How Do I Negotiate with Investors?
In negotiation, people consistently act according to their own incentives. Therefore, it should come as no surprise that institutional investors are primarily self-interested when dealing with entrepreneurs. One of the positive things about negotiating with them is that their incentives are clear and objective. They want to get the best possible return for their investors—the limited partners in their funds.
When working to persuade an entrepreneur to take their investment dollars, institutional investors often market things like their reputation, ability to make introductions, company-building experience, and passion for products and innovation. While investors sometimes provide help in these areas, they usually only do so if they feel it will help the company during their investment period. This narrow focus on short-term financial return often creates a misalignment of interests and incentives.
How so? Let me share a personal example.
In the late 1990s I was an early employee at a company in the Linux space that was backed by a prominent venture capital firm in Silicon Valley. While we had good initial traction, growth eventually slowed and our options quickly narrowed. Red Hat was the logical buyer, and they gave us a reasonable offer that would have produced liquidity for investors, kept the technology alive, and preserved the employees’ jobs.
As a management team we were excited about the possible deal with Red Hat, but were surprised and frustrated when the investors blocked the deal. Their explanation was that the return on their invested capital would not have improved the IRR (internal rate of return) of their fund, and therefore wasn’t a deal they were willing to support. We were told to keep “swinging for the fences” which ultimately led to a sub-optimal deal for everyone.
When exploring a partnership with investors, it’s particularly important to consider the alignment of incentives at the following three stages:
1) The Due Diligence Stage is the “dating” process before an investment is made. During this time, investors generally want to take as long as possible to evaluate the company in great detail, while the entrepreneur wants to move quickly to minimize disruption to their business. Investors want exclusivity during this period, while the entrepreneur benefits from a non-exclusive process, which helps to maintain a competitive dynamic. Investors look at an exclusive period as having an option on, rather than a commitment toward, a transaction. Seek investors who have a history of following through on their commitments and have a high close rate. You should also bear in mind that internal dynamics at an investment firm can have an impact on the likelihood of an eventual closing. Things like stage of the fund, hierarchy, and promotion dynamics often factor in.
2) The Partnership Stage is the period where the investor becomes a shareholder, and is now focused on an eventual liquidity event. During this stage of the relationship, interests tend to be fairly well aligned, assuming both parties have a similar view of the time frame for liquidity. Investors are sometimes more focused on quarterly progress and measureable results, while entrepreneurs are usually thinking about the long-term health of the business.
Discuss your expectations for the partnership in detail, including frequency and approach to board meetings, type of help desired, and relationship issues, including style and chemistry. Rather than focusing on the brand of the investment firm, remember that the individual investor in the deal is more important than the firm where he works. This is just as true at investment firms as it is at law firms.
3) The Liquidity Stage is the period where the stakeholders decide if the company should raise capital or sell the business. Hiring an advisor to manage the transaction can be helpful, as this period is usually a minefield of misaligned incentives.
For example, the entrepreneur likely has a high percentage of his net worth tied up in the company, while the investor is largely influenced by the dynamics of the particular fund they are investing out of. In a follow-on capital raise, existing investors often prefer to hand pick the new investors and solidify their influence on the board. In an M&A deal, existing investors are not generally concerned about what happens to the business after the transaction closes. In either case, an experienced advisor can help bring objectivity to the table, and help manage through these and other misaligned incentives.
There are myriad stories of both successful and unsuccessful partnerships between entrepreneurs and investors. In my experience, selecting investors whose incentives best align with yours, and hiring an advisor to keep them honest, are the leading factors in producing a successful outcome.