Spelling Out Your Funding Terms

Negotiating a VC investment can be tricky. So does it pay to spell out your terms to potential investors from the get-go?
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6 min read

This story appears in the March 2006 issue of Entrepreneur. Subscribe »

In 1995, Pamela Marrone set out to save the planet-which, as she soon learned, can be very expensive. Marrone, 49, founder and president of AgraQuest, raised over $60 million to develop and market her company's line of environmentally sound agricultural biopesticides. Along the way, she learned valuable lessons about what works and what doesn't during investment negotiations.

These days, Marrone laughs when she recalls the trials and tribulations of negotiating eight different rounds of capital with more than 70 different shareholders, including VCs, customers, angels, agribusinesses, friends and family. "We've gotten money from everywhere," she says. "We've raised a round of capital every year." As a result, her process of turning interested investors into paying shareholders is well-refined.

Nothing about Marrone or her company seems conventional, so it's not surprising that the way she goes about raising capital is also out of the ordinary. What sets Marrone apart, and perhaps what makes her so successful, is how she uses the term sheet within the negotiation process.

Give or Take
In most negotiations, the potential investors list their expectations or demands, which become the terms of the deal they're offering. This list, or term sheet, sets a starting point for negotiations and is the basis for writing the legal investment documents. "A term sheet is an expression of interest on the part of the investor to invest. It's not an obligation or binding contract to invest," says Todd Pietri, general partner at Milestone Venture Partners in New York City. But that assumes that a cash-hungry business can wait for an interested investor to get serious enough to write a term sheet. Many potential investors, of course, never do.

Marrone says AgraQuest's revenue passed the $10 million mark in 2005 and the company is growing too fast to wait around for term sheets. Instead, she neatly turns the tables and offers prospective investors her own terms. That bold strategy has the dual advantage of speeding up the process and weeding out investors who are less serious about writing checks.

Is there really a shortcut to raising $60 million? Maybe not in the opinion of many sophisticated investors, says Pietri. "We discourage the entrepreneur from creating a formal term sheet," he says. "[The investor will] create what's fair and reflects the value."

The Price Is Right
But the question of what's fair is exactly what's at stake. For Marrone, her term sheet quickly and clearly spells out the value--or at least the price--of AgraQuest stock. That, she says, is one of the first ways to identify investors who are looking for unfair, bargain-basement valuations. "Their first response is usually 'Your valuation's way too high'--so that's where you flush them out," she says.

Looking at the process from the opposite side of the negotiating table, Johan Pontin, founding partner of Boston-based VC fund Pod Holding, says that strategy can backfire. "If the first thing the entrepreneur starts talking about is valuation, there are few things that are more of a turnoff."

"On the other hand," admits Pontin, "if [the entrepreneur is] totally nuts in that area, you do want to find out early so you don't waste anybody's time."

Pontin says personal values are really more important than stock valuation. He compares the negotiation process to dating. "The first thing you talk about is not marriage. You figure out where you are in terms of value systems, and then you go from there," he says. "Valuation comes up in the second meeting or so."

What's New
Term sheets contain more than prices, of course. Experienced negotiators use the term sheet to specify other expectations, like who sits on the company's board and what happens if the company goes bankrupt. These terms tend to depend as much on the risks of the individual company as on the larger macroeconomic environment. During the boom days of 2000, for example, entrepreneurs often dictated most of the terms with little objection from deal-starved (and cash-rich) investors. These days, investors are asking for--and receiving--much more generous terms.

"Terms are very dependent on market conditions; that's something I didn't expect," says Marrone. "Entrepreneurs need to know what's going on around them. Otherwise, they won't negotiate the best terms." Marrone looks to other deals in the biotech market for examples of terms, including valuation and stockholder rights.

Stockholder rights is a broad category that covers how the investment will be treated in both good times and bad. Stock can be "common," which is what the founders typically hold, or "preferred," which gives investors extra protection from loss. "Participating preferred [stock] is something we insist upon," says Pietri, "as is a board seat for the investor group." Don't let the jargon fool you: "Participating preferred stock" means investors not only get their money back before you do (in case of bankruptcy), but they also enjoy the upside of an IPO or other cash-out event. Think of it as letting your investors have their cake and eat it, too.

In uncertain economic times, participating preferred stock can be just the beginning of investor demands. Antidilution terms, or "ratchets," let an investor take additional stock from the company at no charge if future stock is ever sold at a price below what the investor originally paid. In other words, the investor's buy price is "ratcheted down" to the new, lower price.

Check Your Ego
These days, ratchets are less common and more lenient. Thanks to stronger economic conditions and a growing pool of venture capital, entrepreneurs are regaining some of their power in negotiations. Likewise, investors have learned valuable lessons over the past five years and are starting to consider more qualitative issues.

Looking long term, "the deal is just 10 percent," says Pontin. "Eighty percent is what you do in the company, and 10 percent is getting out of it. So I'm not overly concerned about deal mechanics." Pontin, like many full-time investors, says the best investments rest on a foundation of good personal chemistry. If the management team and the investor team don't get along, the investment is unlikely to have a positive result, he says.

On that issue, Marrone is in step with the investment community. The single most important factor in closing an investment deal, she says, is to keep a level head. "There are a lot of entrepreneurs who get indignant about the process," she says. "But you've got to be pragmatic--put your ego aside, and get the money in the door."

David Worrell is author of the e-book Finding Funding.

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