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.


Read the full article on TechCrunch.com:
How to negotiate term sheets with strategic investors

Source: TechCrunch.com By Alex Gold


To Attract Investors, Let Them All Be the 'Last One In'

To Attract Investors, Let Them All Be the 'Last One In'

Raise smaller mini-rounds in close succession rather than one large equity round.

Driving down the Bay Area’s idyllic I-280 — for the third time — from San Francisco to Palo Alto made for a very, very long day. But it gave my cofounder and me time to marvel at the speed with which we were able to supercharge our business with new capital.

In just a few days, we had gone from struggling to close to having enough capital to make the hires and purchases we needed. More importantly, we were able to do this in smaller increments and at successively higher caps, or valuations.

As founders, this is an even bigger win because higher valuations for investors means less dilution for founders. Unknowingly, we had stumbled upon a novel strategy to raise money and lower founders’ dilution risk.

If you’re raising money for your startup, you’re likely spending way more time than you thought you would working and reworking your valuation. You may get offers from investors, but not often enough to fill out your round. Yet, through a simple technique, you can push your fundraising to the next level, resulting in a higher valuation that attracts the funding you need.

Adjusting valuation caps attracts money.

This is called a “step close,” and it requires you to raise smaller “mini rounds” in close succession, at ever-higher valuation caps, rather than one large equity round at a fixed valuation.

This gives founders more control over the timing and strategy of the close. All that needs to be executed is a simple document at signing.

The first key to this technique is employing the valuation cap of convertible notes to your advantage. Often, the value of notes are offset by a valuation cap, which places a maximum amount on converting your notes into equity. This protects investors if, for instance, your company becomes the next Facebook or Amazon out of the gate.

But founders can also use this instrument to their advantage. Companies can issue a variety of convertible notes at different valuation caps, meaning you can raise with a valuation cap of $5 million one week and then, owing to demand, raise the valuation cap to $6 million a week later. For the extremely daring, you can compress this time scale into a matter of days.

Close the door behind you.

The second key to this technique is the “last person in” principle. Very few investors, even the most daring, want to be the first “money in” at a company. The smartest investors prefer to wait until other stakeholders have validated the business before committing.

This is great if you have three-quarters of a $2 million round completed, but it’s quite daunting if you’ve only closed a tenth of that. Smart founders turn this problem on its head, turning a $2 million round into a $400,000 mini-round that’s already received more than half its commitment. Making the round smaller, you give investors the ability to be the last money in for that mini-round — the way they prefer.

Let’s see how these two techniques play out in practice. Say your goal is to close $1 million in seed funding. Because all investors want to be the last one in, close the first mini-round at $500,000 at the first valuation cap. Usually, this valuation cap is lower and offers preferential terms to the first investors. Luckily, you can close this small amount from close family and friends, making it much easier to gain traction.

Once the first mini-round is completed, raise another $500,000 at a slightly higher valuation cap, owing to increased investor demand, company traction and progress. With more traction, you’ll be able to close angels and seed funds. With a higher valuation cap, you get to preserve more equity as a founder as well. Continue this process until you reach your $1 million goal.

You can repeat this process over a period of weeks and months, depending on how many mini-rounds you need to reach your ultimate fundraising goal. In doing this, you’ll gradually drive your valuation up and have fewer dilutions. Best of all, several investors will get to achieve their goal of being the last one in.

Of course, if and when you exit, the opposite often proves to be true. Investors will all want to be the “first money out.”


Read the full article on Entrepreneur.com:
To Attract Investors, Let Them All Be the ‘Last One In’

Raise smaller mini-rounds in close succession rather than one large equity round.
Source: Entrepreneur.com By Alex Gold