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AEROSPACE INVESTMENT
BALANCING VENTURE & RELATIONSHIP CAPITAL
In this role simulation, you will negotiate the terms of a potential $100 million
investment by venture capital firm Aerovent Capital in the startup company Earth
Escape. This will be a balanced concerns negotiation. As defined by G. Richard Shell in
Bargaining for Advantage, 1 a negotiation involves balanced concerns if the immediate
substantive stakes and the future relationship are in balanced tension with each other.
Accordingly, each of you will be scored both on your ability to negotiate favorable
contract terms for yourself and on the quality of the relationship you develop with your
potential business partner.
Substantive Points: Each of you will be given confidential instructions explaining your
interests and preferences regarding the substantive terms of the investment, and their
corresponding point values. Point values for each term are unique to your role and are
based on your role’s personal, professional, and financial concerns. Do not share this
information until the entire exercise, including evaluations, has been completed.
Process Points: In addition to your substantive points, each of you also will receive
process points, based on your counterpart’s perception of your ability to develop and
maintain a positive relationship. After you have concluded the substantive negotiation,
but before you debrief the exercise, each of you will complete a brief process evaluation
in which you assess the degree to which your counterpart met five basic
process/relationship interests (such as trust) discussed in the confidential instructions, and
in which you award process points accordingly.
Your Total Score (Substantive Points + Process Points) reflects your overall success in
the negotiation. Your goal is to maximize your personal Total Score. Your Total Score
reflects the importance of balancing both substantive and relationship concerns. For
instance, you may be able to negotiate all the substantive terms in your favor, but if your
potential business partner has no desire to work with you again, you have left significant
value at the negotiating table, and this will be reflected in a lower Total Score.
1
Shell, G. Richard. Bargaining for Advantage: Negotiation Strategies for Reasonable People. New York:
Penguin Books, 2000.
This simulation was written by Nicholas Sabin, who gratefully acknowledges its genesis in Professor Edward Bergman's Negotiation
and Dispute Resolution course of the Wharton School's Department of Legal Studies and Business Ethics. Copies are available online
at www.pon.org, telephone: 800-258-4406 (within U.S.) or 781-239-1111 (outside U.S.); or by fax: 617-495-7818. This case may not
be reproduced, revised, or translated in whole or in part by any means without the written permission of the Director of Curriculum
Development, Program on Negotiation, Harvard Law School, 518 Pound Hall, Cambridge, MA 02138. Please help to preserve the
usefulness of this case by keeping it confidential. Copyright © 2007, 2010 by Nicholas E. Sabin. All rights reserved. Distributed with
permission. (Rev. 5/10)
PROGRAM ON NEGOTIATION AT HARVARD LAW SCHOOL
AN INTER-UNIVERSITY CONSORTIUM TO IMPROVE THE THEORY AND PRACTICE OF CONFLICT RESOLUTION
AEROSPACE INVESTMENT
BALANCING VENTURE & RELATIONSHIP CAPITAL
Scenario
You are a general partner for Aerovent Capital, a venture capital (VC) firm that focuses
on investing in early stage, high-growth companies in the aerospace industry. Aerovent
Capital prides itself on the very active role it assumes with its portfolio companies to help
build them into successful, industry leaders. You have worked with Aerovent for over
fifteen years and have become one of the most senior partners in the firm.
The current deal you are considering is a $100 million investment in a company called
Earth Escape. As the lead partner for this investment opportunity, you have met with the
founder several times and are ready to discuss a term sheet. During this negotiation, you
will discuss the most significant terms of the potential investment. If this negotiation is
successful, the agreed-upon terms will provide the basis for a detailed term sheet to be
signed later this week. You are extremely excited about becoming an investor in Earth
Escape, but you also realize that convincing the founder of your desired terms while
nurturing such a nascent relationship may be quite a challenge.
