Fundamentals for Startups: How to Negotiate with Investors

I will now be introducing Andy Albertson partner at Fenwick and West and he will be discussing how to negotiate with investors and he represents companies at all stages of development ranging from mature public companies to founding teams with only a business plan and a vision as well as many venture capital and private equity investors for early-stage companies he ensures that they are built for and always planning for future success because he has seen hundreds of deals he provides good and practical advice pertaining to key deal terms alternative transaction stretch structures and how to avoid pitfalls Andy is passionate about what he does and is a trusted advisor to some of the most innovative technology and life science companies in the country Andy great thanks the mics working again ok great so is there a I guess I lost the clicker there's probably something over here all right so how do you start with this sort of topic how do you negotiate with investors so let's start in the beginning what are the types of investors in people that are investing in early-stage you know high-growth technology companies so let's start sort of in the beginning of the lifecycle most companies that I work with and raised at least some capital from angel investors primarily in the very early days its friends and families but there's also you know professional angel investors or at least people that are doing you know 10 deals a month hundred deals a year or some number of checks in the ecosystem and so the way you approach angel investors is gonna be very different than venture capitalists so let's talk about angel investors first so as I mentioned let's talk about some outreach so people that you know oftentimes that first $500,000 a couple hundred thousand dollars is gonna be from people that you have a pre-existing relationship with there's not really an operating business at this point for people to make a bet on and so these earliest investors what they're doing is they're betting on a team they're betting on you so the question becomes how do you expand your reach so there's events there's things like this there's networking there's happy hours a lot of the venture capital funds put forth you know networking events that include angel investors things like that so if you're looking to network with angel investors you should find events around the Pacific Northwest Seattle Bellevue places like that ty is a good group for life science aside wings which is the life sciences angel investing network so it's it's really hand-to-hand combat it's kind of hard to do it at scale there's no replacement for going to advance shaking hands meeting people doing those types of things to get together an angel round so let's talk about what does that look like when you're actually starting to run that process so we're gonna talk probably more about venture capital process but for angel investors you need to juxtapose to that for angel investors you're likely gonna have to lead with some terms so oftentimes there is this dilemma that I'm hoping coach people through of what's the company worth what are the terms of the deal and juxtaposing to venture which we're going to talk about in a venture deal you're gonna receive a term sheet and you're gonna be in a reactive mode for angel investors for Grandma that's putting in 50k out of a 401k they're likely gonna say you tell me what the terms are so the first friction point that we frequently have to resolve is how do you set the deal terms and so in any zero-sum negotiation what I like to do is get the other side to lead with a number or terms and so that's not always easy to do in this context because they're gonna look to you to do that and so it takes some diplomacy right and so oftentimes the message that we sort of craft that people are then going out in the wild and articulating is you know something along the lines of hey I'm talking to lots of investors some are professional investors summer angel investors some are grandma and I'm gonna do a market check and I'm gonna get a sense for what the company's worth because in a private company context there's no valuation you're not looking at EBIT on multiples you're not looking at public company comparables you really is art more than science and so sort of crafting that narrative and then ending with saying okay look and what do you think it's worth right what would be a conversion cap if we were doing a say for convertible note what's a conversion cap or a discount that you would have appetite for and so trying to do that and have that conversation with as many angel investors as you possibly can in order to get a sense for where is their actual you know actual appetite it's not just you being diplomatic and trying to get them to give you a number it is actually doing a bit of a market check you want to understand where can I get consensus to do a round on so once you run that process so you've networked you've talked to the people that already know you you're having conversations what you're gonna do is you're gonna get a consensus around evaluation and so let's pause real quick we're gonna get into the substance of structuring that's a whole nother topic but there are valuations when you price a company so if you were doing like a series seed equity I'm willing to talk about early stage financing series seed equity where it's a preferred stock you're selling an evaluation then there's convertible notes and safes right that are derivative securities that convert into a future round of financing and they're gonna have different terms so the first thing that you negotiate is typically the headline price the valuation so in a priced round what is the company worth on a pre-money valuation and in a convertible note er as safe there's typically really need to things you're negotiating the conversion cap and the discount those are kind of the parameters you're negotiating so the first thing you're going to negotiate is the valuation then the second term is is oftentimes everything else and so the next big ticket thing that might come up or that you'd be negotiating is board composition so in most and we're still talking now distributing you angel deals seed deals this paradigm so in this type of deal we're gonna try to not give up a board seat at all words to live by are it's very easy to put people on your board it's impossible to take them off because it becomes emotional people say why me it becomes a very challenging exercise to remove somebody from your board and so for Angel I'll tell you that the overwhelming majority of them are not gonna get a board seat now sometimes the exceptions gonna be a fund there's a seed fund that puts in five hundred thousand 750 of a million dollar round sometimes they will ask for a board seat and we'll talk about sunsetting it and other things so that's not a perpetual board seat but that will be sort of the core terms that we're going to talk about in the in that negotiation in that process