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Photography: Courtesy of the artist and Gow Langsford Gallery

Artwork: Sara Hughes, United We Fall, 2008, vinyl installation for the stairs and antechamber, Christchurch Art Gallery Te Puna o Waiwhetu, Christchurch, New Zealand

A few years ago a venture majuscule firm hired me to help ane of its commencement-ups negotiate a critical bargain. I expected the VC partner who was on the start-upwardly'south board to be securely involved in the strategic discussions. But the VC in question—ordinarily a hands-on dealmaker—was conspicuously uninvolved. His communication and support would have been useful to the founders, especially with respect to opening doors with governments and potential partners overseas, and then ane solar day I asked him about his seeming lack of involvement.

He described the scene a year earlier, just after his firm had decided to invest in the start-upwards. "There was a lot of interest in this company, and the founders had a fair amount of leverage. They used every ounce of it to extract a higher valuation," he said. "We kept saying that our firm would bring a lot more to the table than coin, and that the mentoring, strategic advice, network resources, and political capital we could offer were almost unmatched. The founders gear up all that bated and made it well-nigh the money. It left a bad taste in our mouth. The deal was notwithstanding worth doing—barely. Simply we have less of an equity stake in the company than nosotros would usually want, and given all the other portfolio companies that need my attention, I don't feel whatever obligation or desire to requite these guys additional assistance."

In retrospect, the entrepreneurs at the start-upwards made a plush error: Either they undervalued the nonmonetary resource the VC firm had to offer, or they causeless that mentoring and strategic support would inevitably be available. In either case, they negotiated a deal that looked bully on mean solar day one but proved to be perilously misguided in hindsight.

This happens more than often, and in many more ways, than you might think—which is unfortunate, given how valuable and transformative a VC deal can exist for entrepreneurs. Few business negotiations contain the caste of high stakes, uncertainty, and emotion present when company founders negotiate with venture capitalists. On the one manus, reaching agreement on a term sail—the document that lays out how much equity and control a VC will take in return for its greenbacks—is all about assigning rights, etching out protections, and haggling over claims to future returns. On the other hand, these negotiations are fundamentally near picking the right long-term partner and forging a relationship that tin can survive the inevitable disappointments, resolve the unforeseen conflicts, and monetize the mutually earned successes to come.

I study negotiations in a wide range of circumstances and in recent years have taken a special involvement in those between entrepreneurs and their strategic partners, including VCs. As a business concern school professor, I'm often asked for advice past students and alumni who are launching companies. And for many years I've consulted to prominent VC firms, helping them and their portfolio companies with negotiations. These experiences provide a unique lens through which to notice deal-making successes and failures, and the stories in this article are taken from that work (the examples are anonymous, in order to preserve confidentiality). One of the biggest lessons I've drawn from my piece of work is that even skilled negotiators can make costly mistakes. In the pages that follow I'll describe some of those mistakes, exploring why they happen, what they tin can teach u.s., and how to avoid them.

Before we begin, allow me make three of import points. Starting time, this article is not the place to starting time learning the basics of negotiation, a broad topic on which there are many resource. Second, it does not attempt to introduce all the intricacies of the venture majuscule industry, which has its own linguistic communication, protocols, and idiosyncrasies. 3rd, for any large or complex negotiation with a venture capitalist, you lot should consult a lawyer experienced in structuring VC deals. Term sheets can exist hard to empathize, and y'all may need help determining what the various provisions—liquidation preference, antidilution protection, pay to play, drag along rights, vesting schedules, no-shop clauses, and and then on—imply for your current and time to come rights and obligations. At the very least, y'all should contact other companies in the VC business firm's portfolio to find out what was negotiable, why they made the choices they did, and what terms were the nearly consequential in the months and years after the bargain.

Given the considerable resource, fiscal and otherwise, that a VC can bring to the tabular array, these deals can be tremendous assets—but only if they're done well. That means, in a higher place all, thinking not just about what will look practiced in a printing release today but also nearly what will help y'all create and capture value over the long run. Only with that mind-set can y'all strike a deal that takes full advantage of your leverage, build a relationship based on mutual trust, draft a contract that optimizes value (not just valuation), and reach a level of agreement that ensures that each party will be fairly rewarded for future success. Let's consider each element in turn.

