Category Archives: Financing

Cheating is Allowed

One of the things I struggle with as an artist is a constant inferiority complex. While I am a pretty good illustrator, whenever I spend time on any art sites I see the amazing work done by others and feel like I am a complete novice. I’ve spent 20 years learning and perfecting my technique but these others make me feel like I’ve only just gotten started. How did they find an easy button where I still struggle?

If you are a founder of a company, you understand that feeling well. You see your friends and colleagues raise large rounds of funding or get lucrative acquisition offers and you are still struggling to get those first few meetings. Where is the easy button they found?

Often, when you feel this way, you are making some bad assumptions. For example, when I first see a beautiful illustration of a person’s face I always assume that the artist draws the same way I do – from memory or imagination. In reality, many artists trace photos. In fact, there is evidence that even the great Renaissance painters were tracing their subjects with the use of mirrors. Tracing is infinitely easier than drawing free hand, and the result is always significantly better.

However, by assuming they were approaching the problem a certain way I assumed they were simply better than me. In reality, they just found another approach to the problem which is easier and has much better results!

Some artists consider tracing to be cheating, but in reality no one cares. No one looks at a given piece of art and says “Well, they didn’t do this the hard way…”. The same is true for your company! Your goal is to build a successful business, not to build a business the hardest way possible.

What are some short cuts you can take as a founder?

Sell to your friends. Every enterprise software company’s first 10 customers are friends of the founder. In fact, many of those customers might buy the product only because they are friends! That is perfectly fine as long as you quickly move on to non-friend customers, since all they gave you was a head start.
Leverage existing networks. Every YCombinator enterprise software company launches with 50+ customers – how do they do it? Most of them are other YC companies who want to help out a fellow founder. You can do this as well, by plugging into the network of your investors and advisors.
Hire your old team. Many experienced founders initially hire people from the teams at their prior job. Considering how hard it is to hire in the technology market, having the advantage of a trusted relationship and existing work style is a great way to build your initial team. It’s both less risky and easier to close someone who knows you already.

These short cuts won’t build your business for you, but they do give you a head start in a time when you desperately need the help.

The next time you feel like things are really hard perhaps it is worth rethinking your approach to try and find a short cut. Or, maybe it’s just really hard.

Image courtesy of Flickr user Smoobs via the Creative Commons Attribution 2.0 License.

Selling Your Company

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It happens to every founder at some point. You realize building your business is harder than you expected. You’ve been working for a few years without finding breakaway growth. The team is tired and losing some of their passion, overwhelmed by the work that needs to be done. You need to start a new round of fundraising soon and are not sure you want to invest another 3-4 years into building this company. All of a sudden, you find yourself thinking of selling.

Selling your company always seems like an attractive option. Instead of working harder you can get out now for a few millions dollars, pay back your investors and pocket a little extra for the few years of hard work. You read about it happening everyday in Techcrunch so why not you? You have a great team and an awesome product, some large company would surely pay for that.

Unfortunately, that is not how it works.

Companies are bought, not sold (as everyone will tell you). Selling your company when things are not going well requires a number of forces to converge in your favor at the same time:

An acquirer must have the need for your team, product or customers at a price you will accept.
Your team must be willing to work for the larger company for a few years.
Your investors must be willing to sell for a price that is likely a loss for them.

It is surprisingly rare that these three factors converge at the same time. When acquirers come knocking, you and your team might be fresh off a round of financing and flush with your dream of riches. When you and your team decide to sell there may be no acquirers ready to move. And even if your team and an acquirer are on board your investors might not be willing to give up.

That being said, selling while under distress can be done. It takes a lot of work on your part, as a founder, as you need to do a number of things at once:

Focus on maximizing the value (and hence attractiveness) of your business by emphasizing the things acquirers will value. That includes your customers, product, team, etc.
Spend a lot of time networking to find any and all potentially interested acquirers. You need two or more to get a decent deal in negotiations and these will usually come from existing partners who know your business well.
Convince your team to continue to work hard during the search for an acquirer, despite all the uncertainty and unknowns. This can be the hardest part, especially if they are already feeling burned out.

It is a hard balance and few companies successfully navigate it. I have seen teams fall apart right before a deal is closed because of fear and uncertainty. I have seen great teams with great products look high and low never to find any interested acquirers. Even if you find an acquirer, most distressed companies are treated as “acqui-hires” which means the team gets a token bonus in addition to a job offer. A small reward for years of hard work.

