44. Negotiating a Term Sheet (Jason Heltzer)

Nick: Fourteen year veteran of Venture Capital #Jason Heltzer joins us today in Chicago. Jason is a partner at #Origin ventures, a professor at Chicago’s Booth School of Business and has a great blog over at Ventureevolved.com. Jason, thanks so much for spending your time with us today.

Jason: Nick, it’s great to be here.

Nick: Can you start us off with how you got into sort of investing and how you got into Venture Capital?

Jason: Sure. I you know, really been involved in technology my whole life. Taught myself how to program when I was thirteen years old and really been coding and involved in technology since that point. I’ve always been fascinated with finance after my undergrad is in computer science at Michigan, “Go blue” and I was always interested in finance and decided at some point that I wanted to go back to business school. So I went to Booth and I learned a lot more about finance and about a lot of other careers. I had really been a software engineer up until that point. You know, business schools a very important pivotal moment for me because I learned a couple of things about myself personally. I learned that I like to be the underdog. I always knew I liked building things. I was always a tinkerer. I also realized in business school that I like betting on myself; that’s when I perform the best. I’ve always loved learning and I like small teams. I come from a very large company and realize to all of the things I didn’t like about the and when I got to business school I’d worked in San Francisco at a startup for a little bit a. And I realize all these things about myself and realize that venture capital would be a great place where they’d be a lot of variety, a lot of learning, still stay true to my technology roots get involved in finance and obviously building and being in a startup and backing startups that’s a true underdog business and for all those reasons I pursued venture capital and. I would say I got very, very lucky that I got an internship in business school and have been doing it since.

Nick: So are you excited about the Harbaugh higher? I gotta ask.

Jason: I think the expectations are too high. I am very excited. We’ll have to see.

Nick: Yeah, he’s making quite a stir there so far it’s interesting.

Jason: That for sure we knew we were going to get that no matter what. Now, Michigan fans expect wins and they expect wins fairly quickly, have high expectations so we’ll see. I think it’s going to be… There certainly won’t be organ rejection like there’s been with other coaches who are not from Michigan but I do think he’s got a great shot and he certainly has a great track record so I’m excited.

Nick: I know standard of excellence is high so, good luck with that one.

Jason: Thank you.

Nick: Getting into the topic today.., we’re talking negotiation and negotiating a fund rise. I know you’ve written about it in the past and you’ve had your own ups and downs with regards to negotiation. So can you first talk about why you chose to write and address this topic with both your students and also on the blog?

Jason: I got to be in the negotiations in business school and I think part of that is just my own desire to prove that Professor wrong but more seriously, especially coming from an engineering background I think for a lot of people negotiations is a very mysterious thing. People shy away from it. They don’t like it. Like I enjoy buying a car. A lot of people don’t like that experience in the negotiation but I savor that and I wouldn’t say that when I was younger and in a different career. So given the fact that a lot of founders are engineers you know, I wanted to give some pointers. It’s not a mystery. It’s something that you can do regardless of your background and so I wanted to help people understand what it’s like to negotiate because I’ve, to be honest if I’m negotiating a deal, I’d rather be across the table from someone’s a good negotiator. He just goes better that way, the results are better that way and as you start a partnership with an entrepreneur, it’s just… it works better when someone knows how to negotiate. When you have a lousy negotiator, i can be pretty excruciating process and so I think for all those reasons I wanted to write about it.

Nick: Maybe you’ve gotten a little bit better since you got that ‘B’ in business school.

Jason: Maybe… I did blow off the final paper to focus on my entrepreneurial finance class which I got a better grade in. So I guess in the end it was a good idea but my wife pays the biggest penalty for that because I negotiate so many things now again maybe only to prove to myself that I didn’t deserve a ‘B’.

Nick: All right! So as you’ve outlined in the past one of the first things to understand is whether a negotiation is asymmetric or not. What does this mean and why is a negotiation foregone if the leverage is imbalanced?