valuation and then what are the other terms that come out of it and then obviously supposed to be seed equity but the equity we talked about so this is preferred stock and you can go to series sitcom we've made all the documents publicly available there you can read them it's a very simple short form version of a series a financing and then save some notes if you're familiar with Y Combinator those safes are publicly available there's posted they're pretty easy to use and then a convertible note is essentially the same thing as as safe but with the maturity and it's an actual loan so I'm going to pause there on angels and some of the process questions about this yeah the websites I mentioned are there's two of them so you can go to series seed comm seed yeah sssee d and then Y Combinator and their forms are publicly available as well yeah yeah absolutely so it's a simple agreement for future equity and what it essentially is is your pre funding in equity round and so it's an agnostic instrument that will convert into your equity round and so it's either gonna have a conversion cap or a discount and so they can the way the conversion cap works is let's say you negotiate a million dollar round with a five million dollar conversion cap and then you go out and do a ten million dollar round no matter what you priced that series a let's say at the safe money is going to convert at that discount at that conversion cap the discount feature is same concept we did a million dollar round or we did a million dollar safe round and we went out and did an equity round at a ten million dollar valuation some discount to that price per share 10% 20% those are sort of the normal numbers that you see in terms of a discount off those rounds and so when you're negotiating this first round from angel investors those are the terms that you're frequently negotiating is how is it going to convert it equity in the future yeah so the question was how do I feel about pay to pitch programs and the answer is not good so there are so that you know there's alliance of angels there's wings there's tie there's a lot of programs out there that don't charge people to pitch I can tell you that I don't believe that I've ever had a client or myself have a great experience with one of the forums that says hey look you can spend money to come talk to our investors I just have never seen a good outcome with that doesn't mean that it hasn't happened I'm sure that it has because they're still here but you know it's not something that I've seen with great success the terms so we're still talking about seed and just you guys know sort of the agenda here we're gonna talk about things at a macro level and then I have some the core term sheet level points that you're gonna negotiate so we're gonna get into some of the substance but it's primarily on the venture capital side this here is a side we're getting this substance so on this on the series seed sore on the seed level financing there's not a lot of other terms so the way series seed documents work on the equity side it's the price its board then the next one is going to be the right to participate in future financings so it's either called pro-rata rights or pre-emptive rights and this is a big one so this is one of the points that causes the most trouble in future rounds so what this term is is when you go do your next financing do I have the right to participate in that financing and the most reaction is sure I don't care I mean your money is green I would you know like if you want to keep supporting the company in the future that's great most angel investors don't have the dry powder to keep supporting a companies their rage raise larger and larger rounds however it's one of the most problematic provision because what happens in reality is you know there is a herd mentality with startups you've probably heard this before or experienced this firsthand but I couldn't tell you how many companies I've worked with and we are struggling to raise capital to find that first round and then all of a sudden boom you get a term sheet from foundry right or somebody like I can talk to your venture capital fund and now all of a sudden you're white hot and everybody's throwing money at you and now you have to turn your angel investors and the people that previously supported you and say hey look I'm gonna raise three million dollars and in the outside excuse me a lead investor is gonna take 2.5 that's a deal term I have $500,000 to go around and 20 angel investors to satisfy I can't do it and I have two other strategic investors that want to come in for the 250 that I think are gonna add value and continue to support the company along the way thank you early investor grandma whoever it is for being my mentor supporting me but you're not gonna get to participate that's a very difficult conversation to have just emotionally these are real people that support you in the very early days and now add a contractual legal underpinning to that where the person says see right here I get 10% of the round and so do all the other angel investors and so that can really monkey with an existing around because now I have to go back to your other and the lead investor and say hey you know what I know how you want to point five of the three I have to give 60% of it to these people that are all writing ten thousand dollar checks fifty thousand dollar checks I've seen it blow up deals I've seen people burned by that so that's sort of point number number three I suppose that we negotiate like I said the serious though you going go through this early process yeah yeah so the question was we're gonna talk about VCS and angels but let's also talk about some strategics and some of those issues so let's define strategics real quickly so if you are a software company a strategic investor be somebody like Microsoft Cisco people like that and these companies these large companies Amazon's a big one we see a lot they have venture arms they have incubators they have programs where they're looking for new technology now strategics are a bit of a double-edged sword it's incredibly awesome to get a strategic on your cap table a because they have deep pockets they have money it's external validation if Microsoft research turns to their business arm and says hey this data analytics company is a supercool technology we want to demo it internally and we want it we recommend you making an investment in it those are those are great things the primary problem is competitively sensitive information so these companies Microsoft's Amazon's Cisco's of the world they're not making investments out of the kindness of their heart and they're not actually making investments for a financial return many of them are not some are but primarily that's not actually the objective what they want to be able to do is get the early looks at the hottest technologies support their development almost like outsourced research and development and then when that company goes to get acquired goes public whatever it is they want