An entrepreneur? Protect your equity and avoid exiting poor by learning how to negotiate like a CEO.
By Jim James, Founder EASTWEST PR and Host of The UnNoticed Entrepreneur.
In the latest episode of The UnNoticed Entrepreneur, Northern Carolina-based Jotham Stein discussed how an entrepreneur can protect themselves so they get to keep the company that they’re building. He is the owner of the Law Offices of Jotham S. Stein P.C. and the author of the book, “Negotiate Like a CEO.”
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The Essence of Contracts
To protect yourself, the first that you need to know is the language of investors or anyone who’s doing contracting; you need to know the full information. Because what Jotham found is that entrepreneurs don’t have and don’t understand those pieces of information — they’re 100% focused on what they’re doing or creating.
If you’re starting out with investors or co-founders, think about what you need to be included in your contracts so you can protect yourself going forward and you won’t be forced out of your own company. You need to protect yourself, whether it’s from an angel investor, a venture capitalist, a private equity individual, or even your co-founder.
Each of these individuals has their own languages that they use. And you need to know that, along with their interests. If you know their language and interests, then you can negotiate what will be included in the contract that Jotham calls a “Professional Pre-nuptial Agreement.” This will let you stay in control of the company you founded.
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What You Need to Know Before Entering a Deal
Giving an overview, Jothan mentioned that one of the things you need to know if your company enters into any deal is the number of board seats that your investor wants. Typically, a company is controlled by a number of board members and you want those board members to be under your control. Take note that at some point, the investor may want to take control of the board because that would allow them to fire you even if you’re the founder.
The second thing you need to identify is the capital or percentage of the company you’re giving up. The third is about liquidation preferences — which refer to what an investor wants to take back if they sell your company or if your company exits before you get anything.
Then, you also have to think about the relationships you have with your own company. You may want to put in place a strong employment agreement for yourself, the founder, even though you're running the company and controlling the board. Because should you lose control or if something goes wrong, it will allow you to have a clean exit and protect your equity. It can also entitle you to get severance or separation pay, which can help you transition to the next thing in your life (It could be working for another company or starting a new one).
These are things that you need to know, and they all have a language — words and contracts behind them.
What Should You Prioritise?
One of your top priorities should be how you can protect your control over your company (it’s typically the board of directors). Keep in mind that investors want to take as many board seats as they can because once they get control of the board, they can kick you out or do what they want. They don't have to listen to you as the founder. Even though you want to do a certain thing, if the board will say that they’d go for what the investor wants to do, then you lose.
Next is about protecting your equity. Equity is another word for stock, stock options, or restricted stock. In the US, most individuals have common stocks. In the UK, it’s called ordinary shares.
When investors put money in your company, you have to be concerned about their co-liquidation preferences. For instance, if they put in $1 million, they may indicate in the contract that no matter what you sell the company for or what you do, they’d get the first $ 1 million off the profit. If they stated that they prefer double participating, then they’d be getting double the amount (in this case, $2 million).
Third, you should have your own employment agreement with your company. Keep in mind that even though you’re the founder, you still have other various relationships with your company — an employment relationship, being an officer of the company, and being a board member.
Your employment agreement will set out all your protections, including equity protection.
Picture this scenario: You’ve put in $10 million for your company. Then, the board tells you that you have to work over a period of time for those shares — for example, four years. If you will get fired after two years, then you will lose half of the equity that you had as a founder.
If you have an employment agreement stating that if you’re fired, you get to keep all your equity, then, at the very least, you can protect what you started out with.
You must protect yourself as an entrepreneur. Unfortunately, many entrepreneurs fail to do it until they’ve been mistreated.
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In Jotham’s book, he describes all of these things that you should know. And then, after you know what these are, you need to be able to talk about it. If you have any leverage, even if it’s outside your personal comfort zone, use it to negotiate and bring up the terms before you sign a contract with your investors, board, and company.
If you think you have no leverage, at least go in with your eyes wide open — and pick who among your investors will do the best for you. Remember that often, investors invest knowing that they’re going to get rid of a founder or a management team.
Personally, Jotham believes that when you start out with your company, you should enter into these protective agreements even though you're voting as the only member of the company or you’re in control of the company.
You should vote on your own agreements to protect yourself, your equity, and your severance. And when you do that, you’ll be stronger when your company goes into Series A or Series B funding because you can negotiate off what you have included in those agreements.
From a psychological business perspective, you’ll find it much more difficult to negotiate if getting investors with a letter of intent (a short non-binding contract that comes before a binding agreement and represents the basic terms of the agreement) comes first before you put in place your own protective agreements.