Jason: You know the old adage of ‘You really can’t go into into a negotiation unless you’re willing to walk away’ is another expression, another way to express leverage and the ability to walk away from a deal or forward a negotiated agreement and walk away. When you have a great imbalance of leverage one side or the other has a lot of power, it’s not as much of a negotiation. If you go back to economics too, when you’re trying to buy a ticket for a Black Hawks game in the Stanley Cup, I mean you’re pretty much a price taker. You’re going to take whatever the market is going to spit back out at you and in a negotiation you know that balance, it’s not supply and demand but that balance becomes really important to see where the pricing, let’s put it all the terms and the category pricing comes out and so when you have an imbalance of power one group can just dictate what the terms are going to be and there isn’t a lot of back and forth. A negotiation really to me is the art of trying to understand each other’s goals and to try to customize a solution. Take all the puzzle pieces and figure out how they fit together. To me and this is a function of my background too, I look at as an engineering exercise, understanding what are all the constraints and what are the possible solutions.

Nick: Yeah, your example before about buying a car, I was thinking that a lot of people hate that experience but in all honesty I think it is an asymmetric negotiation where you as the buyer have more power because you can always walk out and go to a different dealership.

Jason: Right. I actually have a thing on my blog under random about how to buy a car which is…

Nick: Really?

Jason: Yeah.

Nick: I gotta read that.

Jason: …It’s a new car. It’s not good for used cars but I guess you’re right. I mean if you think about that though, they’re excellent negotiators for the product that they’re selling but few people realize that what they’re selling is a commodity. Everything the car companies try to do when the options are designed to create a commodity and your right. Buyers have a lot of power but they’re so intimidated by the expertise in by the mystery that’s introduced that it does feel a symmetric and it really isn’t. Part of is just understanding and obtaining the information about the pricing of a car. If you’re able to do that as a consumer, you can win. So you can read more about that in the blog but I do enjoy buying cars.

Nick: I will check out that link and I will link it up in the show notes but Jason, before we get into strategies and tactics for negotiation, can you first highlight the top three to five areas that are most often negotiated on a term sheet?

Jason: All be Captain Obvious here for a second and you know. Evaluation is the biggest. It’s the one that has a pretty big impact on both sides that are negotiating and that’s one. Two iss founder vesting tends to be a pretty sensitive topic for founders. I can understand that and I’d would say the last is control provisions you know. How decisions are made, what decisions are made by the board, what’s made by shareholders, how does the board operate, who decides when to sell the company, all those things and understandably are pretty important to either side and those are the areas we see negotiated most frequently.

Nick: Why do you think founder vesting is always such a focus area? When I had #Brad Feld on the program, he talked about how often in most cases it’s favorable to the founders because of somebody self selected out then the ones that stick around they can retain their ownership and grow it without sacrificing dead cap space on on the captive 7:33 (unclear). Why do you think that’s always such a sticking point?

Jason: I think it’s an emotional thing and I understand this you know. When you have an entrepreneur whose bootstrap the business who’s invested a lot both dollars, emotionally everything into a company, the concept that after an investment that’s made that all the sudden three years, five years however much time has been put into it now “doesn’t count.” That you know, you’ve got to start earning that back again. I can see it’s discordant with a lot of the passion that entrepreneurs are out there.

Nick: True.

Jason: You know from the investor perspective, we often especially the stage that Origen operates, we’re backing entrepreneurs are very early and a lot of it is about the company in the idea and the traction and the product but so much of it is dependent on the person and if their commitment isn’t there, we want to know what the term sheet stage and when you bring up founder vesting and how a founder reacts to that can be a very telling thing and Brad’s totally right because if you have a multi founder business, when you’re doing the deal and everything’s great and your financing is getting done, founders aren’t as good to think about the perception of

the future of all the different possibilities that can happen and what if a founder leaves and how that might affect them and be advantageous to them, it could be a really, really important detail. So again you know it all comes down to, “Hey, we’re both committing to each other as partners, group of entrepreneurs and group of investors. Let’s demonstrate that in a way with founder vesting.”

Nick: So price control provisions vesting some of the most commonly negotiated things. How about on the other side? What are some of the elements that are typically not negotiated but should probably be a part of the discussion?

