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In the heat of a negotiation, it's uncommon for a founder to radically deviate from his/her current negotiating strategy. This Shark Tank negotiation shows what quick thinking and solid preparation can do when you need to pivot in a flash.
Take a quick look at this clip. We'll deconstruct how this founder gained the best deal he could by converting from an all equity to a composite equity-debt offering.
The founder's best negotiated outcome
Entrepreneurs who want to finance existing or new operations need capital at the lowest cost possible. The cost for equity financing is the amount of equity (firm ownership) one must sacrifice for the capital. A second goal and equally important goal is to command a maximum valuation so that you're in the best position to raise more capital at a later date. Entrepreneurs who go for the quick-and-easy money will:
sacrifice a lot of equity for little capital,
dilute their equity,
dilute the equity of existing shareholders, and
reduce the valuation of their business.
All four (4) outcomes will make it harder to attract investors if you need another round of financing. Thus, the best outcome for the founder is:
sacrifice the least amount of equity for the most amount of capital, and
dilute their equity to a level that allows them to retain controlling interest in their business, and
dilute the equity of existing shareholders to a level that is less than what the founder has but more than what the new investor gained, and
increase the total valuation of their business.
To accomplish these four requirements, our founder receives an offer of $250K for 40%; equaling a valuation of $625K (= $250K/0.40). Let's deconstruct this offer first.
Deconstructing offer 1
We don't know what the Founder's first offer was; presumably it was for $250K for equity less than 40%; and therefore a valuation greater than $625K. Most entrepreneurs enter the Shark Tank for subsequent financing. They already have early equity investors, but, hopefully, maintain majority control of their company. Let's assume the worst-case-scenario:
founder's equity = 51% and ∑investors equity = 49%
If the Shark offers $250K for 40%, that would dilute the existing equity holders (see here to learn more about equity dilution). If accepted, here's how the equity distribution would be:
A 40% equity share would dilute the Founder from 51% to 31% and, more importantly, remove from him control of his company. As a result, he must (and did) reject the first offer.
Counter offer 1
Our Founder counters with a $250K investment for 20% equity, resulting in a valuation of $1250K. Equally importantly, the equity dilution of the Founder and existing investors would keep the former in control of his company.
The Founder is still at risk of losing control of his company if equity investors combine forces, but at least he exits this financing round with a) capital, b) control, and c) a great valuation.
Offer 2
It's not a surprise that the Shark did not accept counter offer 1. Offer 2 is $250K for 33% and puts the Founder back in a suboptimal position.
The Founder still maintains control, but by a razor thin margin. For that slim difference the valuation of the company increased from $625K to $758K. However, given his small margin of control, it would be very easy to supplant his control - in which case that valuation would mean more to the new controllers than the Founder.
Counter offer 2
Our Founder knows the offer above is risky. In order to de-risk, he avoids the obvious counter offer and pivots to a new strategy.
First, let's review the obvious counter offer: $250K for a valuation between 20% (his first offer) and 33% (the current offer on the table). He and the Shark can go back-and-forth negotiating the equity and valuation, which are indirectly related - when one increases, the other decreases.
Instead, the Founder pivots and introduces the other form of financing: debt. He still needs $250K, so he offers $150K as debt and $100K as equity. We don't know the details of the debt, specifically the interest rate and duration, so we can't analyze the this component of the offer. What we can analyze is the equity component, which is now $100K for 10%. By adding debt, the Founder accomplishes the following:
maintains his financing request of $250K,
sacrifices the lowest amount of equity thus far in negotiations (10%),
maintains control of his company (equity of 46%), and
commands the 2nd highest valuation in the negotiations ($1000K).
Accepted offer
Now, it's not clear to me if the Shark knew what was happening. Some Sharks make counter offers to have the final say in the negotiations. This Shark made a counter offer of $150K debt financing + $100K equity financing for 15% equity.
The total valuation drops considerably from $1250K (counter offer 1) to $667K, but it's still higher than the original offer (offer 1). And with 15% equity, the Founder can maintain 43% equity, which is more than his equity in counter offer 1 (41%).
Compared to counter offer 1, the accepted offer results in:
the Shark's equity dropping by 5% (👍),
Founder's equity less diluted by 2% (👍), and
a valuation decrease of $583K (👎).
Compared to counter offer 2, the accepted offer results in:
the Shark's equity increasing by 5% (👎),
Founder's equity further diluted by 3% (👎), and
a valuation decrease of $333K (👍).
This Founder shows us how preparation and quick pivots during a negotiation can result in a favorable negotiated agreement.
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