Negotiating with Investors: The Art and Science
Are you struggling to find investors for your business? Negotiating with investors is hard, not only for new start-ups but also for big companies.
The process can be a bittersweet experience for everyone. Most people believe that negotiations are a battle of fighting for what you want. You’d either win the deal or go home with nothing.
That is not true. With proper negotiation, the deal can become a win-win situation for investors and the founders.
A successful investor negotiation should incorporate terms and ideas from involved parties. But how do you achieve a successful negotiation?
The Structure of Negotiating with Investors
Negotiating with investors begins before sitting down with them and pitching your start-up. It starts way before you contact the person and request a meeting. Three essential compositions compose the negotiation structure:
What are Your Goals?
What is it that you want? Do you need $500,000 in capital? What are your key milestones? Where do you want to take your start-up? If you come unprepared to an investor, you will likely face rejection. How so? Most investors would have seen hundreds (if not thousands of deals). You may be seen as an incompetent founder if you cannot answer their questions.
Knowing the outcome you want to achieve isn’t enough to get the person’s attention. It would help if you showed a plan. From how to accomplish the goals to how much you want to target.
You must be as detailed as possible to create an effective business plan. You must ensure the goals are manageable and strategic for your business’s growth and highlight the fund needs to attain the end goals.
What is Your Offer?
Your investor wants something in exchange for their investment. Ask yourself, “What benefit would they gain if they invest in my business?”
Money isn’t always the solution, and there should be more you’d be willing to offer. An offer that they won’t be able to resist. What is the stake you are giving to an investor? How is the valuation looking like? What is the growth in valuation, say, five years down the road?
Showing business traction can help start-ups visualize if your plan can reach more clients. A business traction measures your small business’s profit and studies how often you have negative sales. It means the higher it is, the more likely investors would be willing to sign a partnership. Having clarity on the offer is the first step when it comes to negotiating with investors.
Who is the Investor?
Research the right people to build a partnership with. Most entrepreneurs hunt in the dark. They do not know who their ideal investor is. You should have clarity on who your perfect investor is:
- What type of investor are they? – Individual/Angel Group/PE/VC
- What is the average investment size?
- How many past investments should they have made? Are they a new investor or a seasoned investor?
- Should they have made any investments in your industry or allied industry?
- What value do they bring to the table? (Money, strategic partnerships, new market, industry influence, brand)
How will you find your ideal investor if you do not know them? I see many entrepreneurs complaining about having to deal with investors. I find that funny – in most cases, these people do not know their ideal investor profile. If you do not get this step right, negotiating with investors could become a nightmare.
Your main goal shouldn’t be to raise capital. But to search for investors with the same passion as you. Remember – these people will travel with you for 3-5 years.
A person who knows about your industry will be more likely to accept the deal. Why? Because what every individual wants is to understand where their investments go. If the person knows the market target, they’ll study if your business has the potential to grow bigger.
The Principles of Negotiating with Investors
Negotiating with investors is a crucial part of a start-up founder’s journey. Here are five fundamental principles to keep in mind:
The Game of Valuation
One of the critical aspects of any negotiation is understanding your start-up’s valuation. Before starting the negotiations, you need to understand your company’s value thoroughly – how is it derived? What is the basis? How does the market value the competition? As you might have guessed, this depends on the stage in which your start-up is currently in.
However, one of the biggest mistakes is that start-up founders are either too optimistic about their valuation or have no clue. Both cases are recipes for disaster. If you are unclear about your business’s ‘real value,’ how do you expect the investors to take a stand? Be prepared to explain and defend your valuation to investors.
Remember, your valuation sets the stage for how much equity you’ll give up in exchange for investment. If both parties disagree with the valuation, making a SAFE note or a convertible instrument, which essentially tags the valuation to the next round, is best.
Familiarize Yourself with Term Sheet Clauses
Term sheets can be complex and often overwhelming for the untrained eye. With many clauses with significant long-term implications, term sheets often give founders sleepless nights. The best way to address this is to familiarize yourself with standard clauses in a term sheet. These include dilution, voting rights, anti-dilution, liquidation preferences, board composition, and drag-along rights. Understanding these terms will help negotiating with investors so that you reach a fair deal that protects the interests of both parties.