Jason: I think entrepreneurs should really strive to understand all aspects of a term sheet. Not just by reading the language but understanding what are the implications of these terms and not just the company today but in the future around and in exit when the company is three, five years from now. It’s really important understand. Now Brad Feld book Venture deals is a great reference to really understand term sheets deeply. There’s no replacement for having gone through a deal yourself of course and not just negotiate a term sheet but how things play out and really going back to the legal docs and understand the dynamics but Brad’s book is a really great start to that. And so I would say in terms of what you should negotiate, well you really need to understand everything. I think there are certain areas like.”The right of first refusal order” for example. If someone is selling shares, is it the company that has the right first to buy those shares or is it another investor where an investor can gain more voting power on a cap table? Those the kind of things that tend not to get a lot of attention in a negotiation but are things that might have some important implications for a company down the road. You know, I think that’s a point the term you should just bring some of these important terms to bear and make sure there’s an understanding on both sides because you know there’s a lot of detail behind all these things and I just say rowfer is one of those areas I think there should be a little bit more attention on but naturally there’s a whole category of kind of a secondary terms that I’m just and encouraging entrepreneurs to think about more carefully all of them.

Nick: You know part of what makes this program unique is I interview investors only, Investors and experts but I have heard a lot of suggestions from folks that would like to bring experience entrepreneurs that have maybe seen a fundraiser into Series B. C. D.. Who have experienced some of the blowback of maybe not focusing on certain terms only? It would be interesting to get some of those folks on and see what they have to say about key provisions that they wish they would have had in focus early on.

Jason: Yeah.

Nick: So, Jason if valuation is the key element that the entrepreneur is focused on, what other elements do you negotiate on to counterbalance evaluation that may be above market?

Jason: To me there’s an opportunity that arises in a negotiation of a term sheet where there are different perceptions of risk or there’s different risk tolerance on either side. If you think about valuation it’s really about the upside in capturing the upside in an investment for both investment on the investor obviously in the sweat equity earn from a founder. If you think about balancing value in a deal you know, there are a lot of different levers. You’ve got obviously valuation. You have to liquidation preference and the structure of the security. Is it fully participating? Is a participating with the cap? Is it nonparticipating? You have dividends, you’ve got option pools at

pre or post. How large is it? You have anti dilution provisions. You know there are different structures you can do with the warrants. There’s a lot of different things you can do and to me sophisticated investors both investors and founders look at value holistically. It’s very easy to get stuck on the pre money valuation and it’s the number that gets reported in media outlets. It’s the number you tell people at a cocktail party and it can be exciting. No one goes to a cocktail party and says, “Oh yeah but my option pools is post money?” You know no one says that and no one says you know, “… but my dividends are you know only X. percent…” It’s too complicated to explain it’s not as easy to put in a headline and I think for as a result of that you see more focus on valuation but to me great investors and great negotiators as founders think about value holistically and I think as I said before there’s an opportunity arises in perception and oftentimes investors are thinking more about downside than entrepreneurs. You know, entrepreneurs by the nature of very optimistic and so that’s why you also see them focus on valuation.

So I think a lot of the opportunity comes when you can “buy as an investor buy” more downside in the form of a liquidation preference or warrants in various other structures by trading some of the upside. Now it’s never one for one thing because liquidation preferences in my mind are more often negotiated away in future rounds than valuation is because liquidation preferences of crew to investors only. Valuation accrues to all previous shareholders. So when a new round comes together and they want to change things up, it’s much easier to change the liquidation preference down than it is valuation because you have fewer people arguing against it. Founders love when liquidation preferences get eliminated because that’s less layers of sediment on top of them one on top of their common stock.

Nick: Sure.

Jason: So to me as you make these trades as an investor you have to think about the probability weighted value of them because they don’t always get paid the often get negotiate away and we all know too that it’s fairly common for those liquidation promise not to be paid in certain circumstances like large exits, IPOs etc… So again you have to think about valuation holistically. You can make these trades. You have to think really hard about what value you’re trading because it’s not always what it seems.

Nick: We’ve had a few different folks come on the program to talk about valuation and it seems like there’s a couple schools of thought on how to approach it. There are some that think of it kind of as an art and more of a dance on all these terms and valuation and clearly there’s others that have a decision model and a spreadsheet with all these different factors and it’s very much a financial exercise for them. Do you subscribe to one of these schools of thought?