what's called a right of first refusal right of first negotiation there's a there's a spectrum of things that we cover win those strategic deals that they want to do let's put that aside for a second the more blocking and tackling is they'll oftentimes ask for an observer so let's unpack that a little bit so there's a board member that investors will frequently ask for a lead investor and a venture around there's something south of that which is an observer they don't get the right to vote they're not a board member but they get access to all the meeting minutes they can attend board meetings they can attend committee meetings and I you know sort of lovingly refer to them as the moles not when I'm representing Cisco but when I'm on the other side right I mean they're they're a spy in your camp and so you have to be very careful so there's the legal the legal aspect of a right of first negotiation and all that kind of stuff and I'll circle back on that but there's the practical day-to-day stuff of do I want amazon's mole receiving all of my board information so that's sort of the operational concern now from the legal one and the future investor concern there's people that are of two minds on early stage strategic investors and how it impacts future venture capital financing one side says that's great it's validation if Microsoft is in there smart money I'm in as well and then there are people that say whoa most high-growth venture backed companies don't go public they get acquired and if Microsoft is on the cap table and has an inside poll here odds are they're gonna be the acquire well what that does is it causes a chilling effect to other acquirers if Microsoft is on the cap table it's unlikely that Apple is gonna want to come in and buy this company or take a look at it for a couple reasons the one of the primary ones is apples not gonna want to be Microsoft's talking horse they're not gonna come in invested in the diligence do all the types of things that it does to get a deal done only to have Microsoft swoop in with their right of first refusal grab the company off from under them not gonna happen and so a lot of founders and a lot of early investors and a lot of VCS do not want strategics on the cap table the other side is they're gonna leverage their network all right if you're an early-stage company and you get Amazon you know Alexa to support your company invest in the company are they opening doors for you in the natural language processing space are they putting their leverage behind it so there's not a simple answer the question of should you raise money from strategic investors so the answer is actually it has to be right for your business for your model for your risk appetite and then make sure that we are thinking hard about observers when can we exclude them from information and when are we going to give them a right to buy the company or not and are we gonna structure all of those things and there's a wide ranges of those things that you would do and so in an ideal world what I would do is if they install would be no board member no observer you're purely a passive financial investor that's probably not gonna get legs the next is that I heavily negotiate and fight for the right to exclude competitively sensitive information in our discretion if we decide it's competitively sensitive we're gonna remove that they likely then push back and want conflicts of interest only which is something different than competitively sensitive and that's how you sort of that's the game and the way you're negotiating the observer rights then on the right of first refusal to write a first negotiation to notice rights so oftentimes what I will advocate for is it's not a right of first refusal let's define that real quick if we're gonna go sell the company for 10 million dollars or a billion dollars you have the right to buy it at that price never going to agree to that right a first negotiation if we decide that we are gonna go sell the company hire a banker to sell it or get an unsolicited offer to sell the company we'll go negotiate with you in good faith first if we get a deal done great if not then we can go pursue this third party and lots of frameworks on how you actually implement that then the third one that's much more palatable to me as a right of notice if we decide that we're gonna sell the company or we get an unsolicited offer to buy the company we'll let you know and that's great right because what we're gonna want to do in a situation we're selling the company is run a competitive process get all the horses lined up in the stalls and then start cracking the whip so we'd likely invite Microsoft to the party anyway so if you can get a strategic deal done where they either don't have a board member or an observer or we can let loosely exclude credibly sensitive information and we just have an obligation to give them notice that we're gonna sell the company that can be a great structure the inverse of all of those things is me jumping up and down on the table screaming don't sign the deal any questions on strategics or anything else that we've covered No okay so we're worried so we've talked about angels the process valuations seed equity safes notes a couple other quick points there's no security exemption for friends and family that's one of the biggest pain points that we always have is you know why can't I raise money from my crazy uncle from Utah as well if you're you know if he's not accredited then you're not gonna have a valid security exemption for that so there's lots of issues around that so flagging that issue okay so venture capitalists this is a this is completely different than than the approach you take with respect to angels let's start in the very beginning venture capitalists when compared to and even I'll talk about West Coast the venture capital funds the way that the good West Coast either philosophically or geographically located which is not always the same thing but philosophically aligned West Coast venture capital firms they are building companies they're building teams they live and die based on their reputation if you watch Shark Tank or are familiar with you know the private equity shops of New York that's not what this is the people that are good VCS are investing in teams supporting the ecosystem and want to be very collaborative and supportive and are gonna give you a right down the fairway term sheet that is sort of the framework when I represent them and I know them personally that is the framework in which we are approaching that when I'm on the other side of the table sure it's investor favorable but it is it is within the bounds of reason and very friendly and supportive and the reason why I say that is some people's reflexive action is if I give something I have to negotiate for something this is hardball I'm on Shark Tank I need to be you know a bigger jerk than the person next to me and that's not going to be productive this is a very collaborative environment in which you should be raising capital so the