Negotiate with Investors for Favourable Terms
I see many founders get carried away with the valuation as if that is the single thing they are chasing their whole life. Remember, valuation is often a vanity metric. What value you deliver to your stakeholders (i.e., employees, customers, investors) is the real thing that can make or break your success.
For each term being discussed, have two things – what you pitch and when you will walk away. For example, liquidation preference determines how proceeds are distributed in the event of a sale. The norm is a 1x liquidation preference. You may probably agree to a 1.25x or a 1.5x. But anything beyond that could be a walk away.
Balance Firmness with Flexibility
Be hard on critical issues that are crucial for the future of your business, but also be willing to compromise on less critical aspects. For example, you may give 1 or 2 board seats if you need more control. You may not be ready to compromise on this. On less important things, you may compromise. This balance shows investors that you are reasonable and business-savvy.
Seek Legal and Financial Advice
Always consult with legal and financial experts with start-up experience. Again, a common mistake that I see founders make is appointing a generic lawyer or a CA who doesn’t understand the nuances of a start-up. For example, a professional who has dealt with traditional manufacturing or construction-related clients doesn’t usually understand the needs of the start-up world.
Negotiating with investors is a step-by-step process. You need to know where to start, how far you can go, and where your boundaries are. Good negotiation is a combination of preparedness, knowledge, and strategy combined with the right advice. The goal is to secure not just funding but a partnership that will support the long-term success of your venture.
Top 5 Mistakes Founders Make While Negotiating with Investors
In this section, we are going to look at the five most common mistakes that founders make while negotiating with investors:
Mistake #1: Optimistic Financial Model
Once, a founder approached me to build a financial model. His instructions were clear – he wanted a model that would fetch him a valuation of $1 billion. There are three problems here:
– The idea of targeting a valuation and building a model is fundamentally flawed. Valuation should be an outcome of your work, the product you make, and maybe the problem you solve. Building a financial model whose only purpose is to achieve a unicorn valuation (in the Excel sheet) is like trying to teach a cat how to bark. Great idea, but you’re probably in the wrong pet category.
– Unlike what you read in textbooks, valuations are often not driven by Excel sheets. It finally boils down to how you execute the idea.
– Building a model for a $1 billion valuation is probably the worst approach to pitching to investors. Yes, it is good to have a broad vision in mind. But most investors are smart enough to see the difference between a nice and sexy financial model and your ability to execute and pull off the numbers in the model.
Mistake #2: Lack of a Strong Team
Investors seek strong, well-rounded teams, not just fantastic ideas or individual founders. Many solo founders came up with a great idea and thought this was the next big thing after the invention of the internet.
Nothing is wrong with that – but ideas are worthless without proper execution. A common mistake is failing to assemble a team that complements the skill sets required to turn the concept into reality.
Mistake #3: It’s not about YOU. It’s about the Investor
Sometimes, founders are so self-focused that they fail to see what the investors seek. It is essential to know your story, vision, and what you’ve built so far. But understanding an investor’s goals, risk appetite, and expectations can go a long way in making the impression and getting them to say yes.
Mistake #4: Networking and Relationships
Building relationships with various stakeholders in the start-up ecosystem is exceptionally crucial. Some founders underestimate the value of networking and building connections. How do you expect someone to invest in your start-up when they don’t know you well? Strong relationships often lead to introductions that boost your credibility and give you a head start.
Mistake #5: Lack of Flexibility and Adaptability
The start-up world is dynamic. If you are rigid in any part of the fundraising process, that can mark your major downfall. Founders who are not open to feedback, resist ideas from investors, or are unwilling to adjust their business model in response to feedback are often likely to get a ‘No’ from the investors. Investors can easily spot founders who can be mentored versus founders who are not.
Conclusion
The art of negotiating with investors isn’t an all-or-nothing concept. Find options for the other party and discuss possible results. As you navigate the challenges of the corporate landscape, it’s crucial to have trustworthy investors by your side. These individuals should provide financial backing and offer constructive feedback that helps you grow and succeed.
When your company gains recognition and success, recognize and appreciate these early supporters who played a vital role in your journey. Securing funding through negotiation involves a delicate balance between creativity and analytical thinking. Investors are more than mere financiers; they are valuable partners whose guidance and expertise help steer your organization toward its objectives.
