Fund Raising

Fundraising – 02 Negotiation I

Negotiating a funding round is difficult and you can easily lose the entire thing if you don’t know what you are doing. Rumor has it that you should get a good lawyer to help you. But truth is, no lawyer can do the negotiation part for you.

So let’s get the basics.

Who is negotiating?

The funding round is negotiated from two distinct hats. On one side, the company that raises funds is requesting financing via equity financing. On the other side, the shareholders of the company are negotiating the financial return and the rights of their investment position with new investors.

Those are two very different shoes.

As a company:

  1. You need a business plan and all that strategic material that answers the S&U questions, or the question on sources and uses of funds available.
  2. You need to show the financial position and projections/forecasts, the opex expansion and capital allocation plan, and all that.
  3. You also need to answer towards key risks that companies in your stage typically have. Those do not include spending money. But hiring good talent, meeting execution plans around operations, development, marketing initiatives. And possibly getting customer feedback and customers.

You sell a result or possible value after the funds you raise have been consumed over k months. Your business plan and strategy tell the investor how plausible it is to get to this result and how to plan to allocate the funds. He buys in or not.

With this in mind, you fix the amount of capital raised and the milestones the company has to meet – especially if investments are tranched. Most of the titleguarantees and reporting requirements in the investment agreements are directed to the management and they give investors a way to remedy. This should of course include you as a shareholder in your company. The rights to remedy should not only protect new shareholders, but all shareholders. If they are deemed generally valid and relevant for shareholders.

What you do not do as a managing director or as a representative of your company is:

  1. Care who owns your company. As a managing director yes. As the company, no.
  2. Care about dilution of your shareholders – or you. This is strictly something that the shareholders have to care about

As a shareholder:

  1. You ultimately want to lose little shares in your holdings of the company. So you are interested in a high valution.
  2. As a shareholder, you want to lose the least amount of control over your investment and hence when negotiating rights associated to e.g. the Series Seed shares or the preferred share class issued, you are negotiating as shareholder. It is simply none of your business as management director what the shareholders negotiate and do. Even if you are two persons in one most likely.
  3. You want to ensure that all rights and entitlements associated with new share classes that protect shareholder value should also protect you as e.g. a common shares holder.
  4. You also have an interest to prevent other shareholders from using particular performance successes or failures to benefit a single or a set of shareholders over others. A missed milestone by the company should equally


How to start a negotiation

Step 1: Flooring the valuation discussion
You start a negotiating with two hats and two single statements.

  1. The Company needs € x in cash to execute on the businss plan for next y months.
  2. The Shareholders are willing to accept equity financing of this amount as a valuation of z.

And you should absolutely nail a range with just these two or three dimensions:
1. Money raised.
2. % you give away for this
3. Time in which these funds will be consumed.

If you are negotiating on this level and get a commitment of let’s say €500k investment for 10% in the company, you have effectively created the following term sheet.

  1. You raise €500k
  2. You give out 10% of your common shares.

And that is a starting point. Now comes the valuation.

Step 2: Pumping the valuation

Especially 2 is very important. Because from this starting point, you can price up the valuation for every right that the new shareholder wants.

The Standard Negotiation

  1. Preferred share class ? Valuation goes up.
  2. Liquidation preference ? Valuation goes up.
  3. Anti Dilution ? Valuation goes up.
  4. Uncommon anti dilution (full ratchet..)? Valuation goes up a lot.
  5. Tranched Investment ? Valuation goes up.
  6. Milestones ? Valuation goes up.
  7. Put Option ? Valuation goes up.
  8. Excessive Covenants and Title Guarantees ? Valuation goes up.
  9. Excessive control rights ? Valuation goes up.

The more aggressive negotiation (when having a lot of competition):

  1. Company pays legal fees? Valuation goes up.
  2. Investor wants to invest in effective pre-money (founders have to pay option pool) ? Valuation goes up a lot.
  3. Investor does not commit of stocking up the ESOP pool in case of extending rounds? Valuation goes up.
  4. Investor does not bring in any revenue/leads pre-investment ? Valuation goes up.
  5. Investor doesn’t appear very convinced ? Valuation goes up.
  6. Investor is super convinced ? Valuation goes up.
  7. Investor delays final offering? Valuation goes up.
  8. Investors wants to call too many references? Valuation goes up.

As you are using this framework to pump up the valuation, you will (a) learn the price points that this investor gives for each right, and (b) slowly leave the range at which the other investor is willing to invest. That is a good thing.

For example a put option is posing a massive risk to the shareholders and the company and should be rigidly priced.