outreach process so the best way to run I'll be pretty pretty specific here the way that I like to do it in specifics is to build three tiers of potential partners potential investors venture capital funds you start with the tier that is hey I would definitely take their money I would love to raise money from them they'd be a great partner but they're not my dream partner but they would be great then you have a middle to a middle tier which is something north of that and then it's the dream partner and what you do then is you start with Tier three and you work your way up and the reason is no matter how many times you practice your pitch in front of your grandmother in the mirror you're gonna get questions you've never asked been asked before you're gonna say something and you're gonna go I don't like the way I articulated that or I love the way that I said this everything in life you get better with practice in pitching is the same thing and so the best way to do to start with people that are these are real pcs you'd really take their money but what I what up what you're doing is you're learning you're understanding they're gonna ask you questions and rip apart your deck and you just want to absorb as much as you can learn as much as you can leave reiterate the deck practice your pitch after you've incorporated all that information and you're working your way up so by the time you get to the tier 1 people you've had many many pitches the other thing that happens is you get a term sheet and if you start with that very top idream partner Bill Gates gave me a term sheet it's gonna be pretty hard to say you know what Bill I'm running a process here I'm talking to five or six other people next week and I'm gonna get back to you that's a very hard thing to do you're just gonna pop some champagne in sign you're not gonna negotiate the terms you're not gonna continue your process you will never know if you could have got a better term sheet from fill in the blank and so it's much easier because this goes in time this isn't all like one day where you line up you know 50 meetings it's gonna be spread over weeks and potentially months and so if you start with tier 3 and then we got a great term sheet that's great now you can have that conversation much more confidently and then you have that in your back pocket when you go speak to the tier 2 and tier 1 investors give a little bit of swagger I got a term sheet my back pocket and so when you go into that meeting and they say who else are you talking to first of all never ever tell them ever I know this is being recorded and I represent a lot of BC's here's a secret secret time they collude they're Russia they're Trump they're are colluding over your term sheets because a I have observed it and B it's amazing if you're gonna get three term sheets it's all oh my gosh it's weird how the valuation in terms all came back radically similar hmm and then oftentimes it's hey you know it was a five million dollar round let's increase it to six and I actually you know you got room for some other VCS that you might want to come in I'll take three and if I lose other people could take two so there's deal sharing there's collaboration that's probably a better way to describe it than collusion but don't tell them you want to basically run a mini auction or a small process and so when you have that term sheet in your back pocket and you can go into those next meetings it's gonna look and feel pretty different you've practiced we're now at our dream partner I can have that conversation I can answer those questions I mean they say who else you're talking to top to your VCS your peer firms and I've already got a term sheet my back pocket great terms but I want to continue the dialogue and get a lots of feedback great question the question was if you're not communicating with other investors or other VCS how do you build a syndicate how do you get other people involved and the answer is once you sign the term sheet with the lead investor once the lead investor has signed a term sheet and they'll be you know there's an exclusivity provision in there that says you'll work with us but there's an exception for getting other investors pursuant to the terms of this term sheet and so once you sort of have haggled off all the terms random mini process optimized for everything that we can optimize you sign the term sheet and then it's okay who else should we talk to right I I've spoken with VCS that are interested you now new lead VC you have other people that you're friends with the you share deals with now that we've aligned on the core economic terms let's get other people around the table and be plenty of time in the process to do that yeah the question was how do you set VCS into the tiers an example was if I want to be the next blue apron do I just look at blue aprons cap table and say hey those are all the people that I should be talking to great question it's subjective right and so what you're looking for are people with investing experience in the space right if I'm a blockchain investor I'm less likely to invest in a life sciences company right but if I'm a 16z crypto that's probably a really good partner for a blockchain technology company so part of it is domain right domain expertise to is what is the size and reputation of the fund I want investors with deep pockets with big funds they're gonna be able to continue to support the company that have a long track record of supporting their portfolio companies and providing high valuations and being entrepreneurial focused and favorable companies their investors as I mentioned before investors live and die by their reputation and so having funds that have a good reputation and have made lots of investments in your space it's a good thing and then it's probably personal fit things like geography is this somebody that I want to work with and you're considering all of those things and then coming up with a subjective list and it's not gonna be black and white here's Tier three here's tier two here's tier one yeah I mean it's rough approximations right it's it's it's it's a bit of art one of the important points it's raised by your question though is what about funds that have competitive investments right and so most funds are not going to make competitive investments and so the question becomes how do you scope or size or define what would be competitive the definition of competitive is probably more important than the principles the principles pretty easy to articulate and so what you're really looking for again it's art not science so complementary businesses are not competitive you look at amaz looks say the Amazon for example they're in everything right and they have Alexa and they're big in natural language processing but they're Alexa fund and a lot of their investments are in natural language processing businesses I don't think they're really competitive I mean Bezos isn't sitting around going god our $500,000 series seed investment in you know fill-in-the-blank company that's that's