Successful Negotiations: The Art of Compromising Without a Compromise
Successful negotiation is an intricate process. There are many factors that play a role in whether the outcome is successful or not. An entire book can be devoted to the intricacies behind successful negotiations. I do not intend to teach you how to become a better negotiator, but merely to bring a couple of nuanced observations to your attention, which I believe will significantly increase the probability of reaching successful outcomes. My observations apply to transactional business negotiations, although they may affect other situations as well.
Notice that I said “reaching successful outcomes” and not “out-negotiating the other party” or “winning over the other party.” I didn’t say “negotiating a good deal” or “how to avoid a bad deal.” My focus is on how to avoid failures in reaching any agreement and walking away from a potential deal altogether, or the corollary, which is how to reach successful outcomes.
In my view, when two sides enter business negotiations and such negotiations do not produce a successful outcome, then both sides have lost! This is particularly so if there were ways to avoid an unsuccessful outcome. I am not suggesting that there are ways to ensure that failures never happen. What I can tell you is that, from my experience, a large number of failed negotiations could have been salvaged. It is those kinds of situations that I would like to make you aware of and to help you avoid. I believe that my suggestions will not only allow you to salvage an otherwise failed negotiation, but will also make you a much better overall negotiator as well.
I’ve negotiated business transactions for the better part of my career. I was responsible for all business transactions for a large corporation as the vice president of mergers, acquisitions, and investments. Subsequently, as a venture capitalist, as you may surmise, I have been involved in hundreds, if not thousands, of transactional business negotiations. I have experienced a lot, noticed a lot, and learned a lot. There are two specific nuances that I’d like to discuss in this section, and both are, in my view, rarely discussed in business literature and both could be critical to a successful outcome. The first observation is about the person who really makes the final decision to accept or reject a deal with the other side. It is not who you might assume it is. You might assume that the person with final say in a negotiation is the highest-level executive. Technically, you might be correct. Indeed, the buck stops with that executive. However, my intent was not to ask an obvious question; it was to raise a nuanced question, with a nuanced answer, but with a fundamental implication about how to avoid failed negotiations for reasons that could have been avoided. To ask the question properly and accurately, I should have asked instead, “Who may have veto power that even the top-level executives would be reluctant to overrule?”
I am not looking for some clever interpretation of my question. Neither am I looking for some obscure éminence grise in the organizational structure who may have the legitimate ability to formally veto the top executive. This is not a mysterious person. All are aware of this person, but few give it a second thought. This person is each of the lawyers assigned to the negotiation team, on both sides. (Just as an aside and for the purpose of completeness, when the deal involves technical issues, then the technical experts on the team will also have such a veto power, but this fact is not pertinent in the context of this chapter.)
Thus, the first nuanced observation is: The lawyers advising the negotiating team, regardless of title, position, and importance in the organizational hierarchy, have an informal veto power that not even top-level executives will likely ignore.
This is so because whenever legal implications are in the balance, legal advice is rarely ignored, regardless of the situation.
Legal advice is just that—advice. The giving of advice implies that a final decision rests with the person who receives the advice. This is true in most cases, but there may be exceptions. Legal advice is normally presented with various alternatives and their legal implications, according to the lawyer’s expert opinion. The businessperson will weigh legal advice and the implied business trade-offs and make the call on which alternatives to accept and which to ignore or reject. However, there is a redline no businessperson, not even the top executive, will cross. The redline is drawn by the lawyers should they say, “I would definitely not recommend moving forward or accepting what is in front of us.” Or even in more subtle ways, like, “I really don’t like this option, or the alternative.” Or, “The risk here appears too high.” Even though technically it is just a recommendation, de facto it becomes a definitive position for the executive.
What makes the above so important from my perspective is the fact that most deals that fail do so for two overall reasons. The first one falls in the domain of the business team and its inability to reach proper compromise on the overall business terms. The second one falls in the domain of the lawyers and their inability to reach agreement on the myriad of the nitty-gritty details behind the business deal that need to be captured in the text of the final agreement. This is when the adage “the devil is in the details” truly comes to life.
In my experience, sometimes (perhaps even often) negotiations fail because the lawyers and their business teams have different styles of communication and approaches to negotiations. Thus, the key questions are: What is the difference? How does it lead to obstacles and potentially failed negotiations? And, more importantly, can it be averted?
