I didn’t invent this quote (can’t remember where I heard it) but what a great one to help remember that with most business-related transactions, price is definitely not the only factor. Three such transaction types relate to the things I commonly write about on this site:
- Fundraising (valuation)
- Technology licensing (royalty or license fee)
- Acquisition (price tag)
In this article I provide insights into possible terms for each type of transaction that could dramatically change the value equation.
Fundraising
Founders often get so infatuated with the amount of dilution they’re going to experience as a result of fundraising that they focus almost exclusively on getting the highest valuation possible. I’ve even seen founders practically fall on their sword in order to get a $3.7M pre-money valuation instead of the investor’s proposed $3.5M.
“Time kills deals”, which means in the extra time it takes to convince the investor to come up to $3.7M, a couple of things can happen. They could drop your deal in exchange for another one or, to the point of this article, they could insert other terms into the term sheet or edit existing ones in such a way that the higher valuation is less impactful to them.
What sort of “other terms”, you might ask? Consult with your attorney for a more exhaustive list and deeper explanation, but here are several for an equity round of financing (a “priced round”) to make my point:
- Extra Liquidation Preference
For example, 1.5-2X invested capital instead of the standard 1X. - Participating Preference
Commonly referred to as the “double-dip” provision because the investors get both their regular liquidation preference and they get to participate in the remaining proceeds of the acquisition on a pro rata basis (versus being forced to pick whichever is better). - Tranche-Based Investment
Instead of getting all of the new investment up-front, the investor spreads it out among some number of “tranches” that are contingent upon performance-based targets. - Warrant Coverage
The investor gets extra equity in the form of a warrant, which causes additional dilution for the founders and existing equity holders. - Stock Option Pool True-Up
The investor can push for an amount that is higher than you would like or need. Since this almost always occurs “immediately” prior to the new financing, you and your existing shareholders take the dilution hit – not the new investor(s). - Voting Rights
Could cover a whole host of vote-requiring approvals like board seats, compensation, dividend accruals, forced exit, etc. - Board Seats
Namely, the balance held by the Preferred versus Common shareholders. - Conversion Timing for Convertible Notes
Instead of converting “with” the new investment, the investor could require that they convert “immediately prior” to the new financing (you take the dilution, not the new investor). - Dividend Accrual
Just like it sounds, the investor accrues dividends until some exit happens. - Anti-Dilution Protection
Some aspect of this is found in most equity financing terms sheets but the investors could dial the terms up with things like “full ratchet” rights or similar.
I’ll stop there but obviously the list could be longer. Notice that all of the items in the list can be categorized as either Control, Exit Economics or Risk Mitigation. And I hope I’ve made my point: “Tell me your price and I’ll tell you my terms”
Side Note 1: Although the list of negotiated terms above relate to an equity round of financing, a related list could be produced for fundraising with a convertible note or SAFE (see related article titled “Reviewing the SAFE Investment Instrument“).
Side Note 2: I regularly coach entrepreneurs to “optimize for growth, not dilution“. If there are scenarios that allows you to grow considerably faster or accomplish more significant milestones but result in more dilution, take the high growth scenario (with some obvious boundaries). The only equity % figure that matters in the end is the one you have when you eventually exit. You would much rather have 10% in a $500M exit than 20% in a $100M exit.
If you are actively fundraising or preparing to do so, I highly recommend you read my related article titled “Negotiating Valuation with Investors“.
Technology Licensing
In this case, you’re negotiating with a strategic partner that wants to license and embed (or distribute) your technology so they can take it to market under their brand name and both of you can make a lot of money together. You’re pushing for the highest license fees possible and about to walk from the negotiating table over the difference between $2.55 per widget and $2.65. What levers does your strategic partner have to work with? Below are a few:
- Exclusivity
With this you’re prevented from doing similar deals with others (see related article titled “Exclusivity – Run Away or Embrace?“). - Sub-License Rights
Your partner has the ability to strike licensing deals for your technology with their own partners. Wouldn’t you rather do those deals directly? - Future Enhancements
Instead of having an opportunity to decide/define which type of enhancements should cost extra, the partner could request access to all future enhancements at no extra cost. - Support Terms
The definition of first-level versus second-level of support, hours of coverage and other support-related things make a big difference. - Pre-Payments, NRE (non-recoverable expenses) and Volume Minimums
The partner could reduce the amounts versus what you were expecting. - Most Favored Nation Rights
You agree to give the buyer the most favorable pricing and terms that any other future partner successfully negotiates. Yikes!
I’ll stop there but obviously the list could be longer. “Tell me your price and I’ll tell you my terms”
Acquisition (M&A)
In this case, you’re negotiating a term sheet with an entity that wants to acquire your great company. As soon as you determine the potential acquirer isn’t just sniffing around, you start doing calculations to figure out if you can only buy a new Ferrari or if you’ll make enough to buy a small island.
My first piece of advice is to realize that a verbal conversation about buying your company is a LONG way from getting a deal done (see related article titled “Approached for Acquisition – Now What?“). My second piece of advice, hopefully no surprise, is to realize that the acquisition price tag is only one key part of the deal. Terms like the ones below can make a huge impact to the deal economics:
- Escrow Amount and Duration
It is common for a certain amount of the acquisition proceeds to be placed into escrow for a period of time. Both the amount and duration are negotiable and I’d much rather see 10% for 18 months than 20% for 24 months. - Performance-Based Earn-Outs
In this case, you get part of the payout up front but the rest is at risk and only paid if certain performance-based milestones are reached. The devil’s definitely in the details and the longer the earn-out period the greater the risk to you. - Retention Incentives
The acquirer can simply dial down their budgeted amount of bonuses and/or stock-based compensation used to help retain the executive team and key employees. - Accelerated Vesting
The acquirer can insist that you waive your vesting acceleration rights in exchange for getting the higher price you require. That means you’ve got to stay around while you gradually earn the remainder of your acquisition proceeds. That provides a built-in retention incentive, which allows the acquirer to pull bonuses and other retention tools off the table. - Representations & Warranties
You will already have to make various reps & warranties about the state of your business but an acquirer that has to really stretch to meet your price target will surely instruct their lawyers to load up this section in the merger agreement. Future discovery of a violation to these reps & warranties during the escrow period puts your escrow proceeds in danger.
Again, I’ll stop there but obviously the list could be longer. “Tell me your price and I’ll tell you my terms”
Progression Towards a Fully-Executed Agreement
Founders without much business experience are often surprised how many evolutionary steps a deal goes through on the way to being totally done. Below is a progressive list of such stages, ordered by increasing certainty of outcome.
- Verbal indication of intent
- Email indication of intent
- LOI
- Term sheet (has more detail and legal wording than an LOI)
- Draft version of legal agreement
- Various favorable edit rounds (turns) of the agreement
- Partially executed agreement
- Fully executed agreement
Summary
Hopefully you have had at least two conclusions. First, a “good deal” represents a combination of both price and terms. Second, an attorney that is highly experienced with the types of transactions mentioned above is worth their weight in gold.