Empathise Your Leverage

In that location are few things dealmakers worry about more than than figuring out who has greater leverage and how best to utilize whatsoever power they take. It is surprising, then, that they then oft ignore crucial sources of ability or put themselves in unnecessarily weak positions. This is as true in VC negotiations as anywhere.

Ane of the about obvious variables in any negotiation is the attractiveness of your alternatives to the deal. In the context of a potential VC deal, the more firms that are interested in your start-upwardly, the more leverage you have. And although you should avoid squeezing long-term partners to their lesser dollar, as the start-up in the opening instance did, you should certainly leverage your alternatives to fight for terms that are important to you. One time the deal is signed, discarded alternatives will carry little weight, and whatsoever leverage you'll accept going forward must come from other sources. Many entrepreneurs worry too much virtually the corporeality of ability they have when negotiating the term sheet and too little about the amount they'll have later on the deal is washed.

I recently worked with an early on-phase tech company that discovered it would run out of cash in three or four months—much sooner than it had projected, and too early in the product development process. Its initial impulse was to solve the problem past fast-tracking a strategic partnership with a large company that would pay an upwards-forepart licensing fee for its technology. Merely it quickly became clear that it would exist unwise to make such an arrangement before the company was further along with development, then the start-upwards was forced to explore another round of VC financing.

Perhaps considering the start-up was running out of cash and had few options, the one VC firm that was interested offered a low valuation (that is, it would ascribe a depression value to the visitor'southward electric current worth) and a large investment. The combination would accept squeezed the founders' equity considerably. The CEO declined the offering and decided to pursue his third option: to ask for a bridge loan from his electric current VC. Span loans are often perceived as the "pay day loans" of the VC industry, a last-resort grade of brusque-term financing that more often than not carries onerous terms. This case was no different: Although sympathetic to the showtime-up's plight, the VC had to protect his ain investment, and the loan would come with a meaning dilution of management's disinterestedness.

The "running out of cash" problem is not uncommon. Founders oftentimes have likewise much confidence in their business model, too little ability to forecast their burn down rate, and also little willingness to give upward equity. As a effect, they may fail to take in enough money during early rounds of funding.

This offset-upwards might have avoided the prospect of selling equity on the cheap if information technology had accepted more cash (and sold more equity) during the first circular of financing—when it had numerous alternatives and could have commanded a better price. Many founders have discovered that doing a slightly bigger beginning round than seems necessary—or mayhap negotiating an acceptable formula for hereafter bridge loans at the outset—can pay off in the long run: It'due south bad when you have few options, simply considerably worse when y'all are running out of options and out of money.

The story has an unexpectedly happy catastrophe, ane that contains some other lesson on identifying and leveraging sources of ability even when you're out of money and seemingly out of options besides. The CEO went back to the VC with a different approach, focusing less on his own desperation and more on the VC's interests. He made a elementary but elegant example: "Aye, we screwed upwardly, and you take the power to squeeze us on disinterestedness. Simply let'south think nearly what will happen side by side. How many peak people will stay if we dilute their equity positions? Is the premium you'll get worth the potential hit to management morale and firm success?" He persuaded the VC that forcing him to accept harsh terms could exist a Pyrrhic victory, because an equity dilution could cause the start-up to falter or even neglect, zeroing out the VC's investment. The VC agreed to provide the coin, admitting in installments tied to milestones, with no dilution of equity.

Don't focus only on your own options. Understanding the other party'southward interests can give you leverage.

This incident is a great illustration of how negotiators who wish to maximize their leverage need to avert focusing likewise narrowly on their own options (or lack thereof) and should instead endeavour to fully evaluate the other side's interests. In this case the CEO changed the discussion from whether the VC could leverage the get-go-upwards's weak position in club to meet brusk-term goals to whether doing so would actually achieve the VC's ultimate goals. If yous understand the other party's long-term interests and tin can detect an arroyo that will serve them, you will accept leverage even in the absence of bonny alternatives. Fundamentally, ability in negotiation is about what you bring to the table that has value for the other side—which means you need to spend a off-white amount of time understanding what the other side cares about, worries near, and hopes for.

