Doing Deals in the New Decade: 7 Tips for Entrepreneursby Scott Edward Walker on January 20th, 2010
This post is a longer, more comprehensive version of the post I wrote a couple of weeks ago for VentureHacks, one of the best websites for startups, in which I recommended five New Year’s resolutions for entrepreneurs. Indeed, as I noted in that post, during my 15+ years as a corporate lawyer (including nearly eight years at two major law firms New York City), I have seen entrepreneurs make certain fundamental mistakes over and over again in connection with doing deals. So what better way to welcome in the new decade than to provide seven basic tips for entrepreneurs.
(Message to all of my female clients and readers: (i) the term “guys” includes “gals”; and (ii) in tip #6, you can decide what the term “balls” includes.)
Tip #1 – “Diligence the Guys on the Other Side of the Table”
Here’s the advice that I have written about often and give to all of my clients who are contemplating doing a financing: diligence the guys on the other side of the table. Indeed, this is the number one mistake I have seen entrepreneurs make in any dealmaking context. Remember, in financings and certain other deals (e.g., an acquisition by a private equity firm), you will, in effect, be married to those guys for a number of years. Accordingly, entrepreneurs must do what any bride or groom does prior to tying the knot – date for a while and, of course, meet the family.
What does this mean in practical terms? It means surfing the web and learning everything you can about the particular firm and, more importantly, the particular individuals with whom you are dealing; it means breaking bread and having a couple of beers with them; and it means getting references and talking to other entrepreneurs and founders who have done deals with them. Issues to address include: How have they treated their other portfolio companies? Are they good guys or jerks? Can they be counted-on and trusted? Will they add significant value (e.g., through contacts, domain expertise, etc.)?
There is an outstanding video discussion on Mixergy.com between Brandon Watson, a smart entrepreneur (currently at Microsoft), and Andrew Warner, the founder of Mixergy, as to what could happen if you don’t adequately diligence your investors. Brandon is extremely candid and discusses how he got “bullied” by his Board. Moreover, he expressly notes in the comments section of the post that: “The diligence factor was that I knew them, but had never taken money from them. It’s hard to know how people are going to react when they are at risk of losing money because of something you are directly responsible for until you are actually at that point.”
Tip #2 – “Check Your Emotions at the Door”
You have to think with your head, not with your heart – particularly when you’re doing deals. The best deal guys are masters at taking their emotions out of transactions and being extremely disciplined. They will just walk from a deal if they get out of their comfort zone (e.g., with respect to the price, risk profile, etc.) regardless of how much time and money they have expended.
Most entrepreneurs, on the other hand, become emotionally wedded to a particular transaction and are unable to maintain their objectivity the further along they get in the process. They get all excited as soon as someone waves some money at them and allow themselves to get drawn into the money guy’s web. It is critical that entrepreneurs understand this dynamic. Entrepreneurs will generally be negotiating with guys on the other side of the table who are far more deal savvy than they – e.g., venture capitalists, private equity guys, etc. – guys who are masters at playing on their emotions.
This is why it is so important for entrepreneurs to establish a game plan (i.e., dealbreakers) before the negotiating process begins and to have the discipline to stick to the plan and be willing to walk, if necessary. If an entrepreneur is seeking venture capital financing, for example, he should sit down with his transaction team before reaching out to the VC’s to establish his dealbreakers with respect to key terms, such as valuation, the liquidation preference, board composition, etc. The same approach should be followed if he’s interested in selling his company: What’s the lowest purchase price you’ll accept? What’s the highest cap on liability you’ll agree to? Will you agree to escrow part of the purchase price? If so, how much and for how long? Once you establish the dealbreakers early on, you can take your heart out of the equation and think with your head.
Tip #3 – “Create a Competitive Environment”
There is nothing that will give an entrepreneur more leverage in connection with any deal negotiation than a competitive environment (or the perception of same). Indeed, every investment banker worth his salt understands this simple proposition. Not only does competition validate a firm’s interest, but also it appeals to the human nature of the individuals involved. Competitors can be played-off of each other and, as a result, the entrepreneur will be able to strike the best possible deal.