The answer lies in understanding how lawyers think and behave, and how redlines are drawn by the negotiating team. Understand this and you are much more likely to come up with alternatives that will avoid bringing a negotiation to a premature close. Thus, by definition, you’ll increase the rate of successful outcomes and reduce the rate of failed outcomes.
Lawyers are trained to see nuances and exceptions to practically everything. They are adept at dissecting sentences and finding words to alter a point so that it becomes acceptable to both sides. At the same time, practically every lawyer when writing up their first version of their draft will word it in a way that gives them the greatest “protection” and minimizes their own “legal exposure.” Clearly, they understand that it would be unacceptable to the other side, since the other side would want the exact opposite. The lawyers understand this well, and expect further negotiations. It is just the way legal negotiations work.
However, while lawyers are very good and adept at slicing and dicing the language, defining and redefining, and allowing for exceptions, the businesspeople who do the actual negotiations are not as adept at doing the same.
A problem may arise when the business negotiation team gets the legal briefings and advice. The team is made aware of legally sensitive issues that they need to protect, or get as concessions from the other side. At this point, the lawyers do what they always do—they describe the legal position that needs to be maintained with the broadest protections possible. When the other side is not sensitive to an issue, they will yield to the broader protection. Conversely, if they see the broader protections as detrimental to their position, they will not accept them. However, unlike the lawyers, who can easily adjust the language to reach amicable compromises, businesspeople are not equipped to work with nuances of language to reach compromise, so they insist on maintaining the original language and guidance given to them by their lawyers. Thus, a potential for a deadlock exists.
A similar problem may arise not because of legal briefings, but for the exact same tendency. Businesspeople know what they will not compromise on, no matter what, which is their redline from a business negotiation standpoint. However, since they are not very adept at using language to refine the final definitions of the redlines, they define them in very broad terms. So, instead of fighting a “battle” for a narrowly defined position, they fight a broadly defined position—a whole “front.” Clearly, the broader the definition, the more likely a conflict will arise, increasing the likelihood of irreconcilable differences. An example by way of a metaphor will help illustrate what I mean.
The Tale of Two Armies
Assume two armies have an informal truce. They are not in a state of war, but they do consider each other a potential threat. Neither side wants to escalate the situation on the ground. There is one area in the desert where a river flows within the territory of one army. Off the river, a small irrigation channel has been dug, which crosses over into the territory of the opposing army and is the main source of drinking water for them. The army controlling the territory of the river considers the river a strategically important barrier.
The distance from the front to the river is half a mile. The army that controls the river territory has little defensive capability should the river be breached. As a result, the top general issues a directive to all the units along the river to defend the front at all costs and not allow the other army to reach the river. The order says, “Fight to the death, if necessary.”
Imagine that a captain responsible for the small but vital sector of the front, where the channel crosses into the territory of the other army, sees a large unit from the opposing army approaching his defensive line. The officer in charge of the approaching army unit approaches the captain under the protection of a white flag to deliver a message, with the hope of avoiding an all-out war. Below are a number of scenarios that together will help clearly demonstrate the point I’m trying to make. For the metaphor, assume that the top general at headquarters is a lawyer in the business world and the officers are the negotiation teams.
Scenario I: The officer with the approaching force tells the captain, “We must have access to the river. We are ready to die to do so. Allow us to get there and we can avoid a war.” The captain sends the following message to his general: “Enemy approached us. They are ready to die if we don’t let them get to the river. What should we do?” The response is predictable: “Are you crazy? You must not allow the enemy to reach the river. Fight to the death, if necessary.” A war breaks out subsequently.
Scenario II: Same as scenario I, but the defending officer attempts to understand why the other army is ready to start a war over this. So, he asks the aggressor officer, “Why is it so important for you to reach the river?” The answer is, “I have no idea. My superior officer told me to get to the river and control the access to the river. He said fight to the death, if necessary.” The captain sends the following message to his general: “Enemy approached us. They are ready to die if we don’t let them control access to the river. What should we do?” The response is predictable: “Are you crazy? You must not allow the enemy any beachhead at the river. Fight to the death, if necessary.” A war breaks out subsequently.