Maximize Trust

A successful serial entrepreneur told me about a day he spent agonizing over whether to call a VC with whom he was near to shut a $10 million financing circular. When he had pitched the VC, a month earlier, his business was gaining momentum, and he had laid out ambitious financial targets. Since then, nevertheless, a major strategic partnership of a sudden seemed less secure, it appeared that the offset-upward'due south pricing strategy might non be working, and a fundamental employee was on the verge of leaving. Although he had no legal obligation to reveal these developments before the shut, he did feel a moral obligation, but he worried that the VC would modify his offering or walk away from the deal.

Finally the entrepreneur picked upwardly the telephone. "This is either going to exist the kickoff of a very trusting relationship or the terminate of the dialogue between u.s.," he said. He held zero back as he shared the bad news. To his surprise, the VC reacted positively: He didn't pull the plug or try to renegotiate the terms. I later asked the VC why he chose non to factor the developments into the bargain terms, as he surely would have had they been known at the start. "That type of telephone call is not usually fabricated," he said. "Usually subsequently we brand an investment, we wait for what we telephone call the first 'Oh, due south—' board meeting, where we learn about something that was not disclosed during the pitch. The founder'southward full disclosure changed my perspective on him as a person more than information technology changed my perspective on the visitor or its prospects. To recut the bargain would have reinforced the notion that he will be punished for delivering bad news."

It's hard to overstate the extent to which VCs put a premium on trust—or the extent to which untrustworthy beliefs tin derail negotiations. Another VC told me about a founder with whom he'd been in conversations nigh a potential investment. The founder had made no secret of the fact that he was also in talks with another investor, saying he would prefer this human relationship merely wasn't ready to have the electric current terms. The VC offered to brand some significant concessions if that would seal the deal. The founder said it would, and the two men shook hands, agreeing that they had a bargain. A few days later the VC learned that the founder was shopping the revised offer around. The VC chosen him and told him the deal was off—he was no longer willing to invest in the company. Multiple apologies from the founder and numerous interventions from his lath members failed to change the VC's mind.

VCs expect you lot to ask for better terms, to comparing shop, and to use whatsoever leverage you have—but not later on you take reached an understanding. It may seem obvious that this founder acted unwisely and unethically, simply in the fevered pitch of bargain making, even smart and well-intentioned people can lose sight of the fact that beneath all the term sheets and financial projections, the VC negotiation is a process in which people are deciding with whom they want to associate for years to come. In VC relationships, as in any long-term partnership, information technology's much easier to build trust than to rebuild it. If you detect you've settled on terms without sufficient consideration or have made commitments y'all cannot keep, you're better off playing information technology straight: "I think I may have agreed to something I'm not actually comfortable with." That will be an awkward chat, and the VC may non be willing to reopen the word. But odds are yous'll have a better effect than if you renege on promises when they go plush or inconvenient. Venture capital is a pocket-size industry, and, equally i entrepreneur puts it, "In my line of work, yous don't have a CV. You lot just have your reputation."

ane. VC attention and support are limited resources, and you'll exist competing for them with other portfolio companies. A VC firm's willingness to spend time and political uppercase on you is a function of both its equity stake and its emotional pale in your company. Y'all stand to lose if you lot negotiate these stakes down too low.

ii. Beware of entrepreneurial overconfidence. When yous're raising money, have into account the possibility that your progress will be slower than expected and that your business model will evolve. That may mean selling somewhat more equity upwards front than seems necessary, so that you can avert negotiating for more than greenbacks later on, when you have fewer options.

3. Your leverage is not only a office of your alternatives—information technology has simply as much to do with the VC'due south alternatives. Having few options is not and then terrible if the VC needs you lot to thrive. Seek to understand his interests and exist prepared to educate him most why his exercising too much power could hurt both parties in the long term.

4. Transparency is oft less costly than you lot fear. Experienced VCs have seen most issues earlier, and if you're honest about setbacks, they may have useful communication to share. Even if being transparent decreases your leverage, it will increment their trust in you lot—a trade-off worth making.