I learned this important lesson as a young corporate associate in New York City. As I briefly discuss in my video post “Lesson Learned in the Trenches of Two Big NYC Law Firms,” I recall having two M&A transactions on my plate: one was a divestiture – i.e., the sale of a division of a multinational corporation being auctioned by an investment bank; and the other was the sale of a private company to a competitor (with no i-bankers involved). In both deals, my firm was representing the sellers, but as we worked our way through the negotiation process of each deal, we ended-up with two completely different acquisition agreements with respect to the material terms.
In the auctioned deal, because the i-banker was able to play the prospective buyers off of each other and create a competitive environment, the final agreement was extremely seller friendly and included broad materiality qualifications, a huge basket/deductible and a cap on seller’s liability of 10% of the purchase price. In the private-company transaction, however, there was only one prospective buyer — and the buyer’s principals knew that the seller was anxious to sell and thus were playing hardball. Accordingly, in that deal, the deal terms ended-up being extremely buyer friendly and included a large portion of the purchase price being escrowed and a cap on the seller’s liability equal to 100% of the purchase price.
The lesson learned, of course, is that you must create a competitive environment (or the perception of same) in order to have strong negotiating leverage. There is, however, one important caveat that entrepreneurs should keep in mind: this game must be played carefully and is better-handled by someone with experience. The last thing an entrepreneur wants is to end-up with no deal at all.
Tip #4 – “Be Careful with LOI’s”
A letter of intent (an “LOI”) — sometimes referred to as a term sheet or memorandum of understanding — is often executed in connection with all types of deals. The entrepreneur must understand that, depending on the deal and the context, there are different LOI strategies and considerations that must be addressed. For example, in the acquisition context, a selling entrepreneur should try to negotiate all of the material terms of the deal in an LOI because it is at this point in time when his negotiating leverage is the strongest (see #5 of my post “Selling a Company: Ten Tips for Entrepreneurs”); on the other hand, a buying entrepreneur’s main goal with respect to an LOI is merely to lock-up the seller and prohibit it from shopping the deal for a reasonable period of time – his negotiating leverage is strongest after the LOI has been executed (see #1 and #2 of my post “Buying a Business: Ten Tips for Entrepreneurs“).
Another major concern with respect to LOI’s is that they may be deemed enforceable by a court of law (i.e., be deemed to be a binding agreement), despite language in the LOI to the contrary. This issue often arises when entrepreneurs play lawyer — and draft and execute LOI’s without having them vetted by legal counsel. Indeed, I represented an entrepreneur a few years ago who not only executed a LOI that he drafted in connection with an acquisition (he said it was “too small to run by me”), but also took the principal on the other side out to dinner and drinks to celebrate. When my client refused to close the deal a couple of months later due to a significant diligence issue, the principal threatened to sue claiming they had agreed to a deal. I was left in the awkward position of explaining to my client that as a result of the express language in the LOI and his actions subsequent to its execution, a Court was likely to agree with the principal’s position. Accordingly, he ended-up settling the matter by agreeing to pay the target’s legal and other expenses. Lesson hopefully learned.
Tip #5 – Watch-out for the “Good-Cop, Bad-Cop” Routine
Experienced deals guys (such as private equity guys and venture capitalists) employ all kinds of negotiating games. One of their favorites is the “good-cop, bad-cop” routine. Here’s how it works: The deal guy plays the good cop and is smooth, friendly and agreeable; he makes the entrepreneur feel like all of his important issues are being taken care of. But then the documents arrive — chock full of bells and whistles and boilerplate provisions designed to protect the deal guy’s firm/company and often with significant gaps on the deal points. When the deal guy is questioned by the entrepreneur as to what’s going on here, the answer, of course, is “it’s my lawyer’s fault” (i.e., the “bad cop”). This game will continue throughout the negotiating process as the deal guy charms the entrepreneur while his lawyers pound away on every significant issue.
