Negotiating with Terrorists (Lawyers, Venture Capitalists)

“If I had a gun with only two bullets and faced a lawyer, a venture capitalist, and Stalin, I would find myself negotiated out of the gun by the venture capitalist while the lawyer revised Stalin’s First Five Year Plan.”

Tootly began with the prominent venture capitalist firm Thompson Oak Achievement Dropship Ventures (the general rule of thumb: all top venture firm names contain either a last name, the name of a tree, a business-success related adjective, and a completely random reference -- TOAD contained all four, and was thus considered a “prince of the venture capital ball”). Jacob and Ben met Tim Thompson, a General Partner, at an overpriced and overrated Italian restaurant for “Neapolitan Brunch” (a meal no self-respecting citizen of Naples would ever associate with) in downtown Palo Alto.

General vs. Limited Partners

Venture capital firms may seem self-determined, but the truth is that the buck doesn’t stop there. While the General Partners of the venture capital fund control the purse strings for startups, the Limited Partners are the General Partners’ benefactors. Limited Partners (or LPs) are typically very large investors -- like pension funds, sovereign wealth funds, and overly trusting wealthy individuals -- who are attempting to “diversify risk” and “demonstrate their innovative investment strategy.” It’s worth noting that nearly 90% of all venture capitalists implode, which is certainly an innovative way for a pension fund to obliterate value.

The first meeting with Tim was promising; Jacob had nailed his elevator pitch and Tim had chuckled after the simulated fart and “sound of money” line. “He said they were looking to initiate a seven year fund focused on the mobile ecosystem, and our initial success would send a strong signal to their LPs.” Jacob and Ben were thrilled with his response, but Tim needed more before he was ready to “make it rain on Tootly.” Not soon after, Jacob had his Powerpoint and business plan in front of Tim, three Junior Partners, five VPs, and two analysts.

Exhibit: Junior Partners, VPs, and analysts

To call them glorified bitches would be offensive to female dogs. Many of the larger venture capital firms have other members below the General Partner level, generally to demonstrate to LPs that they mean serious business when they’re losing money 90% of the time. Like many underlings, most of these employees exist to provide General Partners with plausible deniability for poor decisions they themselves make. Unlike other underlings, they’re inconceivably conceited and cocksure about their scapegoat status. They also engage in administrative bullshit (like monthly investment reports) that LPs demand for “transparency,” despite the dirty truth that no one ever tells the dirty truth until the money completely disappears (at which point, the General Partners will place blame on Junior Partners, who will blame the VPs, and so on). Eventually, an analyst can work his or her way up to General Partner, although that route is not entirely dissimilar from the path of a Padawan Learner to Dark Lord of the Sith. Yes, Anakin Skywalker would have made a “killer” venture capitalist.

The presentation went well, despite a fair number of questions from the brown-nosing junior employees meant to impress Tim rather than critique Tootly. Either way, Tim appeared satisfied, and told them he’d have a “term sheet” (a document with his terms for funding -- exactly as you’d expect) ready for them by the end of the week.

Never content to rest on their laurels (especially when their laurels had just had another celebratory cheeseburger), Jacob and Ben engaged with another venture capitalist before the week was out. Jacob had learned, from one of his favorite professors, that “good decisions were made from a range of viable alternatives.” Which meant talking to many firms without the others knowing. They pitched next to Jim Johnson, of Johnson Outstanding Cedar Knesset ventures. JOCK was a well regarded boutique firm, though like many smaller firms, the benefits of bureaucratic freedom were balanced with the fact that their General Partners were clinically insane. After Jacob finished their presentation, they faced a volley of ridiculous questions from Jim, who was wearing a fleece and jeans without any undershirt; with his impressive physique, it appeared he was more interested in highlighting his ripped man-cleavage than obeying the demands of style or good taste. Ben remembered many of the questions:

“So how is this social? I don’t get a sense this is social. It should be social.”

“How are you going to ensure audio fidelity? Mic placement can be a real bear for fart sounds -- I should know, I was the advisor to a sound engineering company.” (venture capitalists love to stress their knowledge of an industry based on a few hours a month at their portfolio companies’ board meetings)

“What other novelty sounds are you investigating? Have you considered sex sounds?”

Questions aside, Jim was convinced about the opportunity, and told Jacob and Ben that he’d have a term sheet for them by the end of the week as well. Before long, Jacob and Ben had meetings scheduled with TOAD and JOCK back-to-back at Cafe Borrone in Menlo Park. As it was late October, the weather was beginning to transform from the paradise of summer to a wintry drear (despite what you may have heard, Silicon Valley has no spring or fall), and they were surprised to see both Tim and Jim sitting at the cafe amidst a misty drizzle. This caught both Ben and Jacob off guard (as they were planning to negotiate with them separately) -- but Tim and Jim waved them over all the same. Tootly’s co-founders sat down, confused.

