Negotiating “timebomb” termsheets – By Deepak Srinath

(This piece was first published in VC Circle on Jan 17, 2012)

Fred Wilson of Union Square Ventures, the best VC blogger in my opinion, recently referred to a blog post on negotiating job offers (http://t.co/2MNZUIKZ) and said “replace the words “job offer” with “term sheet” in @spolsky’s post and the advice is still spot on”. What Fred is referring to here is the “exploding termsheet”, a commonly followed practice in which a VC issues a termsheet with a really short validity period – sometimes less than 24 hours. VC’s use this tactic to lock in deals and prevent entrepreneurs from shopping around for other offers. The intent may also be to prevent entrepreneurs from fully understanding implications of certain clauses not giving them enough time to negotiate. While this tactic invariably pisses off entrepreneurs, they succumb to it many a time because they do not want to risk losing out on the offer.

I actually believe this tactic can be detrimental to VC’s who want to invest in the best entrepreneurs. Let me illustrate with an anecdote – One of our clients was in advanced discussions with three funds for their first round of funding, lets call them funds A, B and C. Fund A was the first to move to termsheet stage and sent us a draft copy of their standard termsheet without any numbers and specifics. We received this at around 3 pm in the afternoon and we were told by the fund that if were fine with the broad terms, they would send us a copy with the numbers filled in by 6pm or 7 pm the same evening. However, the termsheet would expire by midnight on the same day and if were interested we needed to sign and send it across before that. We requested for a couple of days time to properly review the termsheet and negotiate terms. The fund declined and said that they did not like to have their termsheet floating around after they made an offer. We had to sign the same day or the offer would fall off. The entrepreneur politely declined the offer and walked away from the deal. To the entrepreneur, this was a clear indication of how his relationship with the fund would pan out and he did not want investors on his board who would hold a gun to his head and force decisions on him.

A few days after this, Fund B made an offer and sent us their termsheet, with all numbers filled in. Over the next couple of days, we negotiated various terms and arrived at a consensus on most of them. By this time, Fund C was also very close to making an offer and we naturally wanted to compare offers and make an informed decision. We decided to be completely transparent with Fund B and told them that we were expecting another offer and requested for a few days to make a decision. Fund B’s response to this was that they wanted the entrepreneur to make a decision based on what was best for him and did not believe in forcing him into a decision. They were happy to wait for us, but requested that we do not leave this hanging indefinitely.  We promised to give them our decision within two weeks. The offer we received from Fund C in a few days was marginally better than the offer from Fund B. However, the entrepreneur was so impressed with the way Fund B handled the negotiations that he was convinced they were the right people to be on his board and help him build a great company. We accepted the offer from Fund B with hardly any renegotiation and closed the deal within a month.

Looking at this from a fund’s perspective, I understand why VC’s try and push the “exploding termsheet”. However, I think they stand a much better chance of winning the deal by making the entrepreneur comfortable enough to be open and transparent with them. Most entrepreneurs don’t just decide on the basis on valuation or a few other terms. As long as the terms are fair, it is the comfort level with the funds partners that usually sways the decision. I agree that a termsheet cannot be open indefinitely, but the timelines need to be reasonable and fair to both sides.

My final piece of advice to entrepreneurs – Funds are not going to go back on an offer if you take an extra week or two to decide. Once a fund decides to make an offer, they want the deal as badly as you do. So do not succumb to pressure tactics and sign a termsheet unless you’re fully convinced about it. Being open and transparent works best (as with most situations in life). At the same time, be fair to the fund and respect their time too. The VC community is a small closely knit group and if you try and play one fund against they other, you’ll do your reputation more harm than good.

 

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The perils of taking seed money from VC funds – By Deepak Srinath

I met three interesting startup’s last week. All of them were founded by entrepreneurs in their late twenties or early thirties, who had been part of product teams in other startup’s or global tech firms. The startup’s were pre-revenue or had just signed up a few customers. Typically, in the Indian VC context, these firms would be considered too early by ‘early stage’ VC funds to do a Series A. They would be asked to come back in 6 months time when they had signed up more customers and had discernible revenue traction. However, to my surprise, all of them claimed to have termsheets or were in serious conversations with VC funds – not seed stage focused funds, but regular VC funds.  What’s even more surprising was that the quantum of funding they were offering ranged from $200K to $500K, not the usual $2 million plus that these funds like to invest.

A few top tier VC funds have started making investments in the realm of angels/seed stage funds. When a VC fund makes a seed type investment, they are essentially purchasing a low cost option to participate in a full round if the startup shapes up well. Unlike an angel investor or a seed fund, a VC fund’s economics don’t work on a  $200 K investment; their economics work on making much larger investments in each of their portfolio firms. So how does this matter to a startup as long as they get the money, right? Maybe not, let me explain.

In most cases when a VC fund makes a seed investment, they contractually tie in an option to lead the next round, which is typically in the $2 to $5 mil range. If the fund exercises this option, the startup loses out on talking to other funds and discovering the best possible valuation and terms. If the fund does not to exercise the option, other funds will be very wary to investing in the startup. Their view will be that if the fund who did the seed round and has an inside view of the startup does not want invest, surely there must be something amiss.

A few VC funds who make seed investments mention that they do not tie in an option on the next round for precisely this reason. Nevertheless, with or without a specific option to invest, if the fund does not participate for whatever reason, other VC’s will wonder what’s going on.

On the other hand when a startup takes money from an angel or seed stage fund, there is no expectation that they will participate in a follow on round. Their model is based on investing a small amount really early and guiding the startup through to a stage where they are ready for a VC fund to come in.