This simulation was written by Nicholas Sabin, who gratefully acknowledges its genesis in Professor Edward Bergman's Negotiation
and Dispute Resolution course of the Wharton School's Department of Legal Studies and Business Ethics. Copies are available online
at www.pon.org, telephone: 800-258-4406 (within U.S.) or 781-239-1111 (outside U.S.); or by fax: 617-495-7818. This case may not
be reproduced, revised, or translated in whole or in part by any means without the written permission of the Director of Curriculum
Development, Program on Negotiation, Harvard Law School, 518 Pound Hall, Cambridge, MA 02138. Please help to preserve the
usefulness of this case by keeping it confidential. Copyright © 2007, 2010 by Nicholas E. Sabin. All rights reserved. Distributed with
permission. (Rev. 5/10)
AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR VENTURE CAPITALIST
Earth Escape claims that the RLV is ten times as safe as any space craft to date and is far
less expensive to produce and maintain. 1 By drastically reducing the safety and financial
concerns of space flight, Earth Escape intends to exponentially increase the number of
private citizens taking commercial space tours each year for the next decade. The tours
will offer anyone with the desire and financial means the opportunity to experience the
weightlessness of outer space, and to view the grandeur of the earth from a distance
previously reserved for only a select few astronauts.
Earth Escape has spent approximately $23 million, primarily funded through personal
contacts of the founder, over the past four years to develop its proprietary RLV. 2 To
date, the company’s single test-RLV has made fifteen tours of space, catering to
extremely wealthy and eccentric individuals. The company currently employs 35
individuals, but intends to grow quickly. Earth Escape is currently seeking funding of
$100 million to produce a fleet of six RLVs and to develop the company infrastructure
necessary to begin servicing the general public.
1
Note that the risks and challenges of orbital space flight are significantly greater than those of suborbital
space flight. You estimate that orbital flight is currently at least 10-20 times as costly as suborbital flight
due to the additional speed and energy requirements of launching a vehicle into the earth’s orbit.
2
All funding to date has been given by wealthy individuals in exchange for common stock.
Copyright © 2007, 2010 by Nicholas E. Sabin. All rights reserved. Distributed with permission. (Rev. 5/10) 2
AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR VENTURE CAPITALIST
You are most concerned with the risks of the complicated and emergent technology.
Earth Escape seems quite confident that its proprietary design will make safety issues a
minor point. However, you realize the devastating effect even one non-routine flight
resulting in a casualty might have on the company’s credibility. Furthermore, you must
account for the risk of pioneering a young market, relying on a few key individuals from
Earth Escape, responding to new competitors in the future, and dealing with potentially
illiquid securities when you hope to exit the deal. Accordingly, you hope to set up the
terms of the Earth Escape investment so that you protect yourself from as much risk as
possible and generously compensate yourself and your firm in the event that the
investment is successful.
To gauge your ability to achieve your process goals, the founder will complete a process
evaluation based on his or her experience during the negotiation. The evaluation will be
filled out after an agreement has been reached, but before any confidential information is
shared. Specifically, you will be scored on the following five process attributes:
Trust: How much does the founder trust you?
Respect: Did the founder feel respected during the negotiation?
Equitability: How fair does the founder believe the process was?
Regard for Other’s Interests: How much did you attempt to understand the
founder’s interests?
Interest in Future Collaboration: How interested is the founder in working with
you in the future?
You will receive a score from 0 to 10 for each of the attributes for a potential total of 50
Process Points. The Process Points you receive will be added to your Grand Total Score.
Copyright © 2007, 2010 by Nicholas E. Sabin. All rights reserved. Distributed with permission. (Rev. 5/10) 3
AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR VENTURE CAPITALIST
CONFIDENTIAL
Negotiable Terms for the Venture Capitalist
The following confidential information regards eight negotiable terms you will discuss
with the founder. 3 The terms may be negotiated in any order. A confidential score sheet
is also included, which breaks down the specific point values for each term. Use this
score sheet to record the agreed terms of your negotiation and to calculate your total
score. For the purpose of this simulation, you must abide by the scoring restrictions.
The point values for each term are based on the totality of Aerovent Capital’s investment
interests, e.g. industry analysis, risk profile, portfolio composition, etc. Note that if the
specified minimum terms are not agreed upon as outlined in the instructions
(unacceptable terms are reiterated as “No Deal” on the score sheet) or the substantive
BATNA is not reached, you will not proceed with the entire investment. Do not show
any of your confidential instructions to the founder.
