Taking Money From VCs: Navigating the Founder's Dilemma
Chris Corbishley is an Investor at Forward Partners, a leading early-stage VC fund providing startups with capital and operational support, with a special emphasis on the UK's next generation of AI, e-commerce and marketplace businesses. Negotiations can be daunting. Whether you’re convincing a senior hire to join the team, deciding terms with suppliers or drafting customer sales agreements, they should always be characterized by cooperation, not conflict. When raising investment, entrepreneurs face an additional trade-off known as the ‘Founder’s Dilemma’. By understanding this better, it's possible to navigate the deal process more openly, and effectively. Fighting Over Lemons The “lemon game” (often interchangeable with oranges), is used by business schools for negotiation training worldwide. The game divides the MBA class into three parties, each of whom are set up to assume they’re in for a tough and prolonged negotiation. One group (the sellers) represent the lemon growers, who having forecasted their yields over the next 5 years, set some constraints and present their terms regarding price and delivery. As for the two other groups (the buyers), one is an 'up and coming' lemonade producer with more demand than they can satisfy, the other, a large bakery selling the best lemon drizzle cake on the market. Each have their own optimistic forecasts of customer demand, seasonality concerns and sensitivities around price (margins). A crucial factor in these negotiations, which becomes clear in the supplier’s presentation, is there aren’t enough lemons to satisfy the demands of each buyer. This sets up an adversarial situation, characterized partly by conflict; fueled by the desire to maximize profits, and partly, uncertainty; due to some obvious information asymmetries. Unsurprisingly, this brings out confrontational, even aggressive behavior amongst participants, where after successive number crunching, and ‘slow reveals’ around each party’s limits on volume and price, each party is left fighting over an empty biscuit tin. Nine times out of ten, both groups of buyers fail to recognize that the cake manufacturer requires only the lemon peel, and the lemonade company requires only the juice. There’s a win-win outcome for those who ask the right question. The moral of the story is that negotiations are never a zero-sum game. You should approach them, not as a conflict but as cooperation, and never assume anything. Get inside the other party’s head to understand their needs, wants and fears. Be open about the things that matter, ask questions and listen. Making Choices A concept known as the ‘Founder’s Dilemma’ reveals the importance of making some hard choices before even approaching VCs for investment. As startups grow, entrepreneurs face a dilemma. On the one hand, they must raise resources to grow their business. If they choose the right investors, they can outperform. In fact, HBS research shows that founders who gives up more equity to attract good people and investors, build a more valuable company than ones who part with less equity. The founder ends up with a more valuable slice, too. On the other hand, in order to attract investors and executives, founders must give up a degree of control over decision-making as a quid pro quo. The Trade-Off (Noam Wasserman, 2008) This tension creates a trade-off between founders who want to be “rich” versus those who want to be “king”. While the “rich” options enable the founder to build a more valuable business, it can leave a sour taste for those wanting total autonomy and absolute control. For founders, one choice is not necessarily better than the other; what matters is how well each decision fits with the funding options available to them, as well as their reason for starting the company in the first place. For instance, founders in the lower left quadrant who want “no strings attached” are less suitable candidates for VC investment, hence angel investment might be a better fit. Negotiating Price. Negotiating Terms Assuming both parties are interested in moving forward, there are two aspects both parties may want to negotiate on: Price and terms. It is rare that either party will go hot and heavy on both, and there are often a few nips and tucks along the way to help ensure mutual agreement. Most terms (vesting schedules, board seats, decision-making checks), touch on this point of control. There are some term sheets that can make early stage founders (and investors) shudder. Fortunately, many will have reasonable measures to ensure an appropriate level of governance designed to protect their investment. We’ve published our term sheet in order to expedite these discussions, and for founders to get a feel about how we operate through the deal process, ahead of offering terms. Valuation can be a nebulous concept for founders (and investors). An important point to bear in mind is that early stage investments are true partnerships. These are relationships that can last 10+ years. Similar to the lemon game, no one party stands to gain from leaving another ‘hard done by’. It is in everyone’s interests to avoid disincentives. Fund economics and minimum return requirements aside, when negotiating price, VCs (and founders) should always focus the discussion on value, and not on valuation. Exploding Term Sheets Finally, when you get that offer, it is important to move quickly. It is not good practice for either party to keep terms lingering. Founders want to get back to the business of building their business, and investors hope for the same. For this reason, many term sheets will have expiry dates in order to keep the pace in the deal process. Pick Up The Phone One of the most striking observations (from someone who has played the lemon game in and out of class) is just how important open and frequent (synchronous) communication is to the deal process. Information asymmetry can can lead to all manner of misunderstandings and if left unchecked, it can cause a breakdown in trust, and leave everyone second-guessing. Where appropriate, call out investors, request some ‘radical candor’ and if there’s an inkling of doubt or concern about the business plan, the market or the product, multiply that inkling by 10 and look to address it in future meetings or conversations. Sometimes (if not, always) picking up the phone and chatting through terms, concerns and legals can be far more effective than exchanging long-winded emails.