5. Y'all can build trust most hands when the other party is vulnerable. Information technology's when y'all could accept exploited them but chose not to that others learn to trust yous. If the VC is vulnerable, use the opportunity to build trust rather than to seek advantage. In a long-term human relationship, trust built today enhances opportunities in the time to come.

6. Play information technology straight. If y'all're not in a position to make a delivery you tin can stick to, say so. If y'all accept overcommitted, don't renege. Instead, own up to information technology quickly. The VC may be open up to renegotiation if y'all have been forthright.

7. Beware the attraction of valuation. Negotiate well-nigh all elements of interest to yous, not just the investment level and disinterestedness dilution. Don't forget that y'all had many nonfinancial motives for becoming an entrepreneur.

eight. Employ your bargaining power wisely. Valuation and disinterestedness pale matter only if your company eventually succeeds—and if it does, other provisions could have a greater bear on on your ultimate fiscal advantage. Consider multiple scenarios for your firm'southward success and summate what various terms would yield.

nine. Pay close attention to which terms the VC accentuates in her demands. Her focus can reveal of import information about her core concerns, underlying interests, and hereafter plans for your firm.

Focus on Value (Non Just Valuation)

In simple negotiations, focusing on a unmarried, top-line number sometimes makes sense: If you're selling your house, for instance, you lot might not even meet the buyers, and despite issues such every bit inspections, financing contingencies, and the endmost date, the selling cost is far and away the top priority. In many other negotiations, though, the signed contract is only the beginning of a relationship. In these situations it can exist a mistake to focus as well narrowly on price and non enough on drivers of long-term value. When negotiating a job offer, for example, people tend to obsess over the starting compensation, but factors such as geography, responsibilities, prospects for learning and advancement, and even length of commute can have a greater impact on their enduring happiness and success.

VC negotiations may exhibit the greatest disparity of any type of deal between how much people should focus on a single factor and how much they actually practise focus on it. The factor that gets asymmetric attention is valuation. This is the metric that will be reported in TechCrunch, and it's what your friends (and "frenemies") will ask well-nigh when they take you out for drinks to gloat the deal. Simply other terms may be far more important, especially if you hope to play a long-term role at the company.

More than i VC has identified this shortsighted emphasis as founders' biggest error. "They focus too much on valuation and not enough on control," i VC told me. "It's astonishing how much control founders are willing to sacrifice in guild to obtain a $4 meg valuation instead of $3.v meg. These numbers don't affair much in the long run, but the bear on of macerated control can last forever." The tendency is especially remarkable when you lot consider the passion most founders have for what they are trying to create, for their company'south mission, and for their vision of its future. Once founders have sacrificed board control or ceded voting rights on too broad a category of decisions, those decisions are, of grade, technically out of their hands. Most VCs are very reluctant to use their control rights to contravene the wishes and objectives of management, just if disharmonize or a breakdown in trust between management and the board occurs, founders may detect themselves severely constrained, if not replaced.

None of this means you lot should ignore valuation—information technology's an important consideration. But it's a mistake to confuse it with value, given that most founders also care a lot well-nigh factors such as their function, prestige, self-identity, and autonomy. To maximize valuation without regard for nonfinancial considerations is to sign something of a Faustian deal.

Strive for Understanding

Even when control is not the business concern, you ought to pay close attention to terms other than valuation; at that place are boosted provisions that can have a huge impact on how much money you'll eventually see. And if you wait at them advisedly, the terms a VC business firm proposes can aid you sympathise its unspoken concerns and assessments of your start-up's futurity.

Let's consider an example involving two of the items often spelled out on a term sheet—liquidation preference and participation. Liquidation preference gives a VC house the right, at the point of sale or at some other liquidity upshot, to recoup its investment (or a set multiple of it) before the founder takes any render. Participation refers to whether the VC is entitled to a share of the value that remains in one case the liquidation preference has been paid out. Liquidation preferences are often gear up at one to 2 times the size of the investment, and participation can range from none to full.

