How to Negotiate Term Sheets with Strategic Investors

How to Negotiate Term Sheets with Strategic Investors

Three years ago, I met with a founder who had raised a massive seed round at a valuation that was at least five times the market rate. I asked what firm made the investment. She said it was not a traditional venture firm, but rather a strategic investor that not only had no ties to her space, but also had no prior investment experience. The strategic investor, she said, was looking to “get their hands dirty” and “get in on the ground floor.” 

Over the next 2 years, I kept a close eye on the founder. Although she had enough capital to pivot her business focus multiple times, she seemed to be at odds,serving the needs of her strategic investor and her customer base. 

Ultimately, when the business needed more capital to survive, the strategic investor didn’t agree with the founder’s focus, opted not to prop it up, and the business had to shut down. 

Sadly, this is not an uncommon story as examples abound of strategic investors influencing startup direction and management decisions to the point of harm for the startup. Corporate strategics, not to be confused with dedicated funds focused on financial returns like a traditional venture investor like Google Ventures, often care less about return on investment, and more about a startup’s focus, and sector specificity. If corporate imperatives change, the strategic may cease to be the right partner or could push the startup in a challenging direction.

And yet, fortunately, as the disruptive power of technology is being unleashed on nearly every major industry, strategic investors are now getting smarter, both in terms of how they invest and how they partner with entrepreneurs. From making strong acquisitive plays (i.e. GM’s purchase of Cruise Automation or Toyota’s early stage investment in Uber) to building dedicated funds, to executing commercial agreements in tandem with capital investment, strategics are getting more savvy, and by extension, becoming better partners.  In some instances, they may be the best partner.

Negotiating a term sheet with a strategic investor necessitates a different set of considerations. Namely: the preference for a strategic to facilitate commercial milestones for the startup, a cautious approach to avoid the “over-valuation” trap, an acute focus on information rights, and the limitation of non-compete provisions.


Strategics must facilitate commercial milestones.

The best strategic investors are those that drive specific and relevant commercial milestones for your business. Essentially, this means basing the investment on a long-term commercial contract, at market rates, to deploy your product across the strategic investor’s business. The strategic should be looking to do this as well because, as well – an investor first and foremost – their own traction will power the growth in valuation of their investment.

For example, if your business is in the healthcare space, you should have a long-term commercial deal to deploy your product across different segments of the investors’ business to capture the most long term value. A good example of this is Ascension Ventures’ investment in Ingenious Med, which came in tandem with a long term rollout across all of Ascension’s health system Limited Partners. 

However, this comes with a catch! The Pilot Agreement. What you may be think is the biggest break in your company’s nascent history is actually a bit of a trap as strategic partners may disguise a pilot or test agreement as a commercial agreement. Often, these pilots are unpaid or at significantly discounted rates with no guarantee of long-term sustainability. More importantly, there is an acute risk that a strategic may exercise undue influence over a product and build one that is specifically dedicated for them rather than one that can scale for the entirety of the market. 

What should you look out for in an agreement? It should contain a significant amount of detail, which can help drive greater accountability. Make sure the agreement has specific terms and agreements, the desired outcome, copyrights and ownership, license and acceptable use, disclaimers, confidentiality, and the timeline for deployment. All at the scale that matters to you.


Avoid the over-valuation trap.

Historically, strategic investors may not have been as valuation sensitive in negotiations because they are judged on the strategic value of the investment and not on Internal Rate of Return (IRR) as traditional venture investors.

With strategics, this can have some inverse and troubling consequences. For instance, about two years ago, I met a media startup from Hong Kong raised capital at a $100 Million valuation on only $1.5 million in revenue from one inexperienced strategic investor. Unable to raise capital at that valuation, the founders had to take a significant devaluation in ownership to sustain the business. 

Before starting negotiations with a strategic, do your research and seek to understand as many comparable valuations in your space as possible. Valuation is often more art than science. Only accept market rate valuation, accounting for traction, technology stack, and team from investors.

Look for financial angels to put in capital or at least evaluate your business in comparison to the market rate. For example, Casper, the mattress startup, took in funding from traditional financial angels before accepting investment from the retailer Target. By looking to financial angels and even early stage investors to value the business, they prevented any risk of over-valuation. 


Beware of information rights and board seats.

If the investment is sizable enough, then the strategic investor may want to sit on your board. This position gives the strategic investor access to information rights over the most important developments in your business, including relationships with possible competitors. 

While you should be open to the idea of having the strategic investor join your board as part of the negotiation process, it is important to learn more about their intentions and objectives for joining. The position should be beneficial for both parties and include the ability to leverage the strategic investor’s expertise, connections, and knowledge in exchange for the information rights.

If a full board seat is too much to consider, one possible alternative is to provide the strategic investor with board observer rights. This position provides the strategic with the ability to sit in and listen to board meetings without the ability to vote as a member of the board, as they may also be looking to get insight into the company’s future intention – and see where they may compete with the strategic.

But again, as Mark Suster’s excellent article here references, there are risks even in this strategy.  Specifically as startups attempt to seek consensus, the board observers can have more sway on the vote than if they were to have a formal board seat. 

One way to possibly prevent this is to include a recusal right for the strategic’s board position in regards to sensitive matters. These could include discussions with a potential direct competitor to the strategic investor, a shift in the focus of the business, or any other sensitive information. For example, if a competitor business to the strategic investor wants to come in and be a customer, the strategic could excuse themselves from those discussions to avoid any potential conflicts of interest. Strategic investors are intelligent enough to understand the necessity of this provision and often welcome it in negotiations.  


Look out for broad non-compete provisions.

