Why We Negotiate for Worthless Terms
There I was, sitting at my desk, my HP laptop overheating as I tried to build a model in Excel that simulated 5,000 random 25-year sequences of events helping Caroline demonstrate to an outside independent auditor that a preferential term we had built into our equity at one of our investments wasn’t worth anything.
First, a note about auditors, regulators, or really anyone tasked with oversight. When they show up to examine you, they will find something wrong. That’s their job and people like to show the people they report to that they can do their job (mostly). So if you have that mindset going into one of these situations, you can leave a lot of frustration on the cutting room floor.
Back to my overheating laptop…
What I think the auditors were skeptical of is the fact that we had negotiated for a term that on its face wasn’t worth very much. In this case we’d been asked to pay a higher valuation than we normally would to make an investment. We wanted to do it – we liked the business, people, and opportunity – but we also didn’t want to get our asses handed to us because we overpaid. Remember, the only way to definitively lose a game is if it doesn’t end on your terms.
So we said to our prospective partners something like: Look, if reality is within spitting distance of plan, we’ll split everything pro rata, but if the bottom falls out, we get all of the earnings until the business recovers. And the only reason for that is that we’re investing at a valuation where we can’t hazard the risk of the bottom falling out and only get part of the economics.
Because we both believed there was a low probability of that happening, they said fine.
My Excel spreadsheet proved that assumption out. The median value of all of those randomizations was zero and the mean was immaterial. So there was a chance the preference could come into play, but it was indeed a small one.
So why did we negotiate for a “worthless” term? Because we never want the game to end.
– By Tim Hanson