Negotiation is one of the most critical parts of any private capital markets deal. Contrary to what most venture capitalists (VCs) may believe, the negotiation phase in a deal isn’t limited to a week-long term-sheet negotiation period. Expert negotiators start laying the groundwork for a deal right from their first interaction with a startup founder. As Forbes puts it, the negotiation in any VC deal is centered on the mutual trust between founders and VCs. This trust is usually built over a period of weeks and sometimes months, where both parties attempt to express their goals and expectations and arrive at a mutually beneficial agreement.
The second element vital to a VC deal negotiation is leverage. VCs that fully understand their leverage are in a position to dictate all the processes leading up to the negotiation stage much better. This helps them avoid proceeding with fundamentally unviable deals, saving them valuable time and effort. Leverage is one of many negotiation tools VCs can use to steer deals toward their envisioned goals.
In this article, we discuss how VCs can determine what the right amount to invest in a startup would be and how they can successfully negotiate that number.
Tips for negotiating with startups
Here are a few tips to help you build a framework of mutual trust and successfully leverage while negotiating with startup founders.
Being a more active listener is general negotiation advice that can be beneficial in most collaborations. Listening is all the more relevant to VC deals, given how much they depend on a central relationship based on mutual trust and understanding. Being an active listener allows VCs to truly understand a startup’s business model and actively brainstorm with the founders to refine it. This helps VCs come off as more supportive and empathetic, which directly influences a founder’s decision to work with them.
Naturally, VCs that provide active inputs during the vetting and negotiation phases are perceived as more value-adding by founders. This perception can then be leveraged by VCs to arrive at the best valuation. Apart from being inquisitive and developing an excellent eye for detail, being an active listener entails offering practical and actionable business advice.
For example, when a FinTech startup expresses its concerns about scaling up before the next funding round, VCs should seek to understand their fundamental problems with the idea. This information can then be used to craft a mutually viable solution that allows the startup to scale while taking care of its financial and operational concerns.
- Maximize trust
Building and maximizing trust in a VC relationship involve being completely transparent about your goals as an investor from the very beginning. You should also make active efforts to align these goals to that of the startup as much as possible. When VCs successfully align their investment goals with a startup’s proposed growth trajectory, it helps the founders see the deal as a collaborative effort to help their company excel. This allows them to trust VCs and work with them more closely to tackle any operational problems.
Trust also contributes to a VC firm’s overall social capital. A firm that is perceived as more sincere and trustworthy than others will naturally attract both startups and limited partners. Being transparent about their investment motivations allows VCs to build a solid foundation of trust for successful deals and a respectful, mutually amicable position for unsuccessful ones. It also gives startups an incentive to be more transparent and voice their opinions in the planning phases more definitively.
Understand your leverage
Leverage is one of the most important negotiation tools a VC can have. It allows VCs to understand how hard they can negotiate and what’s the most they stand to get out of a deal. Thorough market research is needed for VCs to fully understand the leverage they hold over a startup.
For instance, let’s say a real estate startup ABC approaches you for a seed-stage investment. The startup, while promising, needs major operational changes to be able to establish itself properly in any local market in the country. Moreover, your VC firm specializes in real estate companies and can help ABC find the necessary resources and contacts to scale successfully. This would allow you to negotiate a higher equity share for a relatively lower seed investment as opposed to other firms that might not have as much experience working with real estate companies.
Leverage is all about knowing what you bring to the table and the value it holds for the other party. Competitive research can help you analyze what other options are available to a startup and how you fare in comparison to them. This would help you get a clear idea of how much equity you can ask for in exchange for a certain sum of money. A VC firm may also choose to leverage its position in the form of venture debt.
Focus on value and not valuation
Startup valuations can often be misleading. Most startups come up with a valuation based on previous funding rounds or by comparing themselves with other similar startups, both of which are not foolproof strategies. Determining how much a startup is really worth involves several variable factors like market conditions, forecasted consumer trends, the strength of the founding team, and the startup’s future operational plans. This makes it extremely difficult for VCs to objectively determine how much a startup is worth. Some VCs cite ‘gut feeling’ as their go-to option in such situations.
Judging a startup based on a gut feeling or intuition is a skill that VCs pick up and hone over the years. You can either use a personal checklist to determine which startups can be trusted with bigger sums of money or simply make a judgment based on the proficiency and business acumen of the founders. The basic idea here is to judge a startup by the value you believe it can bring to your portfolio and not its past valuations. Every startup, no matter how operationally sound, is only worth as much as the value it adds to your portfolio.
For instance, if adding a promising startup to your portfolio can become a potential investment risk because of current market conditions, it wouldn’t be wise to value it highly. Similarly, if a seed-stage startup can help you mitigate investment risks by diversifying your portfolio, you can value it a little higher than usual to gain leverage in the deal. Coming up with accurate startup valuations is a complex task that requires close collaboration between VCs and their due diligence and risk mitigation teams. Treating valuations like a collaborative process driven by your intuition can help you make the right calls during funding negotiations.
Being aware of cognitive biases
Unconscious biases can often influence important decisions within a VC deal flow. While VCs need to emphasize sound, data-backed decision-making, they should also be aware of unconscious cognitive biases that might influence the ‘gut feel’ they rely on to make crucial decisions when data proves to be inadequate.
One of the most common cognitive biases seen in VCs is the similarity-attraction bias. This happens when VCs value startups better when they identify with the founders. While such biases can play an important role in guiding VCs toward the right intuitions, it is important to be fully aware of them while making decisions. Every decision from choosing a startup for your portfolio to finally coming up with a valuation for it should be taken based on historical data trends. Relying on a holistic, information-based approach can help VCs minimize decision-making errors and streamline their negotiation processes.
Zapflow is a state-of-the-art deal flow management tool that can help you capture and analyze deal-related data efficiently. You can reach out to founders, extrapolate information from your exchanges with them, and generate custom reports all on the same digital platform. At Zapflow, our goal is to help VCs switch to a swifter, better-informed decision-making process that can help them make the most out of their data.
Contact Zapflow for a free demo today!