Negotiating Power in Startup Fundraising

Negotiating investment terms with potential investors is tremendously challenging, usually because of the power imbalance between investors and startup leaders.

It is a grim feeling when the excitement of finally getting a term sheet for a potential investment (a milestone that has often required many months and tremendous effort to accomplish!) is coupled with an investor declaring some version of the following when the startup CEO starts asking questions about some of the more onerous provisions in the term sheet:

• “There is no negotiation on this term sheet.”

• “That term is not negotiable.”

• “This is how we see it, given our knowledge of the marketplace and the need to fill out this round with other investors. Take it or leave it.”

While sometimes they find a gentler way to express the same sentiments, it is still not what you want to hear when you are experiencing some sticker shock about what investors are demanding to put their money into your startup. The reality is that it is pretty rare for a startup to receive a term sheet that is surprising for the generosity of its terms. Much more common is a feeling of “They want what???!”

Why It Is Tough to Negotiate with Startup Investors

Two dynamics make it tough for startups to negotiate with potential investors:

1. Information Imbalance

Active investors have a much better handle on what terms mean and what the investing market is like at any given time because they are making investments much more frequently than individual startups are taking investments. Active investors are constantly screening potentially hundreds of potential investments, so they often are in the position of considering which of multiple exciting companies to invest in. This gives them both market information as well as the power of choice.

In contrast to startup leaders who may be raising money for only the first or second time, investors have often been doing deals for many years and have seen how different terms are applied across many different situations. This creates an inherent imbalance of knowledge that investors exploit when they say things like “This is what the market dictates” or “This is standard,” which may or may not be entirely accurate. A startup’s knowledgeable corporate attorney and the CEO’s relationships with friendly disinterested investors and other experienced CEOs are often your only resources for redressing the information imbalance. This is why it is critical to be mindful of the experience base of your corporate attorneys to make sure they are doing enough fundraising transactions on a routine basis that they can tell you what de-identified others are seeing as “market” terms in the present moment.

I caution that published “state of the investing market” articles are often subject to significant unrevealed information biases. Given the reality that a substantial percentage of deals that are used to calculate those statistics are from Silicon Valley tech companies, if your startup isn’t the same as the under-the-covers and usually uncharacterized or disclosed company types, geography, and industry variables, then those statistics may not apply to you. Furthermore, remember the statistics maxim, which states that summary statistics (averages, medians, etc.) tell you nothing about the individual case. I have had many conversations with first-time founders who say things like, “I have read on the internet that this is the amount of dilution I should have to pay for a seed round” or similar. The only way you know what YOU have to pay is to get a lead investor to declare the terms on which they will invest in YOUR company. The abstract summary statistics of what the market averages might be are only mildly relevant!

2. Negotiating Power Imbalance

Virtually all negotiations involve a power imbalance between the parties. Understanding your relative power versus the power of the potential investors on the other side of the negotiation is essential to knowing what opportunities you have to push for better terms. This is a tricky business because many of the fundraising stories you read about do not provide enough transparency on the parties’ relative negotiating power, which can easily lead to erroneous conclusions as you try to learn from such tales. Here are some examples of the factors that tilt the teetertotter of negotiating power:

• The Unproven Nature of Earliest Stage Startup Fundraising:  At the earliest pre-seed/seed stage, startups can be challenging for investors to assess because the product is still in development, product-market fit with multiple customers has yet to be demonstrated, the team is a skeleton crew, the leadership is unproven, and so on. This means that convincing an investor to take a meaningful chance at this stage of development is arduous work – and the startup CEO is often just trying to find an investor willing to take the leap. While there are some investors out there who have enough capital to toss around initial checks on the ephemeral nature of these earliest-stage startups, that is unlikely to be enough to fuel the startup for long. The bottom line is that startups at this stage are a dime-a-dozen, and the negotiating power is firmly on the investors’ side of the teetertotter.
  
