Friction Kills Deals

0:00 Today, we're going to talk about deals and specifically, I want to talk about getting deals done.

0:10 My philosophy about this is that the more you can remove friction from a deal, the more likely it is to get done. You see, friction slows things down. Sometimes friction kills deals. And by friction, I mean the unexpected, right?

0:25 right so at MATH we try to use standard documents that everybody knows right we want to spend our

0:33 time and money building the business not paying the lawyers so in later stage deals those are

0:40 nvca docs the national venture capital association lawyers have all vetted them they're available

0:45 free online earlier stage it's series seed docs very similar just a little simpler structure

0:51 And for the earlier stage than that, it's probably a YC safe.

0:58 These docs make transactions easier, faster, and less expensive.

1:02 But lately, I've seen a trend.

1:05 And the trend that I've seen is entrepreneurs who think,

1:07 ooh, I'm going to tweak this.

1:09 I'm going to make it better for me.

1:11 And good for you for having the foresight to want to make a better deal.

1:17 But you're adding friction.

1:19 and you have to understand what the benefit of that is and whether or not it's worth it.

1:26 Worth risking the deal maybe not closing. So the most common I've seen lately is people taking the

1:31 standard safe and changing the discount rate from 20% to 10%. That sounds like a big difference.

1:37 It's half as much. I want to walk you through really quickly what the impact of that is.

1:42 So let's say you have an early stage company and you're raising a safe with a $5 million cap

1:47 and a 20% discount versus a 10% discount.

1:51 We don't know what the impact of that is

1:53 until we raise the subsequent equity round

1:56 and the safe converts into equity.

1:59 Now, it's important to realize

2:01 if you're raised with a $5 million cap,

2:03 you do not expect the next equity round

2:05 to be below $5 million

2:06 because that would be considered a down round,

2:09 even though technically it's not.

2:11 So north of $5 million.

2:13 And that the investor gets the better price

2:16 of the cap or the discount. So with a 20% discount, if the next round is at 6.25 or greater,

2:25 the cap is going to kick in. It doesn't matter what the discount was. So there's this very narrow

2:31 band in which the discount actually matters between 5 million and 6 and quarter million.

2:37 So let's take a concrete example and I'm going to run some numbers. Let's say that your next round

2:45 is right in that sweet spot, $5.5 million.

2:48 And let's say you raised $2 million in that round.

2:51 What is the impact of the difference in the discount

2:54 to you, the entrepreneur?

2:56 Well, I did the math, and here's how it comes out.

3:00 If you did a standard safe with a 20% discount

3:02 and your next round was $5.5 million pre-money

3:05 with adding $2 million,

3:07 I even added a 10% option pool to make it realistic,

3:11 you'll end up owning 54.1% of the company.

3:17 Now, if you were an amazing negotiator

3:19 and you negotiated a 10% discount instead

3:22 and you happen to raise in the middle of this sweet spot

3:25 you'll end up owning 54.5% of the company.

3:32 All of that work was for four-tenths of a percent of the company.

3:37 You thought you were getting half the discount

3:39 and you were but the impact to your company is the difference between whether you own

3:45 54.1 percent or you own 54.5 percent now make no mistake I'd rather own 54.5 than 54.1

3:55 but is it worth risking a deal getting done is it worth adding friction is it worth the lawyer's

4:02 expense so I want you to think about this the next time you think about tweaking terms in a deal

4:08 what's the gain and what's the expense what are you risking because at the end of the day the most

4:15 important thing is that you get the deal done that you get your company financed so you can move on

4:21 and start building an amazing business