Imagine that a VC invests $2 million for a twenty% stake in a start-up—implying a valuation of $ten million. She negotiates a 2x liquidation preference and total participation rights. This means that if the visitor is sold for $14 million, she'll receive twice her investment ($iv 1000000) plus 20% of the remaining $x million ($2 million), for a total of $6 million. In other words, she'll receive almost 43% of the auction price, even though her equity stake was only 20%. Note that the $10 1000000 valuation in itself has little begetting on how the wealth is ultimately distributed. Fifty-fifty the same $2 1000000 investment on a much lower valuation—say, $8 million—would hardly modify the final distribution; that figure would requite the VC 46% of the sale price. It'due south a stark reminder that if you focus just on valuation when y'all're negotiating a bargain, yous could exist fighting for something that might not, at the end of the day, give you what you want.

It's hard to enlarge the premium VCs put on trust—or the extent to which untrustworthy behavior can derail negotiations.

Imagine that the same company is sold for $200 million. The VC again takes $iv meg to cover the liquidation preference, but at present that's a tiny percentage of the auction toll; most of her render—$39.ii meg of $43.2 one thousand thousand—comes from her total participation. And she gets simply 21.6% of the auction cost—much closer to the proportion of her disinterestedness stake.

To maximize valuation without regard for nonfinancial considerations is a Faustian deal.

These scenarios show that liquidation preference, which is designed to protect a VC's up-forepart investment, tends to take a big impact on how much wealth is transferred to the VC if the company enjoys moderate success simply has much less touch if the company performs spectacularly. If you call back about these issues advisedly during a negotiation, you will discover that a VC'due south preferences about such terms can reveal his interests and his assessment of a company's prospects. A VC who insists on enhancing the liquidation preference may believe that the valuation proposed by the founders is as well high. The liquidation preference serves equally an insurance policy that protects the VC's downside risk from founder overconfidence. Think of it this fashion: If a founder receives a high valuation in substitution for a high liquidation preference, the liquidation preference constitutes a side bet between the VC and the founder regarding whose expectations are more accurate.

Participation is more like a lottery ticket than an insurance policy. If a firm hits information technology big, participation gives the VC a huge windfall—so a VC who focuses on total participation may be projecting optimism about the outset-up's eventual fortunes. A VC who focuses on board seats, voting rights, or other terms that define command may exist less confident in the management team and is perhaps thinking ahead to when information technology volition exist replaced. There is nothing inherently incorrect with whatever of these situations, simply a careful understanding of the dynamics can help founders inquire better questions, engage in a more productive dialogue nigh expectations, and ensure that they choose the correct partner given their own goals.

Many other terms warrant careful consideration in whatsoever VC negotiation, of class. My interest here is simply to emphasize the importance of understanding the consequences of seemingly abstruse provisions on the term canvass and to underscore how the choices a VC makes when negotiating information technology tin can serve as useful signals.A lead negotiator for the National Football game League in one case told me that the only way to actually understand the stakes involved in negotiating a collective bargaining agreement with the players is to compare the bargain to a wedlock. Except, he added, his negotiations are harder than marriage: "You can divorce your spouse, but we tin't divorce the players." Having worked with scores of founders who have negotiated with venture capitalists, I believe a related metaphor helps capture the economic and emotional stakes involved: Founders are like single parents looking for a spouse who will honey and nurture their children every bit much equally they do. And even so, despite the tremendous value that can be created with a VC–entrepreneur partnership, these negotiations can yield poor outcomes. The mistakes are usually not immediately apparent; they manifest themselves over months and years, equally the parties come up against issues of power, trust, control, and much more than. It's of import to recognize that some of the mistakes are systematic and predictable—and hence solvable.

In my experience, most VCs are extremely well-intentioned and competent. Many are driven, merely equally many entrepreneurs are, past a desire to create value for social club; a few are goose egg curt of visionary. But all of them are human, and whenever y'all're dealing with man beings, you need to look well beyond the contract and far beyond today. The lessons offered higher up are targeted toward those who are striving to create strong partnerships with VCs—just they are relevant for anyone negotiating in a earth where a signed contract is not the end but just the beginning.

A version of this article appeared in the May 2013 upshot of Harvard Business Review.