Jason: You know, I subscribe to both you know. I think you because it’s a hard thing to do an early stage business is you know, you use the math to calibrate your thinking. You also use your intuition in comparison to other deals that are similar  and in the end you’re looking at the risk versus the reward and then after you do all that analysis you also recognise that you’re operating in a market and sometimes markets are very competitive, sometimes they’re very noncompetitive and so you know, you do all that work and then you realize if you want to win a deal there might be certain sacrifices you have to make and you might have to depart from some of the analytical underpinnings that you’ve done. I think that in general in origin we have really good discipline and so we don’t depart too far from the analytical underpinnings but we also know that in certain big wins of ours like #GrubHub for example, #Dialogue Tech and others

where we push hard for valuation but in the end it was about getting in the deal and it wasn’t so much about whether the evaluation moved a half a million here or there and so you know, all of those things are factors that are inputs into a decision about valuation.

Nick: So you’ve highlighted the characteristics of strong negotiators before. Do you mind touching on a few of the key items and give an example of a well executed negotiation?

Jason: Let me first say that negotiations very personal exercise. It is a lot about your style. My style is a certain way of negotiating that’s effective for me. The advice or perspective I’ll give here may not be appropriate for everybody given the way they negotiate or the kinds of investments they make and sure, that’s an important disclaimer to make. I think strong negotiators are very good listeners and they seek to understand not only their goals but the goal of, I don’t want to use the adversaries but the people on the other side of the table and to me going back to my metaphor, it’s an engineering puzzle. If you don’t know what you’re trying to solve for it’s very, very difficult to have a successful outcome. I think also strong negotiators look for trades. They look for differences in perspectives or differences in way people value things and they look for trades where you can create value on both sides. The best example I have for this is monopoly where I think a lot of people are negotiating hard for the first time and I was an older brother of three and so I was just trying to muscle my brothers right in just saying, “No! Seriously give me this monopoly. It’s a good idea for you” but in general that doesn’t really work and you have to respect the people who are on the other side and try to find ways where you can make these trades and so using the monopoly analogy you know, if I give you a monopoly and you give me a monopoly that’s something that can create a lot of value on both sides. Like I said with valuation where you trade upside for downside. When an entrepreneur might have a view of an optimistic upside and you might have a more sceptical view of the ability of the company to reach escape velocity, that’s an opportunity for you to trade value and come out with a better agreement. I think great negotiators are creative. They listen a lot more than they talk. You know because to me it’s again it’s about seeking and understanding the constraints that exist to get a better solution.

Nick: Jason you’ve also called out some of the mistakes made by lousy negotiators. What are some of those common pitfalls that you’ve come across?

Jason: The classic one is people who are position oriented versus principle oriented. There’s two great books, Getting to Yes and Getting past No which are great books for negotiation and they talk a lot about this. Where you’re stuck on a number. You’re stuck on, “I wanted to be this way” and not on the ultimate goal of what you’re trying to accomplish. Trying to get a deal done, not at any cost but understanding, “Okay, I want to build a successful company that needs to be financed.” Understanding goals at a pretty high level without digging in on certain positions and being open to creative ideas to create value on both sides I think is really important. A lot of the things the mistakes people make in negotiation are kind of the opposite of the strengths which is, they talk more than they listen and they’re trying to sell so much that they lose credibility. There are especially in our marketplace, founders who are looking to get the best terms or maximize terms at almost any cost; who aren’t looking for the right partnership. I had one of the founders I work with really closely many years ago we’re talking to very, very respected fund and the founder came, met with the fund and said “Look, you know you guys don’t pay very high valuations. You’re very tough on the terms. Why should I take money from you?” and had a great response which was, “We pay the lowest but our founders of the richest.” You know, which to me was not so much about partnership but you have to see beyond the money and again, you

might be able to get a better term sheet somewhere else but this is a true partnership. It’s a long term partnership and you want to make sure that it’s the right fit and bad negotiators are ones that choose partners and maximize terms at expense of all else.

