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Behind the Scenes In VC Negotiations

On a Wednesday around noon last month, 55 men and six women trooped into a 43rd-floor conference room in law firm Morrison & Foerster’s midtown Manhattan offices to catch what was billed as "a lunchtime drama in one act."

By KOPIN TAN
DOW JONES NEWSWIRES

What they saw, in fact, was a mock negotiation, one that sought to highlight the type of terms venture capitalists and entrepreneurs quibble over when they sit down to talk deals.

"Over the past year or so, a lot has changed in the area of venture-deal terms, and we thought it’d be interesting to discuss some of these," said John Hempill, a Morrison attorney who presided over the proceedings.

The starring roles in this reality show went to Geoffrey Smith, who was channeling his real-life experience as the co-founder of Interbind Inc., a software developer, to play an entrepreneur seeking to raise $5 million in venture funding; and Fred Wilson of Flatiron Partners, who plays the venture capitalist running a $250 million fund. Morrison partners Joseph Bartlett and Jay Rand reprised their roles as lawyers who do the haggling, respectively, for the company founder and the venture capitalist. The set: a long conference table with a partial view of Central Park, stacks of legal pads, pencils sharpened for action.

On cue, Mr. Smith fired the first snippy salvo: "Let me start by saying I’m very excited to get the term sheets since it’s taken weeks and weeks to get these to us."

The first clause to get both sides up in arms was the "liquidation multiple." This is what investors want ahead of the other shareholders should the company be dissolved prematurely, and is often expressed as a multiple of the firm’s investment (In this instance, it was three times the proposed $5 million commitment). "It’s the minimum return we need for this to be successful — three times our capital investment," Mr. Wilson said, although on negotiation he conceded that this multiple could be reduced should the company achieve certain performance or revenue targets.

The Tussle for Board Seats

Then came the thorny issue of board representation. Told there was just one board seat available to the two co-founders, both Mr. Smith and his lawyer, Mr. Bartlett, bristled and became visibly agitated. "You’re now telling me there’s no room at the table for both me and my co-founder, the scientific brain of the company?" said Mr. Smith, who looked as though he came straight from central casting with his youthful, slightly wide-eyed demeanor (he was also the only panelist in an open-collared shirt, sans jacket). "We feel you’re trying to drive a wedge between us!"

In reply, Mr. Wilson stressed how board rooms aren’t places for the whole management teams given the tough decisions involved. "My position is the only management person who should be on the board is the CEO," he said. Asked, as a compromise, to give an observer status to the other co-founder, Mr. Wilson didn’t budge and said he has to think about it and, even so, might do it only for a trial period. "The board dynamic is really critical for the future of the company," he said, adding it could be "the single most important issue on the term sheet."

Then there were the vesting provisions: Should the founder leave the company, the investor wants the right to buy his unvested common shares at cost, and while a portion of the company’s shares are deemed vested at the time of the deal, the balance is evenly parceled out and will vest only over a period of a few years.

After working long and hard to build the company, "we feel we’re being made to earn back the equity in the company," Mr. Smith said. "But if you’re terminated for cause, we want those shares back so we can go find someone else to run the company," Mr. Wilson argued.

At one point, Mr. Rand pulled his venture-capitalist client aside for a quick huddle. "Some of his reactions are a bit emotional," Mr. Rand pointed out. "He’s probably still living in the, say, 1999 dot-com period, when we’re back at a time more like 1992, or 1993, when there is a far longer vesting period and it takes longer to liquidate a company." Another piece of advice to Mr. Wilson — now was probably a good time to decide who the venture capitalists want to keep at the company, and to let the founders know.

Through arguments over everything from conversion rights to antidilution provisions, the battle lines are clearly drawn. For the entrepreneur, the focus is on the blood, sweat and money he has put into the company, and being duly rewarded and respected for them. But for the venture capitalists, it’s all about protecting their investments.

Managing Divergence and Egos

"The split you start to see at this point in the negotiations is real, and I’ve lived through it," Mr. Smith said. "For me, the hardest part is to tell a co-founder who has been with me since Day One that, ‘Look, the world has now changed and you’re no longer part of it.’ That’s what I’d dread most."

That task, Mr. Bartlett quipped, is even tougher when the co-founders are related, which is often the case.

For venture capitalists, the key is not to push so excessively that the founders are reduced to the role of mere employees. "It’s bad for morale, and if you want your founders to be like employees, you’re really not getting your money’s worth," Mr. Bartlett said, playing his part to the hilt. "Entrepreneurs are still underdogs in this economy."

Is that why Morrison staged this little show — to educate the underdogs? The firm’s partners say they work on many venture deals — with both investors and entrepreneurs — and see this as a opportunity to educate, entertain and update contacts both old and new. "There’s always a need for good advice for entrepreneurs, regardless of whether the [venture] market is up or down," said Mark Abrams, an attorney in the audience who is trying to add more venture-related elements to his Atlantic Beach, N.Y., practice.

But how did they talk people like Messrs. Wilson and Smith into this gig? "It’s all about relationships," Mr. Bartlett said.

"I’ve worked with the firm on a number of deals, and some of these issues are still close to my heart," said Mr. Smith, who is now a managing director of Ascent Group, an investor and developer of medical technology and health-care data companies. What Mr. Smith doesn’t say is how he also happens to be married to a Morrison partner, and how persuasive that factor was in securing his participation.

"He didn’t tell you that?" chuckled one of the other Morrison partners later. "There you go — sometimes, as in term-sheet negotiations, they don’t tell you everything upfront either."

Write to Kopin Tan at [email protected]

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