Scenario III: Same as scenario II, only this time the aggressor officer responds to the question asked in the following way: “The irrigation channel that flows into our territory was accidentally poisoned. We have no other source of drinking water. We will die from thirst unless we have access to the river. We have nothing to lose. We’ll fight to the death to get access to the river, but I can assure you that we have no intention to cross the river and attack you.”
The captain sends the following message to his general: “Enemy approached us. They told us that the irrigation channel was accidentally poisoned. They have no other source of drinking water. They face death unless they get access to our river. They promise that they will never attack us. They are ready to die otherwise. They will fight to the death. What should I do?”
The response is likely to be, “I feel sorry for them, and hate to see them die from thirst. But I don’t trust them enough to place us in such a vulnerable position where they have a beachhead from which they may possibly one day decide to attack. You must not allow them any beachhead at the river. Fight to the death, if necessary.” A war breaks out subsequently.
Scenario IV: Same as scenario III, but one or both of the officers is not a pedestrian thinker. So an additional conversation ensues, as follows: “Would you accept another option to get the water you need? Would you still demand a beachhead at the river?” The aggressor officer sends a message to his superior officer (assume the superior officer is a lawyer for the other side): “If we get all the water we need in another way, would we still need to fight to establish a beachhead?” The superior officer responds, “What is the other way of getting drinking water, and can you guarantee that we can get as much as we need?”
The conversation continues between the two officers who are trying to avoid a war. The captain says, “Let me explain our situation. We don’t want, and will not try, to stop you from having drinking water. We also don’t care all that much about that little narrow irrigation ditch that gives you access to drinking water. What we really care about is your potential ability to then cross the river and attack us. I will fight to the death to stop you from doing that. Keep in mind that this is exactly the reason why we established our front line half a mile past the river, giving us a safety zone. This guarantees that you don’t have any access to the river and therefore will never be able to cross it. So, I can give you access, as long as I have a guarantee that you will not be in a position to attack us. A promise is not enough for us.” Both officers then begin to think of ways by which the armies can get what they want, thereby avoiding a war. I can think of a number of different ways of accommodating the most essential sensitivities of both sides, without compromising anything important to either side, yet avoiding a war. Following is just one example.
Assume the following messages are written by each of the opposing officers. The captain sends the following message to his general: “Enemy approached us. They told us that the irrigation channel on their side was accidentally poisoned. They have no other source of drinking water. They face death unless they get access to drinking water. They will fight to the death if they don’t. There is a way to avoid war, if we allow them, under our escort, to drive their water trucks each morning to the river to fill them up with water. Can I commit to this solution, or should I prepare for an all-out war?”
The other officer writes to his superior officer, “The enemy is ready to allow us as much access to drinking water as we need. However, they would like to do it in a different way that addresses their concerns. They will let our water trucks drive to the river to fill up, each and every single day. This will avoid war. Can I agree to these terms?”
Of course, both officers would get approval for this solution and so avoid a conflict. This situation happens all the time in business negotiations. Just substitute the word “war” with a terminated or failed negotiation.
As in this example, businesses have specific things they want to protect or achieve at all costs. These things become their redlines. To do so, either because of initial lawyers’ briefings, or lazy thinking on the part of higher-level executives, the negotiators draw a wider circle around these specific points, thereby establishing a kind of safety zone. The circles then become the “front lines” for the negotiating team; as in our example, the front was half a mile from the river itself.
As I mentioned earlier, businesspeople are not adept at digging into the reasons behind the way the front is established to see if some adjustments are possible. Those who can do it generally find a way to avoid a hopeless conflict. All it takes is a little redefinition of the front without having to compromise on anything important. In most cases, they will have enough of a safety zone between the boundaries of a specific point and the broader circles drawn to allow for creative adjustments. Most negotiators are “pedestrian” thinkers who often don’t think deeply enough to find creative alternatives. Or, like the officers at the front in some of the scenarios, they may not even know that it might be possible.
To avoid failures of this kind, first make sure that the difference between the specific points and the safety zone of the other side is understood. Then, seek creative ways to find solutions, which will narrow or bend the safety zone circles, but still fully protect the real specific points of sensitivity.
My experience has proven to me that, in most cases, it is absolutely possible to avert such “wars” in business negotiations. That is why I selected as the title of this chapter “Successful Negotiations: The Art of Compromising Without a Compromise.” Below are a couple of real-life examples to further illustrate this point.