super competitive with us or vice versa right it's not so it's subjective around that now if you said all the people that owned blue apron they're probably not gonna raise a competitor of blue apron but people that are in let's say the food delivery tech space that aren't directly competitive that would be interesting fit for that type of model yeah so the question was how do you deal with multiple strategic partners and that's not that uncommon actually so I don't think that it's any different than if you have a single one other than you're doing it twice it depends oftentimes they have different interests oftentimes they have definitely different interests but I would keep them as separate as possible in the negotiations they're gonna have their own legal teams and their own business teams and they likely are not are looking at the business from a different perspective but you will have separate and distinct deals with each of them and I think it's important to focus on those core principles that we talked about for both of them but having multiple strategics at the same time is completely fine and if anything it gives you more leverage to say hey we're not gonna give you a right of first refusal read first negotiation even a notice right because I would have to give it to this person too I'm gonna be able to exclude you from any meeting or any materials if I in my sole discretion determines credibly sensitive because if I don't give that to you then I and you sort of go that game yeah yes yeah so the question is as you're working your way through the tiers which logically takes time what are you telling the early investors as you're working your process and that's part of the reason why we start with the Tier three is because it's easier to push back or to stall or fill in the blank with those investors and so what you're doing is twofold first of all you're candid and transparent so it's it's oftentimes thank you appreciate the term sheet it's it's fantastic it's an honor we'd love to be your partner I'm committed to my early investors and my existing board to running a good process and being thoughtful about it and making sure that we're sort of talking to a bunch of different investors I've got a process lined up for the next two weeks three weeks I'm gonna have to let that play out a little bit and then I will circle back with you with comments on your term sheet and our thoughts depending on how these other conversations go most VCS are professionals and they would honor and respect that and not you know no you have to respond in the next five days or our term sheets gone you might get some of that what is at the bottom of most VC LED term sheets is an expiration date it's a bluff right I can tell you categorically I've never once had a term had a term sheet that expired on a Monday and we got back to him on a Tuesday they were like sorry like you lost the term chef it's I've never seen it enforced most the time it says you know I'll use March now March blank and it usually lines up with like the day that we signed the term sheet you just kind of like fill it in so there's that so that's sort of the the diplomatic side of it there's no easy way for me to describe how to do it other than being thoughtful in diplomatic at the time and reading that you know the verbal body language of the investor but always being candid and transparent and then there is once you do start getting that it's time to accelerate the process so let's say that you said okay look you know it's I'm gonna raise over six months I'm gonna start investor you know outreach now but really I'm mentally budgeting three to six months to get all this done in your first meeting you get a term sheet it's really good 36 months isn't gonna work anymore you now go straight up the list start hammering folks and you say hey look you know I don't mean to apply time pressure here but got a really good term sheet I thought you'd want to take a look at this deal familiar with your fund if we can meet in the next week tomorrow whatever that'd be great if not I can't guarantee the deals still gonna be here and it gets people to move quickly the other dirty secret again secret time that VC's any any venture capital fund can meet with a company and make a decision within two weeks any period longer than that doesn't mean they're not still deliberating debating calling customers doing diligent work research but if they say hey our process is gonna take a month it doesn't have to take a month any VC can get it can get their diligence done and a term sheet in your hand within two weeks if they want to and so diplomacy and then applying some pressure on other people to move more quickly no easy way to do it though any other questions yeah great question I wanted to make sure we talked about so the question was how do I get in front of e C's right that's not an easy thing to do and so the answer is I'll tell you how I typically manage it with the companies that I work with the best way to do it is to either know that first of all if you know if you know them directly so you've gone to the create 33 which is the madrone labs you know deal downtown and met Tim Porter over you know and got his email and you can shoot it to them directly that that's path number one that's fine you have some sort of existing relationship path number two is there is somebody in your network that has been a successful entrepreneur that has a connection with them so many serial entrepreneurs around town that have raised money they've had all the VCS on their cap tables if you are a degree of separation or know that person directly it's you know hey Bob know you've had madrone on your calf table would you mind shooting this you know Tim Porter I think he'd be a great fit for my business and then if that person can pass along the deck that's great because it comes from an entrepreneur that knows you that knows them that entrepreneur hopefully has made the money in the past that's gonna they're gonna look at that they're gonna go that's great let me see what let me see what you know Bob sent me this time if he likes it I'll probably love it number two would be a peer investor or some other investor so oftentimes you've done an angel round before you're going to VCS and so most real sort of angels at around town making active investments they know most the VCS around town and in the valley and have a relationship with them because that's how a lot of VCs get their deal flow so there's an ecosystem here and so angels you know send referrals to be seized and so if you're you have people on your cap table that is your next best way to get an introduction to a VC to get the deck and then what I do is I serve as the residual so I represent you know most visa you know all of me sees around Seattle many many in the valley or have been opposite all of them and so can get a deck into anyone basically in the country right either myself personally or our firm and so once people go through the list they say hey I don't have an introduction to