6 Tips a startup founder should know before negotiating with an investor

Money, money, money… As a startup founder you’ll probably need funding from external investors at one point in the life of your company. Can you trust an old uncle that has put some money aside? How do you share the cake with investors that want to have the bigger piece? It all starts with being fully prepared! These 6 tips will already get you started…

1. Make sure there is an agreement amongst the founders

Before you start negotiating with third parties, first take a good look at yourself. Do you have a co-founder? Does your startup have multiple shareholders? Make sure you’re 100% aligned before you want to approach investors! You don’t want to negotiate with your co-founder in front of a potential million dollar deal, right?

The best way to make formal arrangements is by setting up a shareholders’ agreement. Among others, the shareholders’ agreement will often contain 2 topics.

The first topic is the general governance of the startup: which controlling rights will be assigned to whom (on the level of the management of the company and on the level of the shareholders of the company)? Will there be 1 leader or would a tailored solution be possible? Let’s say Tom and Sarah are co-founders (shareholders) and managers of a startup. Sarah is a creative girl who’s good in Sales. Tom, a finance boy, is extremely talented in cost calculations. Sarah and Tom agree that with regard to their expertise and talents, they want to have a more decisive vote on several decisions related to Sales & Marketing resp. and Finance. It all comes down to agreeing who’s in command of what.

The second topic of the shareholders’ agreement addresses the exit scenario. What if Sarah gets the opportunity to be head of Sales at a famous Marketing Agency in LA, and Tom wishes Sarah to stay active in the startup? They could agree on Sarah becoming a silent partner, but what if Sarah doesn’t want that? What if Tom gets ill and has to leave the company in order to save the business? Are pre-emptive rights an option here?

Startup negotiating with an investor

Creating a shareholders’ agreement isn’t obligated, but strongly recommended. It forces you and your fellow shareholders to think about events that could happen in the (near) future (good or bad) and how the company’s shareholders will handle these events. You also create a contract when you get married, right?

The biggest advantage of already having a shareholders’ agreement between the founders is that you, as a founder, already walked through this – often difficult – process. Moreover, it forces you, as a shareholder, to look at the (near) future, not only of your company but also of yourself. A serious investor will almost always require a new shareholders’ agreement. If you have already done this exercise once, you will understand the legal concepts better and the process will most likely go faster.

2. Choose your partner wisely

You probably already know there are multiple ways to get your startup funded. Besides different kinds of subsidies and acquisitions, you have various types of “investors”: VC’s, Business Angels, friends/families/fools, a wealthy retired entrepreneur, or even your college professor who saw potential in your PhD developments. Everyone with a healthy bank account could be a potential investor, basically. Nevertheless, all of them have different reasons for investment. So it’s crucial you understand your potential investors’ motivation before asking them to fund your company.

Let’s go back to our co-founders Tom and Sarah. Tom’s dad is a good friend of a retired entrepreneur. He believes in Tom’s product and wants to support his startup, but will be less interested in the return of his investment on a rather short period of time. On the other hand, Sarah has been in contact with a VC, also interested to invest in their startup. Typically, a venture capitalist already has an exit scenario in mind: invest, boost the business in 5 – max 10 – years and finally, sell his shares. If Tom and Sarah are aiming for a long-term partner, the VC might not be the best option. The retired entrepreneur could be a more suitable investor for Tom and Sarah if they are looking for a mentor and sounding board for the upcoming 20 years.

Another possibility for Tom and Sarah’s startup is a collaboration with a corporate. Corporates often invest in startups to get access to their innovative technologies and skills. The good part is that Tom and Sarah will immediately have a big market to sell to. The bad part is they could be limited to that specific market. They will, most likely, not be able to sell to the corporate’s competitors, which could be a deal breaker for the startup.

Which kind of investment are you looking for? Don’t just look for money, look for the added value the investor can offer you and make sure it fits your long term vision for the startup.

3. Focus on the size of the cake, not just your piece

This tip is closely related to the next one. Very often, founders of startups are fixated on the percentage of shares they want to keep for themselves. At first glance, it seems normal for every founder that the majority of the shares should stay in his/her control to manage the company.

Let’s turn the world upside down and say you’re an investor. Would you rather have 25% in Google shares, or 90% shares of a startup that just started 2 months ago?

4. Number of shares doesn’t equal amount of rights

Isn’t it dangerous, though, to give away the majority of your startup’s shares? The number of shares does not equal the amount of rights! Remember the shareholders’ agreement we talked about earlier? In the agreement shareholders define controlling rights, regardless of the number of shares one has in his/her power. In spite of the fact that in many cases ‘more shares’ means ‘more power’, you can create privileged shares with privileged rights.

In short, remember that there are 2 important rights linked to shares: controlling rights and  financial rights (dividends). In the shareholders’ agreement, you could privilege certain people with a smaller share by assigning them more controlling or financial rights. Imagine that Tom and Sarah have a third founder, Erik, the brain of the company. Without Erik, Tom and Sarah would never be able to run the startup successfully. Unfortunately, Erik doesn’t have the resources to invest as much as his co-founders. Tom, Sarah, and Erik could agree Erik only gets a small percentage of the shares, but remains a founder with a significant part of the controlling rights.

5. Once agreed, even verbally, there’s no turning back (or very difficult)

Tom and Sarah have finally found the right investor. Tom calls the VC to talk him through some numbers and, over the phone, Tom informs the VC he’ll probably have a saying in the startup’s Operations strategy. Even during a non-formal conversation, one should be very careful when expressing commitments and agreements. If Tom wants to go back on his promise, he will lose credibility and the VC’s trust. The negotiation process will slow down and we all know that’s not a best case scenario…

6. The devil is in the detail

When things get serious between you and the investor, lawyers will join the negotiation table. They will translate the agreements you make with the investor into term sheets with legal terms. Even though there is often mutual trust on both sides of the table, this is not the time to be ignorant of what’s being recorded on paper! Sometimes, words or even a comma can have big consequences in the interpretation of the term sheet. We strongly recommend you to have a lawyer by your side or have him/her read the terms before signing the deal.

Need some help setting up your term sheet or shareholders’ agreement?
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