The only real chance you have for being rewarded for all your hard work is to build a business that grows. If that looks impossible, maximize the strategic value you can provide through your product, team and customers while pursuing relationships with potential acquirers. In other words, the normal things you do as a founder.

So, time to get back to it.

Image made available By Prokopenya Viktor (my own picture collection) [Public domain], via Wikimedia Commons

The Myth of “SaaS”

How to Get What You Need

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I have many conversations with founders that start with “I need…”. “I need to raise money.” “I need to hire more people.” “I need to find some more customers.”

It is very easy to develop tunnel vision when building your company, as you are tackling difficult problems everyday. Your world consists of aggressive (maybe impossible) goals and you evaluate all the things you need to be able to achieve those goals. Those needs become your entire focus.

The problem with focusing on your needs is that no one else cares.

When prospective investors, employees or customers look at your company they don’t care about your needs, they care about what you can do for them. Investors don’t care that you need to raise money, they care about whether you can produce a return on their investment. Employees don’t care that you need to hire more people, they care that you offer unique and valuable opportunities. Customers don’t care that you need their business, they care about whether you help them solve a problem.

When you think about the world this way, you realize why many first time founders struggle. They focus too much on their needs and not on how to create enough value so that people will want to fulfill those needs.

Getting What You Need

In order to get what you need, you need to make the opportunity to give it to you such a great deal that no one would ever pass it by. So, if you need..

To Raise Funding: Make your company an amazingly attractive investment. This should be a combination of traction, team and vision (and perhaps revenue). Make the terms of investment friendly to both you and the investors so they don’t feel you are trying to take advantage of them.
To Hire People: Make your company an amazingly attractive place to work. Empower new hires to learn and expand their roles, giving them the freedom to be creative while holding the responsibility of delivering important parts of your strategy. Hire for passion as much as skills.
To Sell Customers: Make your product an amazingly attractive solution to a problem they have. Not only should your product be easy to use, it should be easy to get set up and priced to make it a clear decision for the customer.

Remember, when an investor, candidate or customer is considering whether or not to choose your company they are not deciding if you are a good company. They are deciding if you are better than the hundreds (or thousands) of other companies in the market, some of which may be in entirely different industries or businesses. You are competing with everyone to stand out, not just yourself.

So, next time you find yourself saying “I need” try to rephrase it as “Here is what I can offer”. It will greatly improve the chances that you get what you want.

You can’t always get what you want
But if you try sometimes you just might find
You just might find
You get what you need

– The Rolling Stones

Fundraising Fever

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In the past few months, almost every discussion I have with founders who recently started their companies start the same way.

“We are really excited to have you help us, do you know of any investors that might want to invest?”

These are companies that were literally just started, whose product does not yet work and who have no customers. They haven’t even figured out what their business might look like, but they want to immediately jump to raising $1M using a convertible note with a $5M cap (yes, those terms are so common I’m not even making them up).

Why is everyone rushing to raise money? Most of the blame falls to the frothy funding market right now and how easy it is to raise seed funding for new ventures. If you look around and see everyone else doing it, why shouldn’t you? It would be nice to have the money to pay a small salary and remove some of the financial stress that goes along with being a founder. Besides, the market might crash at any time and you should act while the market is hot.

It’s tempting, but dangerous.

Fundraising too early can be very risky for your new company. It will distract you from building your product, recruiting customers and learning about how your business will change from your initial vision (and it will change). In fact, you might not end know what kind of financing is right for your business since it is too early to tell.

Let us look at the difference between two example companies, Company A and Company B, in their first six months of existence. Company A decides to focus on product and customers, delaying fundraising until after their Beta. Company B decides to raise money right away to remove some of the financial stress from the founders. We can give both companies the benefit of the doubt and assume they did sufficient customer development ahead of time so they are working on business concepts that have potential.

Below is how the first six months play out for both companies:

As you can see, after the first six months Company A is already in their Beta and has started fundraising, while Company B is still working on their product because they took three months out for fundraising. This is being conservative, since it’s quite likely that fundraising takes Company B more than 3 months.

But wait! Why didn’t Company B just continue their product development while fundraising? Because there just isn’t enough time in the day. Raising funding is incredibly time intensive, requiring meetings and discussions with many investors, only a few of whom will invest in your company. Assuming both companies had co-founders, there are 2 people on the team and at least 1.5 of them would be working on raising money.