For long we’ve bemoaned the lack of adequate seed stage funding in India. This is clearly changing now with the more angel investors and seed stage funds springing up everyday. From an entrepreneur’s perspective, funding at every stage is critical. However, if entrepreneurs have alternatives, they must think carefully before taking seed money from a VC fund.

Internet Commerce Valuations: Pay for strong fundamentals, not for hype – Deepak Srinath

(This blog was first published on the VC Circle blog on 29 July 2011)

There is a raging debate in the US tech and financial media about the ‘tech bubble’ we apparently are in the midst of. Every journalist, blogger, VC and academic is either painting doomsday scenarios or vehemently denying there is a bubble. Either way, we’re seeing unprecedented valuations for social media and social commerce startup’s, both from VC’s and public markets.

US tech valuations seem to have had their affect on the Indian startup scene too. A few days ago The Economic Times carried an article on Snapdeal’s next round of funding – ‘sources close to the deal’ are quoted as saying that the deals site is raising INR 200 cr at a valuation of INR 1000 cr. Rumors are doing the rounds that Flipkart is raising its next round at a billion dollar valuation. If these valuations are halfway close to the truth, we’re talking multiples of 10 to 15 times their annualized run rate or Gross Merchandize Value-GMV (i.e., their current monthly sales multiplied by twelve). Are investors justified in paying such valuations? What about margins and net income, have they become irrelevant?

This debate about VC’s over paying for e-commerce startup’s is particularly important in the Indian startup context. VC funds in India, barring a handful, are still going through their first or second investment cycles and very few of them have seen big exits yet. Most early stage funds have significant exposure to e-commerce and need to show good exits in order to raise future funds. It may not be an exaggeration to say that the early stage ecosystem will suffer if VC’s have overpriced these investments and don’t make good returns.

I actually don’t think these valuations are as crazy as they are made out to be.

E-Commerce companies take a long time to become profitable. Amazon took seven years to turn in its first profitable quarter. Even today Amazon’s net income is small compared to Google or other tech giants. The market values Amazon (P/E of 82) for the kind of profitability it will deliver in future. If you take a closer look at investments in the internet commerce space in India, it is only the category leaders who command such valuation premiums. E-commerce worldwide is all about becoming the no. 1 or no. 2 player in a category and dominating it. So investors are essentially taking bets of firms who have demonstrated early traction and paying in anticipation of what they hope these companies will grow into in two or three years.

However, investors must be wary of paying valuation premiums based on GMV alone. GMV spikes can be achieved by deep discounts or cashback schemes and these will ultimately prove unsustainable unless you build loyalty and repeat purchases. Critical success factors in the long term are low Customer Acquisition Costs and high Customer Lifetime Value (CLV). Profitability will ensue if these two metrics are under control. Investors should be very careful not to pay for hype. As long as premiums are being paid for real fundamentals, all of us will be fine in the long run.

Observations on how good VC’s work – By Deepak Srinath

Two recent incidents prompted me to write this. The first was a VC meeting that left me super impressed- the fund partner had read through all the material we had sent him, analyzed data, made reference calls and asked the most perceptive and intelligent questions. What’s more, the meeting started exactly on time and even though he rejected the deal we were thankful for the insightful feedback. A few days later I was in another pitch to a couple of partners from a fund and one of them fell asleep- I’m not talking about a drowsy eyed yawn, this was chin on neck full on oblivion!! Maybe our pitch was boring, but that’s still no excuse.

The VC pitch phase can be a very jittery time for most entrepreneurs. VC’s become mythical gods who have the power to decide their destiny. As an i-banker I’ve had the opportunity to participate in pitches made to a lot of VC’s over the years. Every VC (the individual and the fund) has their own unique style of handling the pitching process and I’ve seen good, bad and the ugly. Here are a few reasons why I respect the VC’s I do-

1. They always value the entrepreneurs time – Anyone who’s gone through a pitching process is familiar with the ‘we’re running late on our previous meeting’ routine, especially when a VC from out of town has lined up 10 pitches in one day. A line that I’ve heard often enough is “what can be more important to the entrepreneur than pitching to us”. Good VC’s know how to plan their meetings and respect an entrepreneurs time.

2. They do meetings only if they’re really interested – Sometimes VC’s do meetings even when they know they’re not going to invest, maybe to gather information about a sector.  It’s easy to see through when there is no real intent to invest and entrepreneurs end up feeling very resentful.

3. Stay alert during meetings – It’s hard to sit through pitch after pitch and be excited about each one. Good VC’s have the ability to stay tuned in to every pitch they hear.

4.They do their prep – It’s always a great interaction when the VC understands the domain and has gone through the IM or done some background research. Their questions are so much more relevant and entrepreneurs appreciate it.

5. They respond to emails – Entrepreneurs hate it when they pitch to a VC and never hear back from them. Not responding to emails or calls after a meeting is inexcusable. No matter how busy you are, a one line email with a “sorry not interested, or I need a couple of weeks to think about it” helps the entrepreneur move forward.

6. They give candid feedback – Entrepreneurs always appreciate candid, constructive feedback and good VC’s know the art of doing this. Sometimes VC’s reject deals just based on gut feel or think that honest feedback will be too discouraging to the entrepreneur. Whatever it is, getting the right feedback is important for the entrepreneurs’ growth.

7. They engage, don’t dominate – Perhaps the most important skill of a good VC is the ability to engage and build an equitable, trusting relationship with the entrepreneur. This comes to the fore especially during term sheet negotiations. Too often VC’s hold a gun to the entrepreneur’s head and put them in a take it or leave it situation (and vice versa one may argue). If the rationale behind asking for certain terms is explained to the entrepreneur, the entrepreneur is more likely to agree to them (assuming the terms are not blatantly unreasonable).

I suspect VC’s who practice these traits will end being more successful investors, as the best entrepreneurs will prefer to partner with them.

 

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