Step 3: Entering the shareholder negotiation

Now you have pumped the valuation too high. How do you get it down?

  1. By dropping requests and terms that the investor would like to have.
    Namely, the investor will have to withdraw from some of its rights to get his valuation. Most stuff he isn’t overly keen on anyway. It’s just a game he might light to play, but his Limited Partners only care about a few things, the rest is bullshit.
  2. By doing counter-requests: by shifting terms in your favor without changing the valuation.

What kind of counter requests are there?

  1. Investor pays (at least in part) legal fees of the transaction.
  2. No milestones without founder vesting on the new Share class. The investors authorize x % of the new share class to founders if they meet milestones similar to an ESOP pool.
  3. No effective pre-money. New investors either pay in parts for ESOP pool.
  4. Investors commit to opening and extending the ESOP pool in case of round extensions or for the next round. (Series A ESOP pool created out of Seed investor pool)
  5. Commitment to Series X Common share class to retain control if the preferred share class dilution pushes founders under control.
  6. Bad leaver clauses for investors. Milestones are two-ways.
  7. Range based milestones with range-based valuation adoption in tranched investments.
  8. Voting and Decision rights remain with common only OR with all shareholders. No particular control right for new share class only. Acknowledging the preferred share classes grant rights of dilution protection and oversight, but no control rights.
  9. Additional board seat positions for trusted / friendly advisor (Voting or Non-voting)
  10. Investor has milestones, too : e.g. supporting in key hiring, generating k leads, etc. or will increase valuation of tranched payment.
  11. Call option for Common Shareholders to call back preferred classes if conditions are met, e.g. delayed tranched payments, non meeting of milestones.
  12. Call options to call back x% of preferred shareclasses from positive cashflow.
  13. Strengthen the voting rights of the founders to either pivot, extend the business model to possibly adjacent markets that open up.
  14. Negotiate terms of the managing director contracts as to restrict the exclusivity of working for the company.

In principle, the negotiation freedom is there. Anything can be negotiated.

The Company Negotiation

Before negotiating a term sheet, however, the first step is to prepare the company and showcase the business plan. And doing this really really good is a sureway to get a better valuation. So, there are a few things that really make sense to prepare for a good valuation discussion in the Seed / pre revenue stage.

  1. Market Sizing: In EMEA, you have to be a bit cautious in showing how big your market could be in a mid-term strategy. In the US, you can outline the total market you want to attack, as long as you keep focus in a reasonable time-frame. Sizing your markets right and having a clear go-to-market strategy and aligning all the planning to this makes sense.
  2. HR planning: Probably the most relevant item after the market sizing, go-to-market and top line projections. Does your HR planning reflect the fact that you completely know how to structure, hire and manage your human resources? Do you really know how to name and hire and combine sales resources, marketing resources, HR resources, finance and G&A resources, R&D and product / UX management resources. Move away from generic names and plan teams and scale alongside mere units. It will make a huge difference if you plan 10 IT People or you are executing on a sprint team. It makes a huge difference if you hire 10 sales resources or you are building a SaaS POD.
  3. The regional expansion planning: Once you have your revenue goal and your HR plan together, you should ask yourself where you can execute on both plans. Selling hardcore R&D from Berlin is eventually harder than from Munich. Getting marketing and eCommerce platform talent in Aachen might be more challenging than in Berlin. Hiring a ton of people and scaling down if you miss target in Paris is going to be harder than in Ireland. Also overtime is going to be harder in Paris. So are you reasonably planning to get tier 1 talent and have it work 14 hours a day or are you going to get tier 2 to tier 3 talent and send everybody home after 7 hours?
  4. Details matter, too. Why do you allocate 200k in travel if you run an inside sales organization? Why do you get company cars if everybody runs on mytaxi, drivenow and Bahncard 100s or airplanes? Why do you get Microsoft Office for your IT staff? Why do you allocate more squaremeters than necessary for your headcount? (8-12 sqm is the maximum sqm per FTE ratio). Why don’t you plan for headhunters?

That all said, there is a lot more to prepare. But in the end your business plan and the planning inside is will speak a very strong record of your experience or lack of thereof. And running an organizational development plan that is likely able to pull off your R&D and sales and marketing goals and talent acquisition plan is a first step. Then you can show that you are able to deploy the total amount you raise in a reasonable fashion. In the end, investors deploy capital in your hands, so you can deploy it according to the game plan to find the most accretive/reasonable organizational and business development plan you can find around your vision.