  
• More and More Demonstrated Traction: As a startup starts to develop demonstrable traction, such as experienced management, FDA approvals, beta customers, first revenue, a more substantial team, and so on, the fog begins to clear, and investors can start to differentiate startup trajectory. At this phase, the startups with strong trajectories will start to generate more investor interest, and with that interest, they will begin to have more negotiating power. At this stage, it may be possible to generate multiple competing term sheets, and that is really when the negotiating power becomes more even between startups and investor syndicates as each side tries to sell the other to get a deal done. It is still not easy to raise, but you can choose the better deal if you can get multiple offers.
  
  
• When The Rocket is Obviously Taking Off: At some point, a startup may really begin to perform, and the negotiating power then shifts again as more investors want in than there is a willingness on the part of both existing investors and management to let them in. I have seen it become strong enough that the startup was dictating attractive terms to investors who were willing to be very aggressive to get a piece of the company. This tends to be later when the strength of the startup becomes apparent, and my fastest closes and most attractive terms have come when the teetertotter of negotiating power is clearly and firmly in my favor as the startup CEO. This is the time when you can be pretty picky.
  

The question of relative negotiating power boils down to your available alternatives. Multiple term sheets from different parties shift the power balance towards the startup. A single investor offering terms means you may be presented with a take-it-or-leave-it choice. For investors, negotiating confidence comes with having multiple startups they are excited about, so if they push hard on terms and the deal blows up, they have other options to pursue. In addition, there are usually more startups seeking funding than there is funding available, so the starting position is generally biased towards the holders of the scarcest resource. In other words, those who have the gold (investment capital) often make the rules (terms).

Tactics for Successfully Negotiating with Startup Investors

I do not want to make this sound easier than it is. While I have experienced the full spectrum of negotiating power positions, from having almost none to being able to decline potential investors who would not accept our terms, the negotiating power balance tends to lean in favor of the investors. However, there are some tactics that startup CEOs can seek to employ to improve their power:

• Do everything you can to make your startup powerfully attractive as a potential investment. Nothing swings the negotiating power in your direction like being at the helm of the “hot investment” that “all” the investors want a piece of. The times when the startup and its existing investors can dictate terms to investors who want in often happen when there is more investor demand than there is “allocation” to be had in the current fundraising round – a great example of how competition amongst investors fuels negotiating power for the startup. What you control to drive up interest is the successful performance of the startup in its large and lucrative target market. Remember that the startup is the “product” when fundraising, so make your startup’s features and benefits as good as you can amongst the startup competitive landscape.
  
  
• Get as educated as you can so you understand all of the variables in the term sheet and how they relate to one another.
  Big ones are often related to security type (note, non-participating preferred stock, participating preferred stock, etc.), valuation, pre-money option pool, Board seats, and protective provisions. You will likely need help from the expert you have in your corner, your experienced corporate attorney, to ensure you understand the implications of the proposed terms and what options might be palatable. You may have to give in to your potential investor’s hottest button – which you will need to discern – but you may be able to make some progress in shifting other terms in your favor. Being able to navigate your way confidently amongst negotiating points can help you land the best possible deal under any given set of circumstances.
  
  
• Be clear about your priorities and walk-away points when going into terms negotiations. Sometimes, you may decide that the terms on offer are sufficiently bad that you should continue to fundraise and seek other options. Several times, I have chosen to walk away from a term sheet, either in favor of an alternative term sheet or because of concerns that have arisen about the quality and integrity of a particular lead investor (remember that you will be in business for likely years with your significant investors – are you ready to get “business-married” to this investor?).
  
  When negotiating, you do not want to make a decision in the heat of the moment. Sometimes, you may have to swallow hard and accept less generous terms to secure the essential funding you need to build the company. At that point, you may have to focus on creating a valuable company that can generate a generous return for all involved rather than obsessing about a point or two of dilution. Alternatively, if you have any other options for moving forward, that best-alternative-to-a-negotiated-agreement (BATNA) is the source of your negotiating power.

Be prepared to be pushed hard by potential investors, and remember that in startups, hopefully, everyone can come together and build something amazing that impacts the world and generates excellent returns!