Mastering LP Co-Investment Term Negotiation: Tactics for a Win-Win Outcome
Within the fast-paced arena of venture capital, negotiating the Limited Partner (LP) co-investment terms and conditions can be a critical inflection point that has lasting implications both for you as the investor, and for the startup. As an LP, you are doing more than providing capital; you want operational alignment and reasonable terms, which will lead to favorable terms that help create the right conditions for reasonably good returns for your investment. The tactical agreements of co-investment term sheets can be nuanced. It is our hope that the discussion in this guest blog will give you the courage to engage in the messy negotiations with co-investors, and provide you with a way to consider the intricacies of co-investor negotiations involving your investment.
The Alluring Hook: Why Term Sheet Negotiation Matters
Picture this: you've found a hot startup with a brilliant concept and a great team. You see the potential for big returns. You also see the risk involved. That term sheet everyone marks down to be a mere formality, is actually a strategic move. It's a document containing the terms and conditions under which you are going to co-invest. Getting that right, may mean the difference between a profitable opportunity vs. a misfortune.
Pain Points: Common Challenges in Term Sheet Negotiation
Differences in Valuation: Differences in valuation often occur when valuing the worth of the startup. Often, the founders and investors reach very different conclusions when arriving at a value for the company. This can lead to lengthy negotiations, and may even become impasses that scuttle the deal.
Control Issues: Investors often want to have control over important company decisions through board seats, or notice when certain matters that allow investors the opportunity to veto accrual.This is often a sticky point because founders want to keep control and have the ability to run the company with their vision.
Liquidation Preferences: Investors want to protect themselves if a company sells or is liquidated. Unfortunately, liquidation preferences that are too rich can have a dilutive effect on the returns to other stakeholders.
Anti-Dilution: Anti-dilution clauses are intended to protect investors against further rounds of financing that could dilute their shares. They can oftentimes be extremely complicated and if not structured correctly can lead to friction.
Analysis: Key Strategies for Effective Negotiation
Valuation Techniques: Knowing and using different types of valuation techniques like Discounted Cash Flow (DCF), Comparable Company Analysis (CCA), and Precedent Transactions, provide a necessary foundation for negotiation. All methods have advantages and disadvantages, knowing when to use them can be critical.
Board Structure: Negotiating an equitable board structure (such as 2-1 structure - two founders, one investor) can provide investors necessary oversight, while maintaining some level of business harmony.
Liquidation Preferences: Aim for 1x non-participating liquidation preference. This will help protect the investor while not stringently penalizing the other parties' interests.
Anti-Dilution Provisions: Choose broad based weighted average anti-dilution provisions. This will protect the lender while not too harshly penalizing founders and future investors.
Depth Understanding: The Art of Negotiation
Negotiating acceptance of a term sheet is not only a matter of numbers; it is a process of relationship building. Successful negotiations involve an understanding of market conditions and the potential of the startup and the terms that an investor may favour. Here are some of the more advanced and/or useful strategies you can use when negotiating a term sheet:
Scenario Planning: Create scenarios for several outcomes, so that you are prepared to anticipate counterarguments and have alternatives to the negotiation process.
You Are Not Alone: Hire legal counsel and financial advisors, who specialize in the venture capital marketplace. Their expertise and aeronautical view can be valuable as you develop your negotiation strategy
Know Your Priorities: Be clear on your deal breakers (specific terms that you need and cannot change) and those areas where you can be flexible. This includes knowing which terms can become a point of focus for negotiation.
Be Collaborative: Treat negotiations as a collaborative process vs. a permission seeking process. A collaborative approach encourages relationship-building negotiations, and a mutual respect development, which often leads to a better yield for everyone involved.
How Evolve Venture Capital Can Help
Evolve Venture Capital is ideally suited for the nuances, complexities, and alternatives of LP co-investment term negotiation. Our experiences enable us to have the unique opportunity to become a successful advisor to our LP clients. We provide:
Expert Advice: Experts do not provide advice that is generally applicable to each investor's individual situation, preferences, or needs.
Market Intelligence: We provide information that allows the investor to enter the negotiation process fully informed about the most up-to-date trends in the market, relevant valuation methodologies, and effective negotiation techniques.
Strategic Assistance: We help the investor plan what provisions are of utmost importance, critically think through the best approach to negotiations, and build relationships with start-ups.
Legal and Financial Support: We have a wide-ranging network of legal and financial talent that evaluates and tweaks any aspect of the term sheet you would like.
In summary, negotiating LP co-investment terms is a learned skill that you can use to improve your investment results. When strategic tactics, relevant experienced team members, and collaborative attitudes are present, a negotiating process can be had with less friction and better outcomes. Evolve Venture Capital supports you and ensures that your investments are both financially responsible and strategically aligned with your big picture objectives!