Depending on how good you are, you either fall into a sweet spot of one or two investors, who will give you money in the range of 500k and 10 million. With that money, you are going to run 18-24 years and have a clear set of deliverables. With a solid business plan – not a fat document, but things that communicate that you know how to deploy 10 million in 18 months and get your goals achieved, you meet the first criterium.

But then you have to start worrying about the valuation. Apart from a business plan, a clean captable and a great team of 3-4 entrepreneurs that are commited and experienced in working together helps. But all those are just indicators.

The crucial part to win the negotiation is : vary your top line goals / the revenue and value story you have in mind to meet your targeted expectation. And then drum up your investor audience. The ability of drumming up a lot of investors that are willing to invest is crucial. Only if you have reasonable numbers of syndicates chasing you, you will be able to enter the negotiation on a high valuation. And only if you are able to go that path, you should show your outlandish revenue growth plan. So running a lot of scenarios for different funding scenarios and using screening calls and short intros to get an understanding how much competition you will have, you can start building out your business model that you present.

Bear in mind that in the end:

  1. More competition means higher valuation
  2. Higher valuation means better top line expectation
  3. More top line expectation reduces your network and overall runrate per money raised and will require you to increase your spending to still hit the 18-24 months runrate target
  4. Etc. etc. Yada Yada.

Don’t negotiate without competition

The above negotiation framework only works if you either don’t need equity financing or your have a serious line up of interested investors negotiating with you.

If you need money and talk to only one potential investor, forget negotiation and accept you will be screwed. There is imply no way you can push for anything.

The only way to win a hostage negotiation is to fully play against the risk of the counter party. Once people are invested in your company, you can always negotiate by threatening to leave the company. But that is not something you can do as first time founder and someone that isn’t yet established.

So how is the negotiation game won? Well, you can guess: by mastery of process and deception.

1. Have someone that wants to buy you before you start. (Optional)

First of all, everyone wants to know his capital protection. So the dirty sauce secret that you should know is that you should understand your exit case before you even start raising capital. Yes. I know you want to IPO your start-up. But if you go for the VC investment route, you absolutely must have a potential buyer. Yes, you must have him. Not have him in mind. Have him. Talk to him. Build the business plan for him. Say you will build this for him. And he will get a cheap way into the investment once you validated the business.

Why is this important? It really gives your investors capital protection. Sell your seed investor on a 200 million exit and he sweats a bit less. It’s pure deception at work here, but do it.

2. Have the metrics

You should really deeply understand what an Angel round, a Series Seed, a Series A and so forth means. An angel round is giving away a bit of equity for a very strong growth story to get the best angels you can have for the lowest amount of money to spare. Learning how to raise money from very relevant and interesting Angels is key. YOu learn this by either having very good angels and a network to them or by very carefully and observantly asking founders that got tier 1 Angels. Angels typically invest with Converibles and you should know the terms inside out and how they might screw your Seed valuation.

In a Series Seed, you get your first shot at institutional investors. And this is a very very very crucial step in your founder career. You don’t pay the option pool from common only, but they must take the hit on their investment. You don’t let them invest on effective pre-money, but on pre-money. They pay for the option pool. Period. You also don’t pay the legal fees. They pay the legal fees. Your advisory board – or in Germany: Bairat – doesn’t get a single right to vote on anything. They are there to observe you, give tips and advise you and add value. Don’t give them any damn right to elect c-Levels, grant options, etc. All they can get is some dilution protection, tag along rights and if they are greedy on the valuation, give them a Liq Pref. No Put options. No idiotic title guarantuees. Fuck them if they want that. And in a Series Seed, you have an exit case, a thoroughly researched market opportunity, you have your founding and first management team in place and some first employees that are critical. You have the soundest financial planning in the world. What does that mean? Forget nailing rent, travel expenses and administrative cost and being perfect on advisory and service providers. You have a clear staffing plan that aligns with your development and product-market fit development strategy. You must know hiring and organizational development inside out, know how to spot an A player and your choice of location must fit this situation. Don’t try to hire top IT talent in a Eastern European Village to save on rent ! Move to Berlin. Period.

So this sums up what I said previously. But nailing all this and getting the best first deal (Angel/Convertible or Seed/equity) is crucial. It ruins your trajectory if you mess the early negotiations up. It makes a difference if you raise 4 – 8 – 15 – 25 – 40 and exit. Or you raise 7 – 20 – 60 – 150 – 300 – 700 and go exit or ipo.

