DEALMAKING 101: THREE TIPS FOR FOUNDERS

by Scott Edward Walker on September 1st, 2019

Introduction

I’ve been doing deals as a corporate lawyer for 20+ years.  For nearly eight of those years I worked at two prominent law firms in New York City, where I mostly handled major M&A transactions.  For the bulk of my legal career, I have been representing startups and emerging-growth companies in seed financings, venture capital financings, mergers and acquisitions, and other transactions.  Based on the foregoing experience, I am providing three basic tips to founders in connection with doing deals.

Tip #1 – Create a Competitive Environment

There is nothing that will give a founder more leverage in connection with any deal negotiation than creating a competitive environment.  Whether you are doing a seed financing, a venture capital financing or an M&A transaction, you have to create a competitive environment (or make the party on the other side of the table think there is competition).  Indeed, as Paul Graham, the co-founder of Y Combinator, wrote nearly 15 years ago in his post “How To Fund a Startup”:

With both investors and acquirers, the only leverage you have is competition.  If an investor knows you have other investors lined up, he’ll be a lot more eager to close — and not just because he’ll worry about losing the deal, but because if other investors are interested, you must be worth investing in.  It’s the same with acquisitions.  No one wants to buy you till someone else wants to buy you, and then everyone wants to buy you.”

The biggest mistake I see founders make – and this happens all the time – is that they negotiate with only one potential investor or one potential acquirer, and the term sheet ends-up being extremely one-sided and unfavorable to the startup.  Founders must understand that it is virtually impossible to negotiate with just one party that has all the leverage (i.e., the money).  Remember the golden rule: he who has the money makes the rules; and the only way to break the golden rule is to get several potential investors or acquirors interested in your startup.  I know that’s not easy to do, but that’s what separates the great entrepreneurs from everyone else.

Tip #2 – Don’t Be Anxious/Desperate

Most founders get very excited when they receive a term sheet for a financing or an acquisition.  They should: it is exciting.  But what founders must understand is that, in baseball parlance, this is merely the first inning of a nine-inning game.  Every experienced deal practitioner knows that a deal is a game, and there is a lot of skill that goes into the game.  Unfortunately, most founders have rarely played the game, and the guy on the other side of the table (like a VC) is usually quite skilled and experienced.

One skill that’s important in the dealmaking game is holding your cards close to your chest.  You don’t want to come across as anxious or desperate; otherwise, the guy on the other side of the table will try to take advantage of you and squeeze you on the significant terms.  Like the pretty girl in high school, you want to play hard to get.  You want the other party to think that he is only one of a handful of suitors, and thus he must improve the terms (e.g., increase the valuation in a financing or increase the purchase price in an M&A transaction).

You can see how tip #1 and tip #2 are related because if you have a number of interested parties, you are less likely to come across as anxious or desperate.  There is an old saying in the deal world: whoever wants the deal least has the most leverage. (Note: this does not mean that you do not want to try to create a sense of urgency with respect to closing — which I will discuss in a future post.)  

Tip #3 – Watch-out for the “Good-Cop, Bad-Cop” Routine

VC’s, private equity guys and corporate development guys employ all kinds of negotiating techniques.  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 founder feel like all of his important issues are being taken care of.  But then the legal documents arrive — chock full of bells and whistles and significant gaps on the agreed-upon deal points.  When the deal guy is questioned by the founder as to what’s going on here, the answer, of course, is “it’s my lawyer’s fault” (i.e., the “bad cop”).  This routine will continue throughout the negotiating process as the deal guy charms the founder while his lawyers pound away on every significant issue.

How do I know this?  Because I represented a number of private equity firms in New York City and 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/stockholders’ liability (both of which are relatively unusual).

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