any a down in the valley their dream partner not a problem send me the deck I'll pass it along with a recommendation that type of thing now what your what you frequently want to do from a tactical perspective is a deck a blurb in the email because people are getting countless decks sent their way and so what you have to envision is somebody walking through the airport pulling up their iPhone skimming the thing that's in there and then going to I want to even open the attachment or not and that's about it and so you know half the time I send out and I send out decks every week I mean certainly every week I'm sitting on a deck for a client or somebody the ecosystem and the question becomes like what pert you know like sometimes I hear nothing and sometimes I sent out sent it out to ten and I get ten people say yeah I'd absolutely love to chat with them please make an introduction it's hard for me to predict but that's that's the process yeah other questions we're still in the first slide but that's just fine the other slides aren't as entertaining yeah great question so the question was how much information do I want to put in the deck it's gonna be sent around and this is one I'm really glad you asked because I wasn't gonna talk about this this is a really good good point to raise people will laugh at you if you ask for an NDA behind your back sorry if you if you go to a VC and you say hey look I'm gonna share with you confidential information where you sign an NDA there's a good chance they'll say man I want to talk to you anymore because it means that you don't know what you're doing at all and you've never spoken with anyone in the ecosystem at all so investors meet with so many companies if they cannot be bound by confidentiality they will forget where they heard this idea or this business plan or that type of thing and it's a policy they will not sign that of course there are exceptions I've had VC sign NDA's for very deep technical white hot businesses where we need to do a deep dive with your CTO and understand what's going on under the hood and we can sign a very limited NDA that's heavily negotiated but just hey I want to go pitch you know they're not no one's gonna sign that in to be embarrassing to ask now on now now the question becomes let me step back I don't put a lot of value in NDA's anyway I'm a lawyer and I'm like I don't put a lot of value on it try to in the number of times that I've had to enforce in NDA in my career is zero and I'm guessing that it will probably remain zero for the rest of my career it's such a factually difficult thing to prove and you have to be so damaged that you're willing to hire $1,000 an hour lawyer to go bring a lawsuit the probability of that happening is extremely small so when I'm advising companies not don't use NDA's but what you're really doing is you sign an NDA okay that's in place now I am going to present to you the minimum level of information that I can present and still achieve our business objectives it's gonna depend on what the relationship is like why do they need the confidential information but it is the bare minimum and often times it's never the crown jewels right there's very few things that are really that sensitive where if somebody else got that information and the deal went didn't go through or they were just a bad actor that they could use that against us in a competitively in a competitive way that's actually very very rare things like financial information yeah I don't want my company's tax return on face book but no but like you know the competition that's you know building the same mousetraps I could really use that against us I mean everyone knows we're a poor startup right it's not a big deal it's confidential but it's not really competitively sensitive let me use an example sometimes in M&A deals this is rare but sometimes in M&A deals we won't even show certain technology the very end a video I mean we were doing a billion dollar M&A deal we have signed a term sheet we've gone through diligence we are negotiating the definitive merger agreement this process has been going on for three months we still have not shown all of the technology yet then the acquirer before they give us a billion dollars is going to darn well see that information but we are gonna make sure that this deal does not blow up and so that the data sight has hidden folders and even then oftentimes what we'll do is these people can see that information these people cannot your engineers are never gonna see this your business unit weeds can do things like that and we have beyond you know confidentiality commitments and that type of thing and these are organizations that are operating and competitive because that's why they want to buy us so I think it's more important to use street smarts and common sense than it is any sort of document wrapper around that yeah question is okay let's try Oh yep going great so the question was do you talk about patents at this stage and this and this goes to one where when I'm sitting around with VCS and entrepreneurs having a beer some people will some people will sort of mock people for their for their IP strategy right for early-stage companies that start talking about their patents and I don't really agree with that so if you are a you have to know your vertical really really well if you are a pure enterprise software company and you go into a pitch with a with Voyageur an expert b2b enterprise software company and you tell them that your mode is all these patents that you have provisional patents on they're gonna they're gonna sort of chuckle because by the time your patent is in force is is issued and enforceable your code is gonna be iterated so many times there's gonna be so many competitors that it's probably not gonna make sense that's not always true in particular in a LML type stuff there's definitely exceptions to that but they'll sort of you know be like God the Andy these guys came in and they spent the full hour talking about their patent strategy it's a software company right it shows that they don't aren't getting good advice so I think it's a matter of life sciences companies are gonna be completely different if you have a small molecule that you're protecting or something like that so from my perspective IP is a critical part of every deck in every conversation at every point in the lifecycle including the early days however it needs to be right size and specific for your business and thoughtful and not in like a backwards looking way not in a way where I'm saying like hey look PCs are gonna sit here and they're gonna expect that I mean you need to have a thoughtful IP strategy right I mean all technology companies are our human power and intellectual property and that's it and so you do need to have one now if it's software it's copyright its trade secret and a lot of your moat is we're gonna move faster than the other people and have better software better developers and all those kind of things on the other end of the spectrum still stick with the tech