Not only that, but when Company A is fundraising they can speak to investors with confidence about their product and business since they have tested it in the market with customers in their Beta. Company B was pitching investors on an idea that may or may not need to change. This means that Company A will likely be able to raise more money on more favorable terms than Company B.

Well, so what? Company B raised money, right? They have plenty of time to figure it out.

Maybe and maybe not. Again, they have yet to understand what their business might look like as they learn from the market. It is possible that the market completely rejects their business model, or perhaps their product is significantly harder to build than they thought. If they cannot get to market with the financing they raised it is very unlikely they will be able to raise more.

Just in case you don’t believe me, there are countless cases of companies that raised money too early and ended up failing because of it. Color burned through $41M in premature financing before failing. Clinkle is in the process of failing after raising $30M too early.

I know it’s hard to work for free and watch your bank account dwindle. I know that it’s hard not being able to hire a few more people to help build your business and make it move faster. I know that you worry about the market turning and financing getting harder to raise. These are things you will worry about for most of the life of your company. Paying a long term price to address them in the short term is only hurting yourself in the long term.

Raising your first capital is an important event in the history of any company. Be sure it is the right time for yours.

The Profitability Challenge

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Here’s a fun weekend experiment for you, something I call the $20 Weekend Challenge: Take a $20 bill out of your wallet on Friday. You task for the weekend is to turn that $20 into $40 by Monday, doubling your money. You are welcome to use any legal means at your disposal, but heading into a casino or buying lottery tickets doesn’t count. You have to turn that $20 into $40 without gambling. It sounds hard, but it is worth it, I promise.

So, what does this have to do with building a business?

Cash and Business

A common refrain in business is that “cash is king”. Most people say that to mean your company does not exist if you don’t have enough cash to pay your bills, but it is also true that your business is designed to take in some cash and output more cash. You are trying to build something impossible in the world of physics: something that produces more than it consumes.

This is much harder than it sounds, as you likely know if you tried the $20 Weekend Challenge. If you are accustomed to working for a salary, you are used to exchanging your time for money which is very different from building a business. Having a job requires little thought on your part since your salary is (usually) guaranteed and your time has flexible value. Building a business, however, requires a lot of thought.

Let’s do a simple thought experiment to prove that point. Your typical employee at a high tech start up company costs between $100,000 and $150,000 depending on your location so let us assume $125,000. No, that’s not all salary, it includes benefits, payroll taxes, accounting costs, etc. (as a business, the salary can be only half the cost of an employee).

Depending on your business model, let’s see how many customers you would need to pay for that employee.

Business Model: Advertising

In advertising you are paid per every 1,000 ad impressions you show (CPM). CPMs vary wildly so let’s assume you make a $2 CPM (which is not bad). Assuming that 20% of your users are active on any given day and those active users generate 2 ad impressions, you would need 286,200 active users every day to support the cost of one employee.

Business Model: Subscription

In a subscription model, you make money through the monthly fee you can charge active customers. Let’s assume, your product costs $50/month to maintain a subscription. That means you need 210 paying customers every month to support the cost of one employee.

Business Model: Selling Products

When you are selling products, you get a one-time fee for the cost of the product. Let’s assume you sell your product for $100 and it costs you $90 to make it, leaving $10 in net profit per sale. You would need to sell 240 units every week to support the cost of one employee.

And remember, all of that only covers one employee.

The $20 Weekend Challenge

When thinking in these terms, I hope the value of the $20 Weekend Challenge becomes clear. In order to pay for a single employee, you have to have a lot of customers. To pay for your entire team, you need a large number of customers. To pay for your team, your offices, your lawyers and eventually make a profit? You need to have all the customers.

You need to take your money and almost double it to simply pay your bills.

Building a profitable business is hard because the cost structure that goes along with companies is high. Some companies claim they are profitable when they achieve Ramen Profitability, but that is really a false milestone. If you can’t afford to pay yourself a living wage, you are not really profitable.

If this makes starting a business intimidating, good. It should be intimidating. It should seem almost impossible. However, I bet when you first started thinking about the $20 Weekend Challenge it seemed pretty hard too. The only way to see if you can do it is to give it a try.

What Investors See When They Look At You

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If you’ve gotten far enough in building your business to think about raising investment, then you’ve worked very hard and survived some near-death experiences. It’s been a tough road and you should be proud of the progress you have made. Well done!