Defining Broad, Counterproductive Redlines
In the late 1990s, a large corporation developed a new technology in its research and development department. The company internally funded and launched a start-up company to bring the product to market. Typical of larger corporations, it overstaffed the start-up with new hires and layered it with a top-heavy bureaucracy (which venture capitalists would never allow at the very early stages of a start-up). Such staffing included internal lawyers, accountants to see that all of the corporate-required financial reporting was adhered to, human resources personnel, a full contingency of salespeople, numerous layers of management, and well-furnished offices.
The start-up didn’t perform to expectations in the first couple of years, which is not surprising. However, the excessive (and unnecessary) overhead costs generated large losses for the corporation. The executive of the parent company decided to sell the start-up to avoid further and future losses. To avoid potential legal liabilities with the managers and employees of the start-up, the parent company resorted to a common practice in those days: It offered management the opportunity to buy the start-up and own it outright (a management buyout).
The management team and employees usually view very favorably such opportunities to become independent entrepreneurs. As such, they would end up personally owning 20 percent of the new company, which was a standard incentive offered by venture capital firms. All the management team needed to do was find a venture capital firm that would be willing to meet the parent company’s purchase price and commit to fund the start-up’s operations from that point on. That is how the start-up opportunity came to my firm’s attention.
The management team gave us an impressive pitch. We assessed that the technology and product had great potential. We also saw ways to reduce overhead costs significantly. We told the management team that our interest was strong and initiated our intensive due diligence process, which took about four weeks. Then we told the management team that we were ready to proceed with the buyout. The management team was ecstatic.
We made a formal offer to the corporation (the parent company) that contained a summary of terms. Of course, it was subject to the final negotiations of the purchase agreement and additional due diligence by us. The corporation agreed to our term sheet, and we both signed it.
We immediately started working on the documentation of the final purchase agreement. As is typical in situations like this, the management team of the start-up was our negotiating team. A few days later, we got the first draft of the purchase agreement from the corporation’s legal department.
As I read the draft, I came across a clause that both surprised me and gave me concern. I had never seen such a clause before in any buyout situation. The clause stated that both the start-up and the corporation would have ownership of the intellectual property (IP) for all the existing and future technology of the start-up. The practice almost always is that the purchaser of the start-up has outright ownership of all of the IP. I thought the clause had been inserted in error.
I called the CEO of the start-up, who was responsible for the negotiations with the corporation, and told him that this clause was inserted in error and to make sure it was removed. I never gave it another thought. Then he called a couple of hours later and told me that the corporation’s lawyers refused to either remove or make any changes to the clause. The lawyers insisted that IP ownership was a condition for the buyout. Obviously, this would be crossing a redline for us.
I asked the CEO whether he was aware of this condition beforehand. He said yes. I was flabbergasted. I asked him why did he not make it clear to us earlier on, before we launched our due diligence process. His answer was that he didn’t think it was such a big deal. After all, it allowed us to do whatever we wanted to do with the IP, as if we owned it solely. It didn’t limit us in any way.
I explained to him that it may be as simple as that from his perspective, but it was not from ours. I proceeded to explain to him that the endgame for us was “exiting” the investment, either through taking the company public (IPO), thereby allowing all shareholders to “exit” and cash out by selling their shares on the stock market, or by outright acquisition—that is, selling the company to another company for cash. The clause regarding common IP ownership might not be much of a problem if we had an IPO, but it would be a showstopper for any exit through an acquisition. An acquiring company would want complete and untethered control over the IP. A shared ownership would not be acceptable. I asked the CEO to explain our position to the lawyers and have the clause removed.
The following day, he called and told me that the lawyers were adamant that the clause remain intact. However, the lawyers were willing to add language to the effect that the parent company would not build a competing product to ours. They believed that such a qualification should satisfy all of our concerns.
They were completely ignorant of our concern and perspective. Their response is analogous to the scenario where the approaching army said that it only needed a small beachhead and promised never to attack or cross the river. My response was exactly the same response of the general’s, which is that nobody would be willing to assume the risk and trust the other side’s stated intent. No potential buyer would accept that kind of a vulnerability. I again requested removal of the clause.
