a netpreneur online conversation

Ransom Parker is a Managing Director of SpaceVest, a leading venture capital fund investing in companies that capitalize advanced technologies. Mr. Parker was President, COO, and a director of the hospital information systems division of Compucare, a healthcare information technology company. He also served as a regional operations manager with Shared Medical Systems Corp. Previously, he held progressively more responsible management positions with the healthcare information systems division of Technicon Instruments Corporation and with Compucare. Mr. Parker received a BS in Biological Sciences from Fairleigh Dickinson University where he also did graduate work and conducted basic research in Human Physiology. He received an MHA in Healthcare Administration from The George Washington University.

in the loop with ransom parker:

negotiating with VCs (and others)

In July 2002, Ransom Parker, Managing Director of venture capital firm SpaceVest, was a special guest in The Loop email list. He took questions from group members on the topic “Negotiating With VCs (And Others).” Following is a recap of that online conversation. Some posts have been edited for length, clarity, flow, and topicality. The complete, original posts can be found in The Loop archives, which is accessible to all subscribers. 

The Loop: What is the average length of the VC investment negotiation process?

Ransom Parker (RP): 120 days from first contact. 30 days from term sheet execution.

RP: Specific red flags include: delayed responses to basic information requests; the company's "over-protection" of customers, prospective customers, partners, industry analysts from investor reference calls; conditional agreement to basic deal terms; excessive negotiation on minor deal points; objections to augmenting the management team post-closing; and insertion of external advisors directly into the negotiation process.

The Loop: Who within the company should be doing the majority of the negotiations for an early stage company? The CEO? CFO? General Counsel?

RP: The CEO. No substitutes.

The Loop: Obviously VCs want their portfolio companies to be skilled negotiators. What are the qualities that VCs look for to determine entrepreneurs that will be good negotiators?

RP: Realism. Responsiveness. Knowledge of deal provisions. Appreciation that successful negotiation is not a "zero-sum game".

Subodh Nayar: When a venture capitalist looks at investing in a business, what due diligence would be typically undertaken to ensure complete understanding of the market factors most important to the success of the venture under consideration. Are there, for example. specialized firms that assess the probable success for a venture?

RP: Venture capitalists tend to "triangulate" on a view of particular market factors in judging the potential success of a venture. Market impressions are assembled from among other sources: the investor's own market knowledge and experience; industry consultants who are current on market dynamics; industry analysts who follow public and private companies that address the market; and direct contacts with other companies that address the market.

These general market impressions are typically fine-tuned through reference calls with the investee company's customers, prospects and trading partners. The objective of these conversations is to calibrate the answers to numerous questions among which are the following:

• To what degree does the customer concur with the previously mentioned market impressions?

• What are the key risk factors associated with the market's development and growth?

• How were the company's technology and product(s) developed (i.e., in a development vacuum or in response to specific customer requirements)?

• What problem is the customer attempting to solve by its use of the technology and product(s)?

• How "painful" is this problem to the customer? Is its resolution critical to the customer's own success?

• Are the technology and product "mission critical" or a "nice to have"?

• To what degree are the company's technology and product(s) designed and implemented to address the buyer's critical technical and business requirements?

• To what degree do the technology and product(s) generate a quantifiable cost benefit and return on investment (ROI) for the economic buyer?

• What competitive and/or alternative solutions did the buyer consider?

• Based on the customer's evaluation of competitive and/or alternative solutions, how difficult would it be for a competitor to develop a competitive solution?

• What were the key factors that drove the selection of the company's product(s) versus competitive and/or alternative solutions?

• What other related products and/or services could the company provide to the customer? Are these in the company's product roadmap? Have customers had input into the product road map?

While there are a number of firms that provide such assessment services, there is really no substitute for the investor's own knowledge of the markets and direct inspection of market, customer, and prospective customer impressions.  

Ben Martin: What should entrepreneurs look for (and expect) from investors when it comes to participating in negotiations for the portfolio company (for service providers, closing of sales in pipeline, future rounds of investment, etc.)?

RP: If the CEO/entrepreneur looks (and expects) investors to drive the company's negotiations with service providers, sales prospects, future investors, etc., then, in a way, he/she could be perceived as abdicating to the investors an important role that is normally expected of and reserved by the CEO. That having been said, most institutional investors have a wealth of experience in these areas that can assist the CEO in such negotiations. The investors are better utilized by the CEO in several ways. Among these are:

• introducing the CEO and company to service providers, prospective customers and partners, and future investors with whom the investor has had prior direct experience in conjunction with other portfolio companies;

• participating in developing relationships with these third parties in his/her role as a Director of the company;

• advising the company on alternative negotiating strategies based on his/her prior working relationship w/ third parties;

• serving as a Board-level reference to third parties as they conduct their due diligence on the company.