Also we’ve touched on a little bit those that are focused on vanity aspects of the term sheet that they want to broadcast again. You know, having the wrong partner or losing all of ground on all the other terms doesn’t make a lot of sense. These things are package deals. You can’t negotiate them piece by piece and then finally, those people who use agents to negotiate rather than negotiating principle to principle, I think that’s a big mistake too and it’s easy to get sucked into that especially for those people who aren’t experience with negotiation or intimidated by it. You just can’t understand the goals of the other party. You can’t find the trades when you’re talking to somebody who has a different set of interests than the ultimate decision maker and so I think that’s another mistake that people make.

Nick: Do you see that often where company ready for series A or maybe a B is retaining an agent to do this negotiation on their behalf?

Jason: Well, lawyers are agents, right?

Nick: Fair enough.

Jason: So when you’re going through the legal documents and you’re going from an eight page term sheet to two hundred pages the legal documents, there are a lot of details that have to get worked out and often the lawyers can get in the way and a lot of them are… Look they’re a lot of great lawyers out there and sometimes get into the detail. They’re proving to their client that they’re creating value by bringing up a lot of objections and oftentimes again, it’s hard to understand and seek the real reason why a red line is the way it is.

Nick: Yeah.

Jason: And so I try to always pick up the phone and talk to the principals and understand because to me that’s the fastest way to get to an agreement that works best for everybody.

Nick: Out of curiosity, you ever gone do maybe final stages of a negotiation and deal didn’t close not so much because you couldn’t come to terms but because the negotiation itself was revealing about character aspects of maybe the founder that brought to light that maybe you didn’t want to work with this person for a long time?

Jason: I’ve never gotten to the end of a negotiation where that’s occurred. I think we’ve seen some of that during the negotiation, at the end of the negotiation where it might change our disposition on the management team or how to flank their weaknesses or have a different approach. Never to replace the management team but usually when we have a bigger issues we find out about the much earlier in the negotiation.

Nick: Right. Diligence and…

Jason: Yeah, diligence and you know it can be excruciating just to get through some of the initial iterations of the term sheet or you, being in the business long enough there are certain patterns

of behaviours you see when founders are trying to play too much of a game with a negotiation or with the fund raising and they get out ahead of themselves too much and so I’ve been in a couple of those situations where the way that the entrepreneur has handled it is not a… Hey, look I’m OK and I’m enough of an adult to know that I’m not going to win every negotiation. I’m not going to win every deal and there’s a certain way to handle that. That’s a very mature way to do and there’s ways that aren’t and there’s ways to negotiate that are very confrontational and aren’t trying to create value. I look at a lot of these negotiations as problem solving exercises and how we’re going to work out issues post investment when we might have a disagreement? We might have a different perception of upside versus downside for example. You know, I think the genesis of your question is about, how much do you learn about people in negotiation? The answer is a lot. Thankfully it crashes and burns usually pretty quickly when it’s going to crash and burn.

Nick: You ever had another venture firm come in and steal a round during your negotiation?

Jason: Yeah, I would say yes that happens, I mean it’s happened in different eras of the venture capital cycle where things are a little crazier. I would say it happened earlier in my career where either I had less credibility or my radar on when it was time to press on a deal wasn’t as good. It happens a little bit less now but yeah it definitely happens and so especially in this market, you have to move pretty quickly. You have to know what you’re doing and understand the terms and you have to start with the term sheet you know. Not one that so trigon that you have a lot of room to give away but you know to me you’ve got to be pretty serious in this day and age because entrepreneurs are making decisions pretty quickly by looking at the first version of a term sheet and whether you’re close enough to continue to engage.

Nick: So Jason, some like #Fred Wilson and #Jerry Newman have talked about how they don’t really negotiate. What do you think VCs mean when they say that they don’t negotiate?

