How to negotiate the best deal with investors
Once your business plan has gained interest you'll want to get the best deal - find out how here
Dealing with offers of investment from venture capitalists (VCs) can be a draining experience. The process is littered with technical jargon and involves dealing with solicitors, banks and accountants, as well as the VCs themselves – all of whom know the process inside out.
It is likely, however, that you do not; so now is a good time to get some professional help. Hiring a lawyer at this stage will pay dividends – literally – later on, but remember to pick one who is experienced in dealing with investments on a similar scale to yours.
Corporate finance specialists at accountancy firms will also be on hand to guide the uninitiated through the confusing maze of clauses, agreements and esoteric references that permeate this type of deal.
The ‘term sheet’
Investors almost always make an initial offer in the form of a ‘term sheet’: a three or four-page document setting out the proposed scope of the deal. It is often referred to as an ‘agreement to agree’, because it feeds into the final contract, but is not in itself meant to be legally binding.
Rob Donaldson, a partner at Baker Tilly, says you should aim to have three or four offers on the table, but no more. This number will give you a good idea of what is the right deal, but it will not make you appear flighty in VC circles.
He comments: “The only real way to find the best deal is to benchmark what’s on offer. You should approach a handful of lenders – their offers will let you know what is ‘fair’. But don’t wallpaper the VC community, because it will put many of them off.”
Each offer comes with its own set of bankers, lawyers and accountants, so it is also advisable to keep numbers down for simplicity’s sake.
The term sheet lets you know what’s on offer and allows you to compare and contrast the various bids you’ve received. It describes such things as what is for sale, how much is to be invested, the method of funding, the anticipated rate of return and the exit plan.
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The investment itself is usually derived from a number of sources, including direct investment from the VC fund and a bank loan also organised by the investor.
In addition, a small portion of the money will be put forward in exchange for an agreed stake in your company. This allows the VC to benefit from the fruits of its investment as your business grows. VCs will also often expect at least one seat on the board of directors, giving them a big say in the company’s future.
Coping with jargon
One unwelcome feature of a term sheet is its liberal use of investor slang. As Stuart Nicol, an investment manager with London Fund Managers, allows: “There is a lot of jargon involved in the process – and we’re all a little guilty of that”.
Daniel Bastide, partner at law firm Thomas Eggar, says a business’s management relies heavily on lawyers and business advisers to cut through the phraseology. But he adds: “At the end of the day, it’s in everyone’s interests that all parties understand what is going on, so venture capitalists will be happy to spell it out”.
Three such terms that you’ll be lucky to avoid are ‘ratchet’, ‘warrantee’ and ‘good leaver’ or ‘bad leaver’.
A ratchet comes into play when the investor and the management disagree wildly on the value of the business and by how much it is expected to grow. The VC offers the management an increased stake in the company if their predictions come true, thereby only having to pay out if its investment is a success.
A warrantee is a promise made by the management that what they have said about a certain aspect of the company is true. One investment can involve a large number of warranties, and it is important to seek formal legal advice about what you are promising. This can help to avoid legal problems at a later stage.
The term ‘bad leaver’ refers to a member of the management team who opts to jump ship before the investors get to their exit date, thereby jeopardising the return on the investment. Good leavers are hard to come by, but they generally leave the company through no fault of their own, because of ill health, for example.
The confusing nature of investor language can make it tempting to consult your lawyer at every turn. Try to avoid this, however, as it can push up costs and slow down the transaction process.
Room for negotiation
Despite all the intense language being knocked about, most of the details contained within a term sheet are not legally binding. The ‘contract’ comes after extensive checks run by the VC company, in a process known as due diligence, and once both sides are happy with what is on the table.
However, you and your chosen VC are bound by three agreements from the time you sign and return the term sheet. One is confidentiality, meaning neither the business nor the VC can share privileged information gained during due diligence. Another is exclusivity: VCs will insist you approach no other fund managers while you are dealing with them.
The last agreement refers to who will pay the VC’s costs if the deal breaks down at the due diligence stage. Unfortunately, investors will rarely agree to foot the bill.
But as Daniel Bastide suggests, these clauses are legal only in an ‘academic sense’ and it is very rare for VCs to splash out on court costs at such an early stage. Much more damaging, he says, is the effect breaking these clauses can have on a company’s reputation. “If it gets out that a company has mucked around a VC firm, the company will find it much harder to then go out and strike a deal with another investor. It’s much better to play ball at this stage,” he argues.
Ideally, get the bargaining out of the way before you strike a deal with a VC. Management teams are at their strongest when they have a number of offers in front of them, especially if they represent an enticing prospect for an investor.
Now is the time to negotiate as much as possible. If you have something an investor wants, then they are bound to be flexible about the deal. At the same time, basic business rules apply: it is in their interests to give you the least amount of money for the largest possible stake in the company – so it’s rarely a good idea to accept the first offer.
“Don’t be fooled by the phrase ‘it’s standard practice’. Everything is negotiable from the interest rate on the loan, right through to the equity stake and fundamentals like the value of the company,” says Donaldson.
David Beer of Beer & Partners, a business angel network, adds: “VCs are usually flexible, though typically would have certain threshold criteria that must be satisfied, such as industry sector and deal size.”
The next step
Once the deal is agreed, however, and due diligence begins, trust becomes the guiding principle of the transaction. From this point on both the management and the investor must work together to see the best possible return from the business – so cooperation is key.
“Whatever the legality of the situation, it is important to maintain trust. The initial process, with its bargaining and negotiating, naturally conjures suspicions – but a good relationship will help the process immeasurably,” says Nicol.
This adds up to a lot of meetings, site visits and talking. The VC will appoint an accountant to check the company’s finances, and will probably also hire a specialist in the busi- ness’s industry sector to carry out commercial due diligence: an assessment of the company in relation to its competitors.
And while lawyers are involved throughout this process, it is imperative that the two sides get along. Establishing a rapport at the term sheet stage is therefore crucial to the success of the deal and will make the latter stages of the transaction smoother and less stressful.