I think it is important to recognize that service providers, sales prospects, future investors, etc. generally tend not to look past the CEO of the company when considering a potential relationship with the company. Inserting investor/directors into a lead position in such negotiations could cause the third party to call into question the degree to which the CEO/entrepreneur is, in fact, in control of the company and able to deliver on whatever commitments may result from the negotiations.

Daniel Odio: I've had several experiences at dot.coms that have failed because of VC involvement. The VCs were looking to make their 10x - 100x return and create a billion-dollar company. The VC's constant pushing on strategy points created an unattainable business model and killed the (smaller but) profitable company as well. After surviving that experience, I feel that it was a VC strategy to force the billion-dollar projections even if it meant probable business failure—the "1 in 10 will make it and write off the rest" attitude. (A side question: Was that an Internet bubble anomaly or standard practice?)

So a slew of questions result as we ponder VC involvement for our current venture.

• Has this at all changed? Do VCs feel some responsibility for inflating the business models of many dot.coms? Have you re-aligned your projections on returns or do you still want to see a billion-dollar market cap?

• Yes, some people *do* say they had great VC experiences. Where's that magical “VC guide” that helps us make sure VC interest is aligned exactly with our goals? Any specific questions we can ask of VC's to ensure this?

• Looking back on the experience I feel that we should have stood up to the VCs and pursued what we truly believed in. Would you respect a management team that didn't go in the direction you wanted to take things? Would you continue to support them through a questionable execution period where it wasn't clear whether they were doing the right thing (and in fact you didn't think they were)?

RP: You've got a lot going on here! A few general comments may be helpful.

I would caution you not to look for "standard practices"; judge all VCs against what you believe those practices to be; and then develop a strategy and set of tactics against those assumed practices. If you do so, then you will set your current goals and objectives against a set of blended premises which are likely to be inaccurate.

Some VCs may feel some responsibility for "inflating business models" so as to "see a billion dollar market cap". We have not done so in our practice. We need not, therefore, re-align our projections accordingly.

As I suspect you are aware, there is no "magical VC guide" that will assure alignment of interests. Presumably, the investors who are on the receiving end of your concerns did due diligence on your prior venture prior to closing. What due diligence did you do on the prospective investors?

Given, your experience, I think you probably know the questions to ask prospective investors to ensure alignment of interests. The issue is not the questions; the issue is to whom should you pose the questions. In your prior experience did you ask the investor about his/her investment philosophy and practices pre-closing? Did you calibrate the response with any of that investor's portfolio companies? Did you conduct any due diligence on the investor with service providers who would have certain visibility into the investor's philosophy and practices? Did you talk w/ any of those who you describe as having had "great VC experiences?" If not, I'd suggest you do so next time.

I would respect a management team that did not go in the direction that I wanted if the chosen direction resulted in the growth and development of the company that the management team represented it could achieve. If not, I doubt that I would disrespect the team. Respect should be a foregone conclusion for all of us. The issue here is that the management team has an obligation to deliver the results that it represents it can achieve. The investors have an obligation to foster and enable such achievement. If the company and investors have to continually work at developing mutual respect, then something is seriously broken.

We, like the majority of VCs, support companies through questionable execution periods. Few are the companies that actually execute at or above the plan levels and in the time frames that they originally project. If that is the case, then it follows that we spend most of our time supporting these companies. That's what we do for a living.

A bit of direct and partially solicited advice: Get over it. Move on. Develop an aggressive yet attainable business plan and model. Select you investor partners carefully. Perform against that plan. Forget the "bubble" and opportunities "lost." Forget placing blame for events in the past. Remember that it works both ways (i.e., it has happened that companies disappoint investors!) There's plenty of blame to pass around -- if that's how we'd prefer to spend our time.

Don Britton: In one of your earlier answers, you stated that "The founder should be careful to assure that counsel represents the company and not the founder as an individual." Can you share with me some examples of what you have seen and how it affected things with counsel representing the founder and not the company?

RP: Take as an example the negotiation of an employment agreement with a founder who is and will remain a member of the management team. Typically the investor will submit its form of employment agreement which is generally "company-favorable." Certain key provisions will take more conservative positions than those frequently desired by the founder. Among these are: compensation, severance provisions, length and terms of non-competition provisions, change of control provisions, reassignment provisions, etc. In the negotiation process it is natural for the founder to seek the advice of company counsel on such issues. The effect of this can be that counsel represents the founder as opposed to the company. The impact of this can be that the negotiation of the employment agreement begins to impact the negotiation of the balance of the investment deal. Most investors would view this as an undesirable complication. The most facile solution to avoid such complication is for the founder to retain separate counsel for the negotiation of such agreement.