3. You define the amount you raise

Never talk to an investor and think about valuation you might get to get a certain amount of cash at your maximum desired dilution. That’s bullshit. As described in the company negotiation section, you have to have a organizational development and scaling plan and the tickmarks to demand a very high amount of cash. You need to show that you can deploy the cash you raise within 18-24 months. This runway doesn’t mean you simply raise 25 months current or average OPEX / gross burn over this time. Now, you also must show a revenue projection that makes you fundable at the next stage. Your hiring plan and metrics must make the top line projection reasonable. Your organizational development plan must support that claim. And your net burn – the burn after you added cash flow from sales / bookings into your model – should translate into this runrate. Typically, you also hire a lot of people, especially people in R&D an sales/business development in this period.

If you nail all that, you have a sizable amount you want to raise, a sizable revenue growth and an even more sizable expansion in total OPEX and COGS, which show how agressively you grow and how well you allocate your resources.

Then you go out to investors, drop your case (pitch deck and your strong financial case) and your drop your ticket. “We are raising 25 million, and we give you a 5 million ticket into our round. Do you want to lead or co-invest”. If you sell them on the case, you have a first checkmark you can  cross off.

Now the goal you have is to have 3 -5 investor packs chase you. Those packs are made up of 1 to 5 investors that syndicate for making it into your Series A. For every pack, you want competition. Let’s keep this simple. 3 packs want to win the bid for your Series A. Yes, you are offering a bidding process for your fundraising. Not begging for money.

3 packs are trying to outbid themselves for getting into this investment opportunity. In every pack you have a lead. Some packs only have one investor. In that case, you can add a new pack. In every pack, the lead drums up more co-investors. In the end, you want the best combination of co-investors, or a 5 institutionals in a pack investment.

So what is the game here? First of all, you need rivalling bidders to drive up the share price. Simple. Right? Cool. It goes without saying, they should be of equal quality, because the best will know you are an idiot if you take the worse ones and you are a dead fish if you do. You only have leverage if the bidders or at least the leads are on par.

Second, you must know that the value add of every investor is independent of the amount he invests. Once he is invested, he will offer his expertise and network to help you grow. That return is marginal, however. If you have one investor, he will give you for example 30 sales opportunities and 2 good hires. If you have the same investor and another 4 investors, you will still get 2 good hires and 30 sales opportunities from this guy. Maybe some more from the others. Good? Yes. That sounds good.

Now there is a difference in how these guys are structured and how good they are. Let’s say you have investor Boo with 15 leads and 1 hire taking the lead. He gets 3 other investors with no value add which are typical co-investor funds. That’s kind of stupid. You could simply take the money from your lead and have the same value add and less coordination issues with your investors. But on the contrary, more investors might mean less power for the lead. Good.

Now you have Maa, the lead that heads the second syndicate. Maa gives you no hires, but 10 leads. He packed 2 other lead investors that now only co-invest, all giving you 10 leads and 1 hire. You get the same dynamics as with Moo, same 2 hires, but 15 more leads. Clear choice, right? Maybe.

Now your have Muu, a tier 1 investor. Helps you to enter the US market, gives you 300 powerful leads. And 15 good hires. Mmh, Muu clearly wins? Yeah, but Muu wants more equity and more control in the board.

You see, the game is not easy or trivial. But it is good to have these opportunities. Boo clearly took the co-investors, because he doesn’t find other leads to join as co-investors and he is desperate to make you part of your portfolio. He needs to ge the co-investors to fill the ticket, because he normally doesn’t do such big tickets. Likely, his follow on will be low and the others might even pass. You don’t know. But Muu drove the price for Moo and Muu. Muu now goes higher and given your negotiation tactic, you might merge Muu and Moo to form a syndicate and even increase the valuation. Cool stuff.

The good thing, VCs talk. And the more competition you get, the more VCs will start to line up and want to invest. You have to know for yourself what game you are playing.

But again, in this tiny Series A example, your ability to play and game those bidders somewhat depends on your strength against your current investors. If the want to involve themselves with your investors, you have far lower leverage. And if you ruined your termsheet in Series Seed and gave away too many rights, you might just not lead the entire discussion with the bidders, but they might. So watch out an be a bigger shark.

You run the company, and you want to be the majority shareholder. But typically first timers fuck this up. So don’t worry.

The critical part here is: find a Seed investor that is nice when you have nothing much to bargain and use the exit player as a lever, your skills and your balls to lever in that negotiation. Once you have your product and first market fit, sales and investor strategy become your core activity. Getting the metrics straight and dressing up the company for your next financing round while sustaining growth is what makes you a 0 or a 1.

Hope this was helpful.







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