However, when you sit down to talk to a venture investor about your business you need to put all of that aside. When a venture investor looks at your company they don’t see it as it is today, they are trying to envision what it might look like in 5-10 years.

Wait, let’s take a step back: How do VCs work?

If you’re not familiar with how venture capital funds work, they are easy to explain. A group of partners (known as the general partners) form an LLC to act as an investment fund. They then raise capital for the fund from large institutions like pension funds, endowments and other funds (known as limited partners). The size of venture funds varies wildly from $20M to $1B, but almost all venture funds have a 10 year lifespan. For the first 3-4 years of the fund, the general partners are making investments in new companies and the remaining 6-7 years is spent managing those investments and making follow-on investments in the same companies. At the end of 10 years, the fund is closed and, assuming there was a positive return, the limited partners get their rewards. (For a much deeper explanation of venture funds, read Venture Deals).

Keeping that in mind, the primary motivation of a venture investor is to produce returns on their fund in 10 years. Considering the high failure rate of start up companies, out of a portfolio of investments in 10 companies they can expect 7 to go out of business, 2 to be moderately successful and one to be hugely successful. In order to produce a return on the entire fund, they need those successes to be huge (return 20+ times the money invested).

Okay, so how does that affect how they see me?

Venture investors, because of how their funds are set up, are constantly looking for companies who have the potential to produce a 20x return on investment. That is very difficult to achieve and not many companies will have that kind of potential. A neighborhood grocery store will never produce that kind of return, nor will your local bookstore.

Not only do venture investors need a 20x return, they need it within 10 years. There are businesses you can grow slowly over 20 or 30 years to produce those returns, but to do it in less than 10 years means that your business needs to grow extremely quickly. To grow that quickly, you need a quickly growing market, a well thought out plan, some critical strategic advantage and the right team to execute your plan.

So, when you sit down with a venture investor, they are looking for signs that your business can produce 20x returns within 10 years.

Ah, that makes sense. So what does that mean for me?

The most important thing for you to convey to venture investors is the potential of the problem you are solving and how large the market is that has that problem. You cannot produce a 20x return on $10M of investment if your market size is only $50M, but you can if your market size is $1B. If the venture investor can envision your company in 10 years operating at that scale, you will get their attention.

After you convince them that your problem/market is big enough, it is time to convince them that you can make that happen. It is very hard to convince anyone what will happen in 10 years, especially investors that hear similar things everyday, but there are some keys to doing it well:

Present a plan. Your plan might change, but you need to have a credible long-term plan for getting to the large outcome. If you can’t build a credible plan at the beginning, it’s unlikely you will be able to come up with a new one as the market changes. The plan you present will also serve to identify the key risk factors that your business will face as it grows.
Show you mean it. You have already been following your plan in building your business, so show off how well you have executed. Remember, your progress so far is not why they will invest in you, but your progress so far is proof that your plan is credible and that you can execute against plans you create.
Sell the team. 10 years is a long time. If your company is going to be very successful, it will be a long and difficult road. Your team is critical because it is those people who will steer the company through those hard times and the venture investor needs faith that you can do it. In the end they are investing in you.
Don’t play fair. If you really have found a big opportunity that can product 20x returns, it is likely that many others have as well. You need to show a distinct competitive advantage that will allow you to win when faced with dozens of competitors going after the same goal.

Hopefully, at this point you are starting to realize why many companies struggle to ever raise venture funding at all. It is great that you have 5 paying customers today, but can you convince an investor that you will get to 5,000? You have 2 brilliant developers writing code, but who is going to sell your product to Fortune 500 companies? You have a great plan and team, but without any customers how can you be sure your product will work in the market?

Time to Focus

The good news is that, assuming you’ve followed at least some of the advice on this blog, you have already built the foundation for a great company that can produce the kinds of returns that venture investors want. In order to successfully raise investment, you just need to make sure to present your company in the way the potential investors need to see it. Focusing on where you can go, and not on where you’ve been, will go a long way towards that goal.

Besides, after all the hard work you’ve put in, it’s fun to think about how successful you can be in 10 years.

Thanks to Leo and Beth for reading a draft of this post. Image copyright Graham Hogg and made available via Creative Commons.

Financing: A Tale of Three Companies

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Image licensed under creative commons by Fornax, 2010.