Jason: Well look that works really great when you have brand power. You know when founders are willing to take capital from an investor at less of a price and those founders a really understand partnership and that quote I mentioned earlier about “…our founders are the richest…” that again kind of relates here to which is, hey look, you know when you get to a certain point in your career and the success and people want to work with you and you have a wide range of great companies that want to take your capital, you can afford not to negotiate. Now that said you know it’s not all about brand power. I think that there is a lot of friction. There’s a lot of time and money and invested in these negotiations and they can be exhausting and as you alluded to it, you want to start the partnership off on a really good foot; and sometimes you negotiation is inherently confrontational. Again, I like to make it a problem solving exercise but there’s no avoiding the fact it’s confrontational and so that can erode that relationship going into what will be a long partnership and so I think there’s also wisdom there by saying, “Look, I’d like to avoid the friction.” I think also certain funds have very deep seated held principles about how they want to structure deals and can go out there and say, “This is the deal. This is how we work and every time this is what we do. It’s uniform.” And most of the incubators, accelerators that’s what they do. They just say, “Here’s what it is. There isn’t negotiation.”

Nick: Yep.

Jason: Some of them do it on the margin. They won’t advertise that but I think there’s great operational value in doing that. I mean there’s a buyout fund here that has a side by side

mezzanine fund and the terms on every single deal they’re all uniform because they realize they’re wasting so much time negotiating debt deals that it wasn’t worth it anymore for a little bit extra point here or point there and so I think a lot of this too is about access to deals. So much of ventures about choosing great deals, it’s not so much about the pricing in the terms. That definitely matters. That matters more in kind of your middle outcomes. If you’re not in a deal that was a huge winner because of a little bit of difference in the terms you know, that’s stings a bit. So again, I think that those people who have adopted that philosophy my guess, you have to ask them but my guess is that these are the motivations behind it.

Nick: Any other final thoughts or suggestions for investors or entrepreneurs on how to better negotiate and how to approach the process?

Jason: I’ve got a bit more on the blog. I’d encourage people to check that out but you know I think in the end it’s an apprentice learned skill and you have to do it a bunch. Every negotiation is different and so that’s how you really become good at it in my view.

Nick: So to wrap things up here Jason, can you talk about some of the things that you’re currently most focused on?

Jason: We continue to look for a good series A deals you know companies. Series A means a lot of different things to people but it typically for us the companies demonstrate some product market fit. Maybe it’s a million in revenue, annual revenue thereabouts plus or minus. We focus on software. We focus in marketplaces. That’s your Grubhubs, that’s your whittles, that’s a track if. We also have done content deals like curiosity so you know media businesses. So we’re still looking at those types of companies still leading the series A rounds. We invest across the country so we’re happy to look at deals that come from various places. Certainly those are specialty areas. All of us our operators are engineers you know. So we’ve built companies and built products like our founders have and love to hear from companies that fit our set of criteria.

Nick: If we could cover any topic in venture, what topic do you think should be addressed and who would you like to hear speak about it?

Jason: #Naval Ravikant would be great crowdfunding is having a profound effect on venture in the next five to ten years. We’ll see venture funds that are really traditional and haven’t you know changed. Haven’t been responsive to the change, fail. You know, die out because their fees streams will dry up or they may not be able to raise money because they’ve got what compared to crowdfunding is a very high fee and you have to be able to justify it and so yeah, I think Naval is the tip of the spear in making those changes in the wedge and there are some regulatory changes that need to be made to make it an even more broad and even more successful thing but that’s somebody I’d like to hear more from and I think good investors need to listen because what crowdfunding is doing and what Angellist is doing in particular is I think very, very important for the future of the business.

Nick: Couldn’t agree with you more. I was fortunate to chat with him briefly at Pre money this year and got to get him on the schedule at some point. So Jason what’s the best way for listeners to connect with you?

Jason: Through my blog, through Twitter probably the easiest ways to do it. Anyone is welcome send me an e-mail at Jason at originventures dot com. I will for sure read it. I probably will respond. No promises. So, yeah I’m quite happy to chat with people and also will be very direct with if something is not a good fit for us or I don’t have the throughput to handle something but I am certainly happy to hear from your listeners and it’s been a real pleasure to be on the program today.

Nick: Well, Origin is a V.C. to we hear great things about here in Chicago and it’s really doing a lot to support entrepreneurs in this ecosystem so thanks for all the writing you do over at Venture Evolved and thanks for the time today.

Jason: Thanks Nick.