His next call made it clear the lawyers would not budge. Their response kept making absolutely no sense to me. If they never planned to use that technology to compete with us, why would they insist on owning it? I asked the CEO whether he knew of any reason that would cause them to be so unreasonable. He said he had no idea why the lawyers insisted on co-ownership. I notified him that we would not proceed with the deal and asked that he send it up the chain of command and out of the corporate legal department. I assumed that the lawyers may just be unreasonable, and that any higher-level executive would see our side of the issue. The CEO promised to do so.
A couple of days later, the CEO called back and told me that the president was notified, but the situation continued to remain a redline for them. I told him that there must be a reason as to why it was of such great importance to justify walking away from the deal. I also made a mental note that my CEO may not be the right person for our company. He never attempted to get all the necessary information in a proactive, anticipatory way. He was a pedestrian thinker who never exhibited a curiosity to comprehensively understand the situation.
Two days later, he called back with some information that shed light on the matter. Some of the corporation’s products used elements of our technology. The parent corporation was concerned that it might expose them to a potential claim of IP infringement if it no longer had rights to the IP. I asked the CEO how important, from a technology standpoint, the “common technology” was to us. He replied that it was minor and completely inconsequential. However, I now understood why the company was so adamant about the common ownership clause. I also understood that, in a typical lawyerly way, the lawyers had created a front to protect a specific point. They were ready to “die” to protect their “river.”
I asked the CEO to go back with a final proposition. We would be willing to have a common ownership of the specific technology that created their anxiety and potential liability. But they didn’t really need to have common ownership on the rest. A day later, he came back and said they had agreed to that. A failed negotiation was averted—the art of compromising without a compromise!
As it turned out, there were additional problems and we became even more concerned about the CEO’s capabilities, and so we decided not to consummate the deal, but it was our choice.
Starting a “War” Instead of Winning a “Battle”
A scientist invented a new technology around which he wanted to build a company. He approached various venture capital firms to raise the necessary money to launch a start-up. We listened to his pitch and liked what we heard. We told him that we would be interested in potentially proceeding with him.
From our experience, one of the greatest impediments for striking a deal with such scientists/founders is their exaggerated perception of the value of their newly founded company. In the venture capital world, this value is referred to as the “pre-money valuation” of the company. It is an important concept since it determines how much ownership the venture capitalist (VC) receives for its investment in a company. Conversely, it also determines how much ownership the founder will retain.
To determine the amount of ownership, the venture capitalist assigns a monetary value to what the founder created before the contemplated transaction, which is the “pre-money valuation.” The pre-money refers to the value before our money goes in as an investment. Once that value is determined, the percent ownership is determined by a mathematical formula.
For example, let’s assume that the VC assigns a value of $10 million to the company (that is, a $10 million pre-money valuation). Let’s further assume that the VC will invest $5 million in cash. Thus, the total value of the enterprise after the $5 million infusion of cash from the VC is $15 million (i.e., the $10 million cash equivalent the founder brings to the party, plus the $5 million the VC brings to the party). The $15 million is referred to as “post-money valuation” (that is, the company is worth a combined cash and cash-equivalent value of $15 million). The VC contributes $5 million of the $15 million, or $5/$15 = 33.33 percent of the value. The founder brings $10 million of value, or $10/$15 = 66.66 percent of the value. These proportions thus represent the percent ownership of the company after the consummation of the deal. Clearly, every founder will try to negotiate the highest pre-money valuation for their company, since the higher the pre-money valuation, the higher will be their percent ownership.
As I mentioned, most founders have an exaggerated estimate of what their company is worth. They think their company will be worth billions of dollars in the future, ergo it must be worth hundreds of millions today. VCs look at it differently. Although the estimated potential may be realistically great, most companies never get there. “Exits” occur much earlier and at much lower valuations, reflecting real performance, not some exaggerated potential beliefs. VCs place a more realistic expectation on performance and potential exit values. The pre-money valuation the VC would be willing to offer is mathematically driven from that exit value.
Let’s assume the VC places a $300 million exit valuation. The VC will then estimate how much money they will need to invest to make it happen. They require a certain multiple return for their investment. Thus, they know exactly how much of the company they need to own to get that multiple return. This in turn determines the pre-money valuation.