If you want to start a company you might wonder where you will get the money your new business requires. The good news is that you have many options, as long as your business plan is sound and the market opportunity is big.

But, before we get to that, don’t confuse the money your business requires with the money you require to maintain your lifestyle – investors will not invest in you so you can pay your mortgage or make your car payments. Investors invest in your company to get a return so if you want to raise some capital you need to present them with a good investment opportunity that is likely to provide a return. It’s up to you to figure out how to cover your lifestyle expenses until you can pay yourself a decent salary, either through your savings or secondary income.

Assuming you have your personal expenses covered, a good business plan and your investment has a potential of return, there are many ways to raise capital for a business and we will cover three of them here. For these examples, let’s assume that you think that the market for umbrellas is going to expand quickly over the next few years due to global warming. Here, then, are the tales of three businesses started to take advantage of the upcoming umbrella explosion and how they might finance themselves:

1. Cash Flow Financing: The Umbrella Store

You decide to start an umbrella store, where people can choose from dozens of different models of umbrellas (either a physical store or online or both). The start up costs only include purchasing some initial inventory and setting up your store, but you are confident that sales can cover that cost. If you do well you might open up other stores, but you will wait for the market to demonstrate demand.

The best option is to finance the company yourself via cash generated from sales at your store. You will put up the initial money from your savings and the more umbrellas you sell, the more you will buy to increase your inventory. It might take a while but you think you can build up a healthy store that can support you and potentially a few employees.

Quick summary of your umbrella store:
Start up costs: $10,000
Estimated Annual Revenue: $150,000
Investors: You

In general, cash flow financing is a good idea if:

Your business will start generating revenue on day one.
Your start up costs are low.
You want to maintain complete control of your business.
You are not sure what form your business will take.

Cash flow financing is a bad idea if:

You can’t afford to provide the initial capital for the company yourself.
Your business needs to grow quickly to take advantage of a market opportunity.

Examples of the kinds of businesses funded via cash flows are consulting businesses, services businesses and small stores.

2. Crowd-sourced Financing: Umbrella 2.0

You design a new kind of umbrella, something the world has never seen before but is definitely better than all of the other umbrellas on the market. The cost of manufacturing the first batch will be significant because of the cost of setting up manufacturing, but after that you can easily grow the business based on sales revenue.

The best option is to crowd-fund your company by raising a little money from a large number of people. Using platforms like Kickstarter or AngelList, you can quickly find a large number of people who believe in your vision for a new umbrella and are willing to back you. In some cases, like with Kickstarter, you are pre-selling the product while in other cases, like with AngelList, you are giving them a small ownership in your company. If your start up costs are not very large, you can just raise funding from just your friends and family without needing to recruit investors that you don’t know.

Quick summary of your new umbrella product business:
Start up costs: $100,000
Estimated Annual Revenue: $1,500,000
Investors: Friends, family and/or strangers on crowd funding platforms

In general, crowd funding is a good idea if:

You require a large amount of startup cash but will be cash flow positive afterwards.
Your product will appeal to a wide range of people.
Your business will grow slowly.

Crowd funding is a bad idea if:

The amount of start up cash you need is very small or very, very large.
Your product is complex and will take many years to create.
Your business needs to grow very fast to take advantage of a market opportunity.

Examples of the kinds of businesses funded via crowd funding are new consumer products and non-profits (charities).

3. Venture Capital Financing: Build Your Own Umbrella

You want to build an online marketplace for people to design their own umbrellas and then have manufacturers build them on their behalf. The potential of the business is huge, but it will take a few years to grow the marketplace to break even and you don’t have a large window of opportunity so you need to move fast.

The best option is to raise venture financing. Venture capitalists and angel investors invest large amounts of money in high-growth companies with the expectation of a 10x return in under 10 years. The risk is high since your company needs to be extremely successful, but the reward is very high as well.

Quick summary of your umbrella marketplace business:
Start up costs: $1,000,000
Estimated Annual Revenue: $150,000,000
Investors: Venture capitalists and Angel investors

In general, venture capital financing is a good idea if:

You require a large amount of time and cash to build your business.
You expect your business to grow very fast (double every 3 months).
You need to spend ahead of revenue to fund your growth.
Your market opportunity is vast.

Venture capital financing is a bad idea if:

Your business will grow slowly.
Your market is small.
Your capital needs are small.