“Next time, you guys should do your research.” Tim had a wry half-smile mixed with a look of disappointment. “Jim and I have a standing racquetball match every Friday morning. As you gentlemen might be aware, racquetball can be a very social sport. Social enough to start talking business.” Jacob and Ben glanced at each other with a shame reminiscent of children caught with their hands in the cookie jar. Only this cookie jar contained cash.

Jim confirmed that feeling in a less surreptitious manner. “Consider your hands caught in the cookie jar. Tim and I both discovered that we were about to exclusively close an initial round of funding with the hottest mobile app company around. Turned out you were trying to sneak a silent one past least for one of us, no?”

Jacob ignored the pun and tried explaining. “We were eventually going to tell you both that we were negotiating with other potential lead investors, but we wanted to keep our options open. Just in case something broke down.”

Tim’s half-smile turned into a half-frown. “Consider this a lesson in trusting us then, and we’ll consider this the last time our trust is breached. And you needn’t worry about having options open. You’ll only need one.” Tim handed Ben an envelope. “You’ll find the terms of our arrangement there. Jim and I will be investing $2.5 million each, at a smaller valuation than we had discussed before. Additionally, we’ll have rights to veto funding or acquisitions, along with enhanced voting rights and a certain portion of equity set aside for future employees.”

Ben blurted out, “But that’s more than we need! And you’re getting more of the company than we agreed!”

Tim finally broke out a full smile. “Both of us want Tootly on our list of portfolio companies, but we’d prefer to pay less for the privilege. You’ll take the full investment from us.” He then leaned in and brought his voice to a whisper. “You should see my list of racquetball partners -- I’m quite the prolific player. If you don’t take the investment, you’ll find it quite difficult to find funding anywhere. It won’t be long before your likeliest source of money is the state lottery. Your BATNA doesn’t seem so hot.”

Exhibit: BATNA

An acronym for “Best Alternative To a Negotiated Agreement,” which in simple English means the outcome if you simply walk away from negotiations. When the counterparty in a negotiation throws out the term during negotiations, you know you’re absolutely fucked.

Jim also seemed quite happy at that. “Don’t look so glum, boys. Just being associated with us will help your future, and we want you to succeed. We just want a bigger piece of your success.” With that, Jim and Tim took their leave.

Ben and Jacob spent the rest of their time at Cafe Borrone mulling over the terms. TOAD and JOCK would each take 20% of the company in exchange for $2.5 million invested each (for a total of $5 million), in addition to 15% of the company being set aside for future employee stock grants. That left Jacob and Ben with 22.5% of the company each, with a high likelihood that their stakes would go down in the future. As is usually the case, the co-founders had their first legitimate argument over equity terms.

Ben wanted to take the deal: “I was worried about the damage to our reputation and future funding opportunities. It may have been an empty threat, but unknown racquetball partners already screwed us once...not to mention the US economy seemed in free-fall, and it was unlikely we’d get funding again so easily.” Jacob was recalcitrant. “I didn’t want to give up so much so quickly. Besides, we had sold 300,000 apps at that point; based on our growth trajectory we could have easily stayed self-funded and spent time smoothing things over with other firms for a later round. Sure, we would have grown more slowly, but it would be independent growth, without restraint. Plus, what the hell were we going to do with $5 million?”

As it turns out, a rather sizable chunk of $5 million went toward legal fees. Jacob eventually acquiesced and agreed with Ben to accept the terms, and the next week they banged out a binding legal agreement (and new incorporation) with more lawyers than either of them felt comfortable using. Unfortunately, another aspect of the term sheet dictated that Tootly, Inc. would be responsible for all legal fees pertaining to the formation of the company and investment (including backtracking out of their poorly constructed online legal agreement), which meant Tootly’s warchest was already down $100,000, using some arcane form of billable hours known only to lawyers, patrons of hell, and the rather large intersection of the two.

Despite their argument, and getting methodically money-hosed by the lawyers, Ben and Jacob were optimistic. “We were funded by some of the best, had enough money to draw a livable salary, and still masters of our destiny. Tootly’s numbers were up and we had well-regarded (if somewhat sneaky and strangely dressed) venture capitalist advisers on our board.” Money in hand, it was time for Tootly to grow. “Not that we had to grow. It’s just that, if we hadn’t, our well-regarded venture capitalists would start questioning why they gave us money in the first place. So we started spending it. Rapidly.”

Copyleft MMXIV Josh Cincinnati