If a strategic investor agrees to an investment and a long-term contract, they may ask for non-compete provisions in their term sheet to protect their business. While you may be aware of non-competes and their applicability to employees – and their attendant unenforceability in states like California, these provisions also apply to strategic investors and joint venture partners. For example, a non-compete clause may prohibit a startup from working with a competitor (or even taking investments from one). The non-compete could also extend to a potential acquisition by a competitor. 

Plainly, you must seek to strike non-compete provisions completely from the term sheet, especially if one of the provisions relates to potential acquisitions. The easiest argument towards this is simple: a non-compete provision effectively limits the strategic’s own upside potential. Since a strategic investor is seeking a return by investing in your startup, remember that this type of provision would put a limit on the liquidity value of the business and therefore on their ROI.


Strategic investors may be the best partner.

As strategic investors get increasingly savvy about startup fundraising and capital, given the right circumstance, they may be the best partner for your early stage company. The recent exits of Zoom and Lyft, both of whom had a strong strategic investor presence in Qualcomm and General Motors respectively, relatively early in both companies’ histories, indicate how the tide is shifting. While great negotiation skills can ensure that non-compete provisions and information rights will not trip up your business down the road, if you can make investment contingent on a long-term commercial contract and adoption of your product, you will set your business up for the best long term success. What type of success? To raise capital again of course, at a much higher and justified valuation.

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How to negotiate term sheets with strategic investors

Source: By Alex Gold

Improve Your Odds of Getting Funded by Matching Your Pitch to the VC’s Investment Pattern

Improve Your Odds of Getting Funded by Matching Your Pitch to the VC’s Investment Pattern

It’s the often unseen trigger — that invisible ‘something’ — that gets them to bite. Seek it, use it, close the deal.

It was an unusually warm February afternoon, and my co-founder and I were sitting outside the Coupa Cafe in Palo Alto, pitching an angel investor, but something just was not clicking. Although our revenue growth was strong, our team was stellar, and our market was the perfect opportunity to generate the winner-take-all, monopolistic business that investors seem to love, the investor just wasn’t having it.

“I still worry — really worry, actually — about your guys’ ability to execute this. I can’t put my finger on it. But I feel it.” Suddenly knowing that (obviously) this investor was not going to bite, I started to realize that beyond perfect decks and personal impressions, there is something more to master in your pitch.

The problem was “pattern matching.” We weren’t aware of it.

The impression you make throughout your pitch is important, certainly, but there’s another aspect to an investor’s interest. Many investors choose their ventures based on predetermined factors. This is pattern matching, and understanding how it factors into the decision can help you make it work for you.

Pattern matching is the habit of an investor to evaluate opportunities based on what has worked before. If a Mark Zuckerberg-style social media entrepreneur walks into a boardroom, an investor may see the look and overall style of the person making the presentation and immediately recognize it as a good fit. This judgment may not even be conscious.

Before your next pitch, it’s important to find ways to make pattern matching work for you. Here are a few things you can do to improve your chances of success.

Research is essential.

Research is always recommended when you’re planning to step in front of an investor, but pattern matching means you need to start that research before you get the invitation to pitch. In addition to standard research suggestions, take a close look at every investor’s portfolio and choose those that are likely to be interested in what you’re offering.

One of the best resources for looking into potential investors is Crunchbase, which gives you insight into what an investor has previously backed, including the amount spent on each investment. If you aren’t sure which investors to pitch, you can also use this tool to identify companies similar to yours and find backers that might be interested in what you have to offer.

Present data.

Maybe you couldn’t pass as Brian Chesky’s twin, but you have a great idea that will disrupt the on-demand accommodations industry. You can still demonstrate to investors that your product will match the performance of similar companies in the space.

Make sure you frontload your presentation with plenty of data that compares your brand to others, directly addressing the similarities investors are seeking in your presentation.

You can also use data to inform your storytelling, winning pattern-matching investors over. Kick off your presentation with a story about a product similar to yours, then follow up with data that shows the similarities between what you’re trying to do and what that successful company did. The investors will immediately see a correlation, and you’ll be more likely to complete the presentation on a win.

Don’t fake it.

In the end, the best thing entrepreneurs can do is to be true to themselves, before, during and after the presentation. Pretending to be something you aren’t to wow a specific investor won’t help if your pitch doesn’t match what your company represents. You’ll probably find if you can get a yes based on that pitch, the investor will require you to make changes that turn your company into something outside of your vision.

The theory behind being yourself is that it will attract the perfect investor to move your business forward. You’ll save yourself time, though, if you follow earlier advice to thoroughly research potential investors and narrow your list down to those with portfolios and interests that are a close match for your business.

Accept the pros and the cons.

There are issues inherent to pattern matching; many of them have been widely recognized. Pattern matching limits diversity and locks investors into a portfolio full of similar companies. If they continue to follow the same pattern, they may, in fact, miss out on new industries that could bring much bigger rewards than if they continued to play it safe.

Once you’ve accepted the pluses and minuses of pattern matching, you can make it work for you. You may be able to leverage your company’s uniqueness by building momentum on a crowdfunding campaign initially, for instance, then taking that large audience to an investor. Another winning strategy could be looking for investors who might specifically be interested in diversifying and embracing your differences, rather than trying to follow the crowd.

Because pattern matching will likely continue to be part of investment decisions, there are things entrepreneurs can do to play to this basic instinct. Careful research can make a big difference in not only identifying ideal investors but also connecting with them during a pitch meeting in a way competitors can’t.

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Improve Your Odds of Getting Funded by Matching Your Pitch to the VC’s Investment Pattern

Source: Published on 2018-04-02 By Alex Gold