side if you have a deep learning if you have artificial intelligence things like that there's a lot of there's a lot of patents in that space so combining that narrative with and by the way we're patenting out our space in doing operation analysis with the top firm to figure out where our core competencies lie and where people have to innovate around us and building a moat that's a pretty compelling story yeah all right slide two so ten minutes left the next part I was going to talk about very technical parts that are negotiated in a deal do we want to go to that or there are other more conceptual questions I want to use the time ten minutes however whatever is helpful I think I can always I can always come back we can do that so let's so let's burn through some of this stuff just so you at least know that the content I'll try to move a little more quickly and I see people taking pictures the Ola stuff will be available I can answer questions I'm not going to turn into a pumpkin okay so a liquidation preference so a liquidation preference is when the company is sold how does the money flow this is the waterfall and so a very investor favorable is is what's called a participating preferred and so what that means is the preferred stock is going to get its preference back typically one X so we put in a million dollars where you get a million dollars back and then the residual is going to go to the common stock and the preferred stock on an ask converted basis everything but your waterfall preferred stock gets our money back then they take as if they are common stock very different economics very different waterfall I have not done a deal with this feature 2008-2009 when all the leverage was on the other side of the table very very rare in this market the next layer down working from the most investor favorable to company favorable the next down is a participating preferred with a cap on it so you get your money back investor then you're gonna participate until you get 3x your amount back and then after that only the common stock will get the residual proceeds now the unstated thing here is and in and beyond that the common stock takes all of it if you think about your your fraction your numerator is the billion dollar exit the denominator is how many shares are participating in that event so you don't want the preferred in that denominator for that waterfall now the one that is the overwhelming majority 99.9% of the deals that I do in this market is a 1x non-participating so the investor gets their money back and if they want to take in the residual proceeds so residual is to find that real quick once you pull your money back everything that's left the residual if you want to participate you have to convert to common stock and you forego your preference by doing that and so when you're building waterfalls and negotiating deals you'll hear people say it's 1x non-participating and your interests are aligned with common so at a certain value inflection point the preferred stop sock is I is economically identical to common stock the only time that a preferred investor would actually want their preference is in a down scenario on any other sort of up exit they're gonna want to take on an as converted a common stock basis and forego just getting their money back it's just your money back it's just you didn't get any return so it's only the downside that they wouldn't want to do that and I'm gonna go in sort of order of importance this is so this is the most important issue in terms of the economics beyond sort of the headline price and stuff we talked about it on questions on this how this operates so if you're out in the wild negotiating a term sheet one extra non-participating anything other than that is gonna be off market and probably not appropriate redemption this is a west coast East Coast I call my Tupac biggie issue if you are raising money from a west coast philosophical not always geographer but philosophically oriented investor you're not going to have a Redemption provision in particular from smart early investors because they know that all of the terms that they get are gonna get stacked on by the later investors so your wellington's fidelities your tea rose and that pre IPO round are gonna get every term you got Plus so really savvy investors know that we're in the series seed word or the series a we know that we're gonna be aligned economically with the common stock very early because the value is gonna go up and our preference is gonna be underwater very quickly and so they'll negotiate for common stock founder favorable terms in the early stage so what this is is do the investors have the right to force the company to buy back their shares you will never see this in a westcoast deal east coast private equity firms venture funds they consider this common and they are shocked when I push back on this because all of their deals have it so it's really who are you talking with and they're totally bipolar it's either in every deal or they'll never ask for it and you should always push back and not have it in particular I believe that philosophically even when I'm representing an early stage investor I remove this we're not gonna ask for this because we'll be used against us by later rounds there we go okay automatic conversion so the concept is when should our preferred stock automatically convert into common stock there's consent there's optional conversion but when should it be we're forced to do it and so an investor favorable provision is it's going to convert if we go public at a price that is 5x what we paid and at raise at least 50 million dollars now this goes back to my point about smart investors and dumb investors in the early stage some investors will just you know reflexively say hey Andy your slide deck says investor favorable I want that term that's totally wrong even from the investors side the reason is let's say that it's a good first round a great first run it's a great series seed we raised on a 10 million dollar pre-money valuation that's a great series seed round when was the last time you saw an IPO the pre-money valuation less than 50 million dollars 1922 I don't know never write it never gonna happen so what do you think you're getting with this term the answer is hosed by everyone after you because every investor is gonna get this it's the me to phenomenon not that not the bad one this is the investor me too this is I'm gonna get every term that the other investors got that's me to plus something and so a lot of funders will say well why do I carry any if I'm not gonna go public for less than 50 million dollars why are you jumping up and down in the table and getting red faced about this issue doesn't matter it doesn't matter and the answer is when we have a billion dollar valuation and we are doing our last round before an IPO and the investor says all right all invested a billion dollar valuation but me too I get the exact same terms everyone else got plus something now we have to go public at a five billion dollar valuation