Examples of the kinds of businesses funded via venture capital are software-as-a-service companies, new drug manufacturers and new chip design companies.

So, what’s your best option?

Hopefully it is clear at this point that the best option for your business depends a lot on what your business is, how fast it will grow and how big it might become. Choosing the right option can be critical to your success or instrumental in your failure. Trying to fund a high-growth company on cash flows can starve your business since you will move too slowly and miss the market opportunity, but raising venture capital for a slow growth company can lead to unhappy investors and poor results for founders.

In many cases companies will combine strategies for the best outcome. For example, you might crowd fund your company to get started only to later raise venture capital financing when you start growing quickly. Or, you might grow using cash flow until you have a big opportunity for expansion and use crowd funding to take advantage of that opportunity.

There are, of course, other options than those listed here, including bank loans, and depending on where you are based those options may be most accessible. Network within your local community to understand the most common options.

Think about your business and what makes the most sense for financing options. But remember that investors are investing in your business, not your mortgage, so be sure to show them why their money will result in a big return.

Negotiation Made Easy

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A significant amount of your time is spent selling when starting a company. Assuming you are good at selling your company/product/vision, you will often get to the point where you need to close the deal. In between the selling and signing the contract is a chasm that many inexperienced entrepreneurs struggle to cross: negotiation.

Negotiation is simply the act of agreeing on terms for a deal. If you have never done it before you may envision it like a TV show with adversarial parties sitting across a table trying to crush the other party. That is rarely the case. Most negotiations are between two parties who really want to reach a mutually beneficial deal and just need to establish the terms of the deal. That does not mean people will not try to take advantage of you, but let us assume a basic negotiation where both parties have good intentions.

The actual act of negotiation is simple. One party makes an offer and the other party either accepts the offer, makes a counter offer or ends the negotiation. This continues until the parties reach an agreement or part ways.

But how do you know what offers to make, and whether the offer you get from the other party is a good offer? To answer that you need to understand some basics of negotiation and a simple process will help.

Step 1: You Win or Lose Before You Start

It’s a general misconception that whether you get good terms for a deal is based on whether you are a good negotiator. That is almost never true. Good negotiators know that the person who gets better terms is the person who has a better BATNA.

BATNA stands for Best Alternative To Negotiated Agreement and represents the worst case scenario for both parties if no agreement is reached. Whoever has the best outcome if there is no agreement has the advantage in the negotiation because they have less incentive to close the deal and can more easily walk away.

For example, let us say you are selling an apartment and someone moving to this city would like to buy it. If there are only a few apartments for sale and the buyer needs to move in the near future you have the advantage as the seller. You could choose not to sell the apartment and wait for another buyer (your BATNA) while the buyer would have to desperately find another of the few apartments for sale quickly (their BATNA). On the other hand, if there are many apartments for sale and the buyer is buying the property to rent it out then the buyer has the advantage. You might not be able to sell your apartment since there are so many for sale and the buyer can simply wait for a better deal elsewhere. In both cases, the BATNA determines which party has the power in the negotiation based on their incentive to close the deal.

The lesson here is to make sure you optimize your BATNA before even starting a negotiation. Consider some common deals you might close and how to position your BATNA for success:

If you are raising money, make sure you have plenty of runway (9-12 months at least) so that you are not under pressure to close quickly. Also be sure to line up as many potential investors as possible so you have your choice (and fallback).
If you are selling your product, always have a healthy pipeline of customers and never bet everything on selling to one particular customer. Try to avoid having one customer make up more than 50% of your revenue.
If you are hiring employees, start the hiring process long before you will need the person since it will take time to find the right candidate. Always interview multiple people for the position even if you think you have found the right fit, just in case you can’t close the deal.

Step 2: Get Into The Zone

While both parties have a BATNA (worst case), they also have a preference for the terms of the deal if it closes (best case). For example, if you are buying a house there is a price you would prefer to pay (practically speaking) and the seller has a price they would like you to pay. The combination of your BATNA and your preferences forms what is called the Zone Of Possible Agreement or ZOPA.

You can visualize the ZOPA as follows:

As you can see, both the buyer and the seller have a range of acceptable prices between their BATNA and their preference. The ZOPA is the overlap in these ranges, the difference between their BATNAs. Note that while this diagram uses Cost as the dimension of negotiation, it could easily be anything including the length of contract, legal terms or location.

