There are several inherent conflicts between you, the users of capital, and investors, the suppliers of capital. Whereas you want to have as much time as possible for the financing, the investors want to supply capital just in time or to invest only when the company needs the money. You should be thinking of raising money when you do not need it, while preserving the option to find another source of capital.
Similarly, you will want to raise as much money as possible, while the investors want to supply just enough capital in staged capital commitments. The investors, such as venture capitalists, use staged capital commitments to manage their risk exposure over six- to twelve-month increments of investing.
In the negotiations of a deal, you might become attracted to a high valuation with the sentiment "My price, your terms." The investors will thus focus on a low valuation, asserting, "My price and my terms."
This tension applies not only to financial transactions but also to the styles of the users versus the styles of the suppliers of capital. The users value their independence and treasure the flexibility their company has brought them. However, the investors are hoping to preserve their options as well. These options usually include both reinvesting and abandoning the venture.
These points of view also clash in the composition of the board of directors, where the entrepreneur seeks control and independence, and the investors want the right to control the board if the company does not perform as well as was expected. This sense of control is an emotional issue for most entrepreneurs, who want to be in charge of their own destiny. Prizing their autonomy and self-determination, many of these users of capital would agree with the passion Walt Disney conveyed in the following statement:
I've always been bored with just making money. I've wanted to do things different ways. Some of them say, "This guy has no regard for money." That is not true. I have regard for money. But I'm not like some people who worship money as something you've got to have piled up in a big pile somewhere. I've only thought of money in one way, and that is to do something with it, you see? I don't think there is a thing that I own that I will ever get the benefit of, except through doing things with it.8
The investors may believe in your passion, but they still want to protect themselves with first refusals, initial public offering rights, and various other exit options.
Your long-term goals and those of the suppliers of capital may also be contradictory. You may be content with the progress of your venture and happy with a single or double. Yet the investors will not be quite as content with moderate success, but instead want their capital to produce extraordinary returns—they want a home run from you. Thus, the pressures put on you may seem unwarranted, yet necessary for the investor.
These strategies contradict each other when they are manifested in the management styles of the users and providers of capital. When you are willing to take a calculated risk or are working to minimize and avoid unnecessary risks, the investor has bet on the art of the exceptional and thus is willing to gamble the farm every day.
Finally, the ultimate goals may differ. The entrepreneur who continues to build his or her company may find operating a company enjoyable. The definition of success both personally and for the company may involve long-term company building, such that a sustainable institution is created. But the investors will want to cash out in two to five years, so that they can reinvest their capital in another venture.
Tools for Managing Risk/Reward
In a deal, the claims on cash and equity are prioritized by the players. Some of the tools available to the players are common stock, partnerships, preferred stock (dividend and liquidation preference), debt (secured, unsecured, personally guaranteed, or convertible), performance conditional pricing (ratchets or positive incentives), puts and calls, warrants, and cash. Some of the critical aspects of a deal go beyond just the money:
• Number, type, and mix of stocks (and perhaps of stock and debt) and various features that may go with them (such as puts) that affect the investor's rate of return
• The amounts and timing of takedowns, conversions, and the like
• Interest rates on debt or preferred shares
• The number of seats, and who actually will represent investors, on the board of directors
• Possible changes in the management team and in the composition of the board
• Registration rights for investors' stock (in the case of a registered public offering)
• Right of first refusal granted to the investor on subsequent private placements or an IPO
• Employment, noncompete, and proprietary rights agreements
• The payment of legal, accounting, consulting, or other fees connected with putting the deal together
• Specific performance targets for revenues, expenses, market penetration, and so on, by certain target dates
These are some of the questions that may help in identifying the bets of the players:
• What is the bet?
• Who is it for?
• Who is taking the risk? Who receives the rewards?
• Who should be making these bets?
• What will happen if the entrepreneurs exceed the venture capitalists' expectations? If they fall short?
• What are the incentives for the money managers? Consequences of their success or failure to perform?
• How will the money managers behave? What will be their investing strategy?
Some of the Lessons Learned
The following tips may help to minimize many of these surprises:
• Raise money when you do not need it.
• Learn as much about the process and how to manage it as you can.
• Know your relative bargaining position.
• If all you get is money, you are not getting much.
• Assume the deal will never close.
• Always have a backup source of capital.
• The legal and other experts can blow it—sweat the details yourself!
• Users of capital are invariably at a disadvantage in dealing with the suppliers of capital.
• If you are out of cash when you seek to raise capital, suppliers of capital will eat your lunch.
Negotiations have been defined by many experts in a variety of ways, as the following examples demonstrate. Herb Cohen, the author of You Can Negotiate Anything, defines negotiations as "a field of knowledge and endeavor that focuses on gaining the favor of people from whom we want things,"9 or, similarly, as "the use of information and power to affect behavior within a 'web of tension.' "10 Other experts in the field of negotiations, Roger Fisher and William Ury, assert that negotiations are a "back-and-forth communication designed to reach an agreement when you and the other side have some interests that are shared and others that are opposed."11
What Is Negotiable?
Far more is negotiable than entrepreneurs think.12 For instance, a normal ploy of the attorney representing the investors is to insist, matter-of-factly, that "this is our boilerplate" and that the entrepreneur should take it or leave it. Yet, it is possible for an entrepreneur to negotiate and craft an agreement that represents his or her needs.
During the negotiation, the investors will be evaluating the negotiating skills, intelligence, and maturity of the entrepreneur. The entrepreneur has precisely the same opportunity to size up the investor. If the investors see anything that shakes their confidence or trust, they probably will withdraw from the deal. Similarly, if an investor turns out to be arrogant, hot-tempered, unwilling to see the other side's needs and to compromise, and seems bent on getting every last ounce out of the deal by locking an entrepreneur into as many of the "burdensome clauses" as is possible, the entrepreneur might well want to withdraw.
Throughout the negotiations, entrepreneurs need to bear in mind that a successful negotiation is one in which both sides believe that they have made a fair deal. The best deals are those in which neither party wins and neither loses, and such deals are possible to negotiate. This approach is further articulated in the works of Roger Fisher and William Ury, who have focused on neither soft nor hard negotiation tactics, but rather on principled negotiation, a method developed at the Harvard Negotiation Project. This method asserts that the purpose of negotiations is "to decide issues on their merits rather than through a haggling process focused on what each side says it will and won't do. It suggests that you look for mutual gains wherever possible, and that where your interests conflict, you should insist that the result be based on some fair standards independent of the will of either side."13 They continue to describe principled negotiations in the following four points:
People: Separate the people from the problem.
Interests: Focus on interests, not positions.
Options: Generate various possibilities before deciding what to do.
Criteria: Insist that the result be based on some objective standard.
Others have spoken of this method of principled negotiation— for example, Bob Woolf of Bob Woolf Associates, a Boston-based firm that has represented everyone from Larry Bird to Gene Shafit, states simply, "you want the other side to be reasonable, not defensive—to work with you. You'll have a better chance of getting what you want. Treat someone the way that you would like to be treated, and you'll be successful most of the time."14
Inherent Conflicts Between Users and Suppliers of Capital