How do I know this? Because prior to launching my own firm specializing in the representation of entrepreneurs, I represented a number of private equity firms (both in New York City and Los Angeles) and have played this game many times. One deal sticks-out in particular — and I remember it vividly because the private equity guy was a master. He was a charming, good looking guy; and the target’s CEO was a woman, who appeared to become smitten with him. Needless to say, this made my job as “bad cop” very easy. When the target’s lawyer complained about all the draconian, pro-buyer provisions in the acquisition agreement, the private equity guy was able to convince the CEO that this is the form agreement he uses for all his deals and that he has certain fiduciary obligations to his investors. As a result, we ended-up with extremely favorable pro-buyer terms, including a “diligence out” and no cap on the target’s or the shareholders’ liability.
Tip #6 – “Work Your Balls Off”
This is the advice a senior partner gave me when I was a young corporate associate at a major New York City law firm: “if you want to be a great lawyer, you have to work your balls off and make the practice the law the number one priority in your life.” He explained that this means everything else in your life has to be pushed aside, and you need to “work, work, work.” And when you’re not working, he added, you need to be reading treatises and articles discussing the deals you are working on to get a deeper understanding of the significant issues. When I explained to him that, after three months, I had been working nearly every weekend and that my girlfriend was ready to leave me. He told me that I need to get a new girlfriend.
I received similar advice from Harry Hopman, my old tennis coach (and the winningest coach in Davis Cup history), when I was playing tennis in the minor leagues after college. He preached to me that: “It all comes down to one word — desire. How badly do you want it? How much are you willing to sacrifice?” And he was right. When I was traveling around and playing tournaments in Europe and South America, I noticed that the best tennis players were generally the hardest working; the qualifiers were the ones going out drinking every night, not the top seeds. Sure there were exceptions – like John McEnroe – but the exceptions were rare.
I have seen this same pattern during my legal career: the most successful clients tend to be the hardest working. Indeed, the private equity guys and hedge fund guys I represented in New York City were animals; working around the clock and cranking out deal after deal. I attribute a lot of their success to just plain hard work. In 2005, I moved out here to California to help entrepreneurs, and it’s been a mixed bag in terms of the work habits that I’ve seen. Some of my clients are intense and put in the long hours; others, however, are just dreamers — and they are the ones who struggle. In short, there are no shortcuts to success.
Tip #7 – “Retain a Strong, Experienced Lawyer to Watch Your Back”
This is obviously a bit self-serving, but every entrepreneur needs a strong, experienced lawyer to watch his back. There is just too much at stake for entrepreneurs to be (i) utilizing sites like LegalZoom or (ii) pulling forms off of the web and trying to play lawyer or (iii) retaining the cheapest lawyer to save money. Moreover, as the Madoff affair and other recent high-profile cases demonstrate, there are a lot of unscrupulous characters out there trying to take advantage of unsophisticated entrepreneurs.
There are also more subtle potential problems from which entrepreneurs need to be protected, including the inherent conflict of interest that certain service providers have. For example, entrepreneurs need to be careful with investment bankers, who generally only get paid if a particular deal closes. Indeed, a middle-market i-banker’s entire year can be made or broken based on whether or not he can close one or two deals.
Unfortunately, I experienced this issue first-hand shortly after moving to California when I got pulled onto an M&A deal in which an i-banker stuck his finger in my chest and warned: “We’re going to get this deal done despite you f-ck’n lawyers.” He then later complained to the managing partner (who had the client relationship) that I was blowing-up the deal because I had retained special environmental counsel from my old NYC law firm and we were pushing too hard on the environmental indemnity. Good work by the i-banker (and cheers to my former managing partner) for getting the deal closed by watering down the environmental indemnity: less than six months later our client’s company was indicted for environmental problems that it inherited as part of the acquisition.
The bottom line is that a strong, experienced corporate lawyer will sober the entrepreneur and lay-out all of the significant legal risks in a particular transaction; he will then push hard to negotiate reasonable protections. If the deal sours and lawsuits are filed, well-drafted documents with appropriate protections become a kind of insurance policy to the entrepreneur.
I hope the foregoing is helpful to entrepreneurs. I have previously covered some of these tips in both video and written format, but I tried to spice them up a little with a few war stories and a little colorful language. Cheers, Scott