If a deal gets closed, it will be in the ZOPA. Ideally, assuming both parties are interested in a mutually beneficial agreement, you would pick the midpoint of the ZOPA and that would be the terms of the deal.

How then do you know where the ZOPA lies? Very few partners will tell you their BATNA, even if they have the best intentions. They have no incentive to reveal their true BATNA and if they can convince you their BATNA is higher/lower than it really is then they can convince you the ZOPA is smaller and get favorable terms.

And in that tension is where negotiation exists.

Step 3. Choose Your Strategy

When you are negotiating you know your BATNA and your preference but not for the other party. Hence, you know one end of the ZOPA but not the other end. There are a number of strategies you can employ to determine the scope of the ZOPA and/or reach a deal on favorable terms.

Here are some examples:

High Initial Offer. To try and determine the BATNA of the other party, you can start with an arbitrarily high (or low) offer. Anchoring the negotiation will force the other party to start higher (or lower) than they might have otherwise and hopefully expose their BATNA quickly. This is why cars are priced so highly on the lot of a dealership, even though no one pays those prices. Dealerships want to determine your capacity to pay and motivation to buy.
This or That. The initial offer does not need to be a single offer and instead could be two different offers with different kinds of terms. For example, you might make two offers of a loan where one has a high interest rate while the other has a pre-payment penalty. The other party, in indicating their preference for one of the options, will help you understand the ZOPA and guide the negotiations in a positive direction.
Iteration. Since neither party knows enough about the other, you can make offers back and forth in an iterative fashion and slowly converge on a result in the middle. Each offer moves toward the other party’s previous offer by some small amount. This slow process of back and forth allows you both to understand the other party’s range and ensure you end up somewhere in the middle of the ZOPA. Most international diplomacy involves this kind of strategy since the parties disclose so little of their internal plans.
Take it or Leave it. In this method, you make an offer to the other party that they can either accept or not but that will be the end (no counter offers). Since you don’t know the other party’s BATNA, you make a guess and give them an offer based on that guess. This is most common when one party knows it has the superior BATNA and can force the deal to be more favorable to them.

Whatever strategy you choose, it is important to consider the impact of the initial offer especially if you are making the initial offer. Whatever the initial offer you make, you will rarely get better terms and in almost all cases you will get worst terms. Hence, you need to make sure that your initial offer is not your BATNA or you will not be able to iterate with your partner.

For example, when negotiating your salary for a new job you should realize that when you are asked for your current salary they are asking you to make an initial offer. You should not ask for a million dollars, but you should tell them what you think you are worth and not the least amount you are willing to accept.

The best negotiators are the ones who can convince you that their BATNA is much different than it really is and in doing so get favorable terms on a friendly basis.

Step 4. Plan For The Long Term

Unlike selling your house, deals that you close when building your business will likely impact your business for the long term. You want to build a positive relationship with your customers, employees and investors that will span many deals and many years. Hence, you need to optimize for long term relationships and not just short term deal terms. This means choosing a strategy that will maximize both the terms of the deal and future deal potential.

With this in mind, it is often not a good idea to pursue aggressive strategies and hard nose negotiation where you win a given deal but decrease the likelihood of future deals. At the same time, friendly but prolonged negotiations can give partners the impression that you are hard to deal with and have a similar negative effect on future deals. Being practical and productive in negotiations will establish your reputation and open doors in the future.

For example, when hiring people for a start up company it can be a good idea to pursue the This or That strategy where you give the employee a choice between a low salary and high equity or high salary and low equity. This gives the employee a chance to show their preference and reduces the amount of negotiation necessary to reach a favorable term.

Conclusion: Negotiations Are Not Basic

While the discussion here involves a single dimension of negotiation where each party has a single BATNA, preference and ZOPA, that rarely occurs. In most negotiations there will be many different dimensions such as cost and time, each with their own ZOPA. You will need to give in on some terms to get better outcomes on other terms. Always keep track of the terms that are most important to you and never drop below your BATNA or else you may find yourself in deals that are not worth doing.

To learn more about negotiation I suggest reading Getting to YES, now included on the Reading List.

Sean on Startups

Thoughts on startups, products and venture investing in Silicon Valley.

Category Archives: Financing

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The Myth of “SaaS”

How to Get What You Need

Fundraising Fever

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What Investors See When They Look At You

Financing: A Tale of Three Companies

Negotiation Made Easy

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