Don Britton: Earlier, you also mentioned objections to augmenting the management team post-closing is a red flag. I can understand how that is a red flag, but how would you go about making sure that you maintain some control over who they want to have join the team? I have seen several deals where the VCs brought in a new player to "augment the management team" that created more negative trouble and disruption than anything else.

RP: The best method of assuring agreement on new management team additions is to do so pre-investment through the creation of a full management organization development plan for the company. All interested parties (e.g., current management, current investors and current directors) should be involved in this process. All should agree on the positions to be filled and the desired qualifications of the candidates to be considered. All should participate in the selection process depending on the level of the position(s) to be filled. If the need for the addition is identified post-closing, a version of the same process should be followed. While there are few guarantees in life, integration of new players has a much higher probability of success under this scenario than under a "paratroop drop" program.

Larry Robertson: As you stated in some of your answers to early questions, valuation is often a point of contention between investors and management. You also mentioned that investors tend to look at a variety of sources to triangulate on valuation. Clearly, many companies will derive their own valuation, perhaps through their own methods, and their valuation conclusions do not always line up with the prospective investor's view. Assuming that both sides are dealing with reasonable and rational sources for calculating valuation, when there is a gap in valuation between the investors and the company, how common is it these days to create a stepped valuation based on performance hurdles that allows the company to benefit from hitting projected numbers that may be higher than what investors project (with obvious downside penalties built in, too)?

RP: It is best to focus my response on our investment practice rather than on the venture industry at large. In a few select cases we have incorporated such adjustments. As a rule we do not favor them for several reasons among which are the following:

These days there are several absolute facts with respect to the private equity markets. One of these is that it is very difficult for companies to complete venture financings across the board. Venture Investors are being very selective. Market conditions favor the investor not the company. As a result, except in unusual situations, we simply do not see the need to make such a concession. More importantly, the mere existence of such an adjustment can cause the management team to make strategic decisions that favor the short term versus long term development of the company. Even more importantly, when the time arrives to review the degree to which performance hurdles have been, met one of the parties—investor or management—is going to be displeased with the results of the review. Either the investor or management will "win." Both cannot. We believe that clear agreement on valuation is best reached up front. The existence of an adjustment indicates that the parties were unable to agree on valuation which, in our view, is not a healthy predicate for the balance of the investor/management relationship.

Larry Robertson: My experience is that many investors use common guidelines for assessing a company's ability to hit its goals and to be a long-term winner in their market. Such guidelines would include team maturity, product maturity, market maturity, and financial maturity. Depending on how a particular company rates on the scale for each of these areas, an investor may be more or less inclined to pursue an investment in the company (all other investment factors of course being equal). Question: Once the investment discussion has reached the point of negotiating valuation, how much do the above factors impact the actual valuation of the company and/or the strength that the entrepreneur has at the negotiating table? (e.g. If the company has an extremely experienced team, with a product that already has a small core of loyal customers, and is serving an underserved but large and attractive market, can valuation be positively impacted in the eyes of investors and can the entrepreneur reasonable argue for a stronger valuation based in part on those factors?)

RP: I think it is fair to represent that all of the factors that you reference play into the valuation decision. It is very difficult and a bit artificial to assume that one factor will be weighted more heavily than another in every situation. Such weighting is very situation dependent. After all of the valuation analyses have been completed the investor then must make his/her own experienced-based, subjective decision. At that point the decision becomes more art than science.

We, like all of our venture brethren, spend as much, if not more, time and energy assisting our current portfolio companies in raising and closing subsequent financing rounds. In these cases the shoe goes on the other foot! Aside from assuring that the fundamentals of strategy and performance are in place, the key driver in protecting valuation is not any of the previously referenced factors. It is the company's ability to secure competing term sheets! If the company is successful in doing so, then competitive forces will serve the company's valuation interests.

Ben Martin: As we wrap-up our first special guest appearance in The Loop, I'd like to thank our friend Ransom Parker of SpaceVest for generously giving of his time to share his insights. Please feel free to send a quick note to Ransom if you would like to thank him personally. Now we'll let him get back to the negotiating table to do some deals.... For more on this subject you can read our conversation in The Loop about negotiations and bootstrapping that led up to Ransom’s appearance.

Next week, Gina Dubbé, Managing Partner of Walker Ventures, will join The Loop to discuss issues in sales and customer strategy, ranging from how to pick the right beta customers, to assessing and integrating the best distribution channels.