On the other side of the spectrum, others would recommend doing the opposite: Don't waste your time in the beginning when you control the company. When you get a sophisticated investor, then you can start negotiating so you can protect yourself.
It’s up to you to learn both sides and decide for yourself which one to follow.
Reaching Out to the Right Investors
Friends and family are usually the easiest investors to work with because they already trust you as an individual. Angel investors are also easy to work with because they’re not looking to control your company and they’re early on. Though you should have contracts in place and have yourself protected, you don’t need to be so worried at that point.
However, keep in mind that every context is different. In fact, many people have been stabbed in the back by a sibling or a friend. But generally speaking, early-round investors aren’t going to get control because they're not going to buy enough of your company for them to be able to do that.
Once you start with institutional investors, you have to be more alert. For instance, if you’re in talks with venture capitalists, then you have to do your due diligence. There are certain VCs that are known to meddle and fire founders immediately. There are also others that believe in management teams and have no interest in removing people.
If you’re talking with private equity, you should do your due diligence as well but have a completely different mindset (which is often geographic-based). For instance, if you’re dealing with someone from New York, know that those in this city are considered to be the most difficult to deal with in terms of being in control of what they want.
You can consider yourself lucky if you have the so-called strategic investors or potential acquirers. These are big companies that are investing and hoping you grow bigger so that they can buy you at some point. They could be motivated to buy your company because you’re making a product that works with their product and they’re planning to have it integrated with theirs.
Often, they invest a lot of money — a lot more than what private equity or VCs might be willing to shell out — all while not having the interest to take control.
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In other cases, entrepreneurs will be too desperate to the point that they don’t mind losing control over their businesses. If such a client reaches out to Jotham, he always reiterates that once they enter into that deal, they may be fired from their own company within a year. Some people don’t mind it, and some do. And this just shows that everyone — entrepreneurs and investors alike — are different.
Entrepreneurs are also different from one another in terms of exiting. Some don’t want to leave their companies. Some have no interest in exiting and yet get forced out. Some leave for the betterment of the company because they acknowledge that the skill of starting a company is different from managing one (some may be great at both, others are not). In the same manner, professional managers may be great at managing companies but don’t have the skillset to start one.
Then, there are the so-called serial entrepreneurs. They know that they’re good at building companies but not at managing them. Many of these have become successful because they don’t have the ego that they need to run the company that they founded. They settle with the fact that they can let somebody else run it — they’ll still make money because they own stocks in the company anyway. And to protect themselves, they have equity, which is their power in the company. They could stay as part of the board or, sometimes, as a chairman who gives knowledge.
In these situations, what entrepreneurs are controlling is dilution. They don’t want to be diluted out of their own company. And there are multiple ways to do that — including contracting.
In negotiating upon your exit as an entrepreneur, it’s not only equity or separation pay or medical payments that are important. There could be other friendly transactions, and investors typically agree because they know that entrepreneurs do it because they want to move on to their next endeavour.
All these things are rather context-dependent. In essence, you have to be aware of who you’re dealing and working with, and protect yourself against it.
Getting Himself Noticed
Before having offices across the country, Jotham started out building his law firm in Silicon Valley.
Back then, he quickly recgonised that there were all these entrepreneurs out there that weren't protected — they didn't know the questions to ask; they were frankly being cheated over and over again and forced out of their own companies. He saved money and ran a quarter-page advertisement in a magazine called Red Herring for a number of months. His ad said: Even CEOs get fired. It also contained Jotham’s credentials (i.e. the schools he went to).
He was stunned by the number of entrepreneurs who called; the return on that ad was great. He discovered that entrepreneurs didn't know who to talk to when they’re being forced out of their company. They’re afraid to talk to their friends and colleagues.
As Jotham heard perspectives and stories from every level of employees — from regular ones all the way to founders and CEOs of companies — it kept him going.
Image from www.jotham.com.
In his book, Jotham also talked about reincarnating yourself if you do get forced out of your firm.
You should realise that you’re not alone: Nobody likes to be forced out of their own company. It’s a horrible experience and it's terrible in different aspects — psychologically, emotionally, family-wise, business-wise, and financially. But you can reincarnate yourself and come back strong.
There are many founders who have been forced out of their own companies and have come back to their businesses or have started new ones. In fact, he often gets calls from happy clients who say that the best thing that ever happened to them was to get forced out after setting themselves up poorly with investors and board members. Now, they’re much happier and have a stronger resolve: They won’t let the same thing happen to them again.
To learn more, you can buy “Negotiate Like a CEO” on Amazon.
This article is based on a transcript from my podcast The UnNoticed Entrepreneur, you can listen here.
Cover image by Rostyslav Savchyn on Unsplash
