism.
- Show that you know what you don’t know. If you receive a question that you don’t know the answer to, admit it and say you will get back to the VC.
Adapted from Harvard Business Review
As you can see, the process of negotiating with a VC requires both a sound technical understanding of your business and terms of the investment as well as good EQ to understand how the interests of the VC line up with yours. Above all, make sure you are well-prepared at every stage of the process so that you can approach the negotiations with VCs with confidence.
What are your tips for negotiating with VCs?
Share with us in the comments below!