For example, assume that a VC requires at least a 5-times multiplier on investment upon exit. Assume that the VC estimates that they will need to invest $20 million in the company. Thus, they will need at the time of the exit $20 million × 5 = $100 million. The VC estimates that it will sell the company at exit for $300 million. At that exit price, the VC needs to own 33 percent of the company to receive the required $100 million return ($300 million × 33 percent = $100 million). To own 33 percent of the company with a $20 million investment, the pre-money valuation will need to be no more than $40 million ($40 million pre-money plus $20 million in cash equals $60 million post-money; $20/$60 = 33 percent). The point of this exercise is to alert you to the fact that a VC has a strict mathematical formula to determine the pre-money valuation of a potential investment.
Given the typical exaggerated estimate that founders have, the VC will bring up the pre-money valuation issue with a founder up front so as to avoid any disagreements over money in future negotiations. They will ask a founder in the very first meeting what their expectations are for the pre-money valuation. They will need to see that the founder has reasonable expectations; otherwise, they will not proceed with the deal and will not start any due diligence.
That was on my mind when the founder presented his business opportunity to us. He told us that he wanted a $40 million pre-money valuation, and wanted us to invest $15 million. Forty million dollars was an exaggerated estimate for the valuation of his company. I liked the deal and was willing to invest the time and resources to do in-depth due diligence, but I had to make sure that it wouldn’t be in vain because of a disagreement on valuation. So I told him that his pre-money valuation would not be acceptable to us.
I told him that the pre-money valuation appeared to me to be more in the $20 million to $25 million range. I proceeded to tell him that if he didn’t accept it, we would pass. I also told him that if our due diligence showed that our estimate of the pre-money valuation was overly punitive, we would increase the valuation. He contemplated this for a while. I’m sure that he had spoken to other VCs and probably got the same pre-money valuation range. He accepted our proposal. We drafted a nonbinding term sheet with that valuation along with other terms and conditions we normally require. He signed it a number of days later, and we proceeded with due diligence.
We liked what we found out in our due diligence. We were ready to proceed with the transaction. However, we thought the company would need to raise at least $25 million, instead of the founder’s initial estimation of $15 million. We thought that his revenues would come in at a slower rate than he estimated, and therefore had to fund losses for a longer time. We gave him the final proposal. We were willing to invest and help raise $25 million, at a $20 million pre-money valuation. All other terms and conditions would remain unchanged from our initial term sheet.
I did not anticipate his response. He said that he would not accept a $20 million pre-money valuation. He said that the minimum valuation he would accept would be $30 million. I reminded him that he was made aware of this valuation in advance and agreed to it. His response was terse: “No, it is unacceptable; nothing less than $30 million.” I told him that $30 million would be unacceptable to us, and asked him whether he would walk away from the deal. He answered, “Absolutely.” I was sorry to lose this opportunity, as I really liked it. But I couldn’t justify the higher pre-money valuation. The math would not justify it for us. I told him that I was disappointed and that we would pass.
By happenstance, I ran into him about a week later. He was very cordial, and we had some small talk. As part of the conversation, I asked him why he changed his mind about the valuation. He was a little evasive with his answer. I kept pushing the issue as best I could because I was curious. He kept being evasive. We went back and forth for a while, with him giving some benign responses, but never a convincing reason for why he changed his mind. I was a bit upset and kept pushing him for the real reason. Somewhere during these interactions, he snapped and said, “There is no way that I will not have majority control over my company.”
I asked, “What do you mean?”
He responded, “This is my company and my life; I will not accept any situation where I don’t own the majority of the company.”
I now realized why he had turned the deal down. He lost the majority vote with the $20 million valuation and our insistence on raising $25 million. His objection, his “front,” had nothing to do with the valuation, but it had everything to do with majority control over the company.
We, as venture capitalists, don’t care how much of the company we own. It makes no difference to us whether we own a minority or majority position. Through separately written agreements, we acquire the controls we require, regardless of ownership. We are driven by the percent ownership, not the “controls.”
I looked at him and asked, “How about if we take half of our position in non-voting shares? This way you’ll still maintain the majority of the voting shares and have the same control you were trying to get through an increase in the pre-money valuation.” He accepted it on the spot. Again, the art of compromising without a compromise!