that's a big deal that's a big number and it's not that you won't convert them if they think it's in the company's best interest to convert they'll voluntarily convert or they'll do it by written consent an automatically convert everyone but they're gonna say pay me so in that IPO discussion your lace your late stage investors your Tigers your TIROS your Wellington's your I VP's of the world they're gonna go oh that's too bad that the valuation you know that the underwriters say it's gonna be a 4.5 billion dollar valuation we're happy to vault to surrender our negotiated rights in exchange for X and that's the game and that's how you get squeezed and when I am in that series F negotiation I won or lost that negotiation five years ago in the series seed because if that term is in the document I will not have the moral authority to stand up and say I don't care if you're writing a 200 million dollar check or not you're not getting this term doesn't matter we've never given it no time in the company's history we ever given this term to anyone and we're not changing that forever for anyone we will win that argument every single time if I have to get up and say hey guys thanks for the quarter billion dollar investment at a billion dollar valuation I know we gave this to everyone else even people there wrote us a five hundred thousand dollar cheque but you're not gonna get it that's hard for me to win that argument and so that's why as as we are collectively here as we as entrepreneurs as lawyers as you are working through these terms you have to skate where the pucks going you have to have a crystal ball these points are critical and it's not immediately obvious and so for serial entrepreneurs they've touched the stove right they've been burned they understand how this can operate and how you can get burned but for people that are doing this for the first time it's important to surround yourself with good advisors that have been through these battles before and can predict the pitfalls that are gonna come in the future good lawyers good advisors good mentors and being calm and thoughtful and introspective on your deal and what you want to do because when you get that first term sheet you know half the time it is it's awesome it's the most exciting feeling in the world to work with an early-stage company that's been trying to get their term sheet done forever and they never thought they would get it they've been working in mom's garage for a year and then you get it you just want to sign it term sheet and give me the check so I can go pay off all my debts and like hire a bunch of people and go take over the world and the answer is deep breath right it's not going anywhere it's more important to do this right than it is to do this fast and these are the type of terms where if you don't have a 360 degree view of where you came from and where you're going you're gonna touch the stove and get burned at some point so we're a couple minutes over so I'll leave you with that so if there's any quick questions I can still answer them great so there's three and a half minutes I'll answer questions and then or I can do one more term one more term all right founder favorable so founder favourable would be no multiple and I lowered the number no multiple find that standard ok anti-dilution so the way that this works is when you do a priced round series a series B Series seated whatever it is there was an original issue price that's just the price per share any dilution is if you issue shares below that price there is an adjustment to the conversion mechanism that results in the preferred stock not converting into common stock on a one to one ratio so I did a deal at a 10 million I did series a at 10 million I then did Series B at 5 million there's a mechanism that would then ratchet the series a down to give them more shares on a fully diluted basis because of the dilution okay that's the mechanism the point that you might see but it's very rare but it's the investor favorable one is what's called a full ratchet and so it ratchets as if you had sold shares at that lower price it's it's kind of explained in concept but if you sold $1 worth of shares at half the price then the conversion ratio is gonna flip so they get two shares of preferred stock boom let's Chuck's position here is important weighted average this is the founder favorable version if you sold it's a formula that weights the number of shares you've sold the price that you sold them at and is a formula to result in the amount of dilution so if you sold one share at $1 less than your prior price then it's going to be a lot less dilution than if you raised a hundred million dollars at fifty percent of the price it's a rational mathematical formula that weights the shares to come up with a weighted dilution so the investor gets kind of whole kind of Trude up but it's not a full adjustment the full ratchet is very rare I mean it's a pretty egregious term sometimes you use it strategically if you get that huge valuation on that first round so sometimes an investor will come in and they'll say look I really believe in the team I really believe in the company I've only done Series C deals between a five and a seven million pre-money I agree with you that this one is worth 20 million dollars you know three to four times what the going market is for Series C deals but if I'm wrong and you come in and do a series B add a 10 million dollar whatever it is any number less than 20 I'm gonna get a full ratchet if you do your next round and above and the ratchet will fall away so it's used sometimes very strategically and very tactically but it's very very rare 99.9% of deals are just a broad-based weighted average I'll do one more voting agreement Board of Directors this is this is gonna be one of the top points that we negotiate we talked about this at the very beginning a normal construct and there's lots of you know if you hate using the word normal a very conventional one that I see frequently is one founder one venture firm and an independent it's a very common way to do it now the tension pointed in concept you'll be negotiating is control the reason why I believe that this is the most common one that I see as well as a very fair one is who has control of this board nobody right I mean it's a it's one of the founders it's the representative of venture fund and it's an independent now what you can advocate for is you know you dream it we can draft it two founders one VC right three founders of you see in an independent what I think I mentioned this at the beginning it's very easy to put people on your board it's very hard to put people take people off and so you know smaller is is better in this context I guess I'll pause there that's that's probably enough time [Applause]

Channel: UW CoMotion

Views: 4,465

Keywords: startups, University of Washington, CoMotion Labs, Innovation, Fundamentals for Startups, Andrew Albertson, negotiate, investors

Id: SWGsQ5fM-BE

Length: 61min 57sec (3717 seconds)

Published: Fri Mar 01 2019