Determining the value of a company in its early stages can be a subjective analysis. With
Aerovent Capital you have found that detailed financial projections of startup companies
are of secondary value to experience and recommendations from industry contacts and
consultants. By forecasting a range of values for Earth Escape five years from now and
discounting them to the present, you think that Earth Escape deserves a post-investment
valuation between $150 and $200 million. These valuations suggest that you should
receive between 50% and 67% of the company equity for your $100 million investment,
but you would be eager to receive even more. 6 You justify the higher equity percentage
by considering your desired risk/reward ratio. The unproven management team, uncertain
future of the public space travel market, unrefined technology, and potentially illiquid
3
Additional terms of the investment will not be considered during this negotiation. For the purpose of this
negotiation it can be assumed that any terms not scored will be in accord with Aerovent Capital’s standard
term sheet.
4
If extremely attractive terms are reached you might be interested in investing more capital. However, this
investment (as is) would be the largest to date for Aerovent and you do not have the resources to invest
more than $100 million at this time.
5
Valuation in this sense refers to “post-money valuation” and relies on the venture capital industry
standard of assuming all stock issued is common stock for simple valuation purposes.
6
Assume percentages of the company are on a fully-diluted basis post-financing.
Copyright © 2007, 2010 by Nicholas E. Sabin. All rights reserved. Distributed with permission. (Rev. 5/10) 4
AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR VENTURE CAPITALIST
nature of the investment all support your receiving a large portion of the company to
offset the high risk factors.
One other significant consideration you should make during the negotiation of your
equity percentage is who will have the majority of shareholder control. 7 As a legal
matter, though a business corporation is run by its board of directors, a majority
shareholder has the ability to take control of the company. 8 Thus, if Earth Escape begins
to fail, there is an importance difference in the influence Aerovent Capital would have
over the company if it owns 51% versus 49% of the equity. You want to make it clear to
the founder that you do not intend, nor desire, to control the future of Earth Escape
through shareholder influence. However, having a shareholder majority offers you
significantly more security in the event that the company begins to fail and Aerovent
must take on a more active role.
Therefore, you have a strong incentive to settle on an equity percentage significantly over
50% by establishing a low valuation based on your idea of fair compensation for the
substantial risk involved in the venture. 9
The most basic option is common stock. If you are issued common stock you will be
placed on an even footing with the existing shareholders without any liquidation or
conversion preferences. As a respected venture capitalist, you find it laughable to
consider not receiving some type of preferred stock given the amount of risk associated
with this investment.
The industry standard for venture capital investments tends to be convertible preferred
stock. 11 If you were issued convertible preferred shares, in the event of a liquidation your
preferred shares would entitle you to recoup your investment before holders of common
stock receive anything. Additionally, you would have the option of converting your
preferred shares into common stock. 12 With this option, in the event that the value of
7
Earth Escape’s bylaws detail that for governance issues requiring a shareholder vote, a simple
shareholder majority is required for approval. Regardless of the type of stock agreed upon in Term #2,
Aerovent shall have votes representative of the Term #1 VC Equity Percentage and shall vote as a class
with all holders of preferred and common stock. Note that you will negotiate your representation on the
board of directors as a separate term.
8
See Bartlett, Joseph W. Fundamentals of Venture Capital. New York: Madison Books, 1999.
9
You may use the company’s valuation to negotiate this term, but settle on the specific equity percentage
for the venture capital firm.
10
At this point all shareholders have been issued common stock.
11
See Cardis, Joel, et al. Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and
Practitioners. New York: John Wiley & Sons, 2001. p. 198.
12
Assume a one to one conversion ratio.
Copyright © 2007, 2010 by Nicholas E. Sabin. All rights reserved. Distributed with permission. (Rev. 5/10) 5
AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR VENTURE CAPITALIST
your equity percentage exceeds the value of your investment, you would convert your
preferred shares into common stock. This option allows you to protect your initial
investment with the benefit of sharing pro rata in the upside potential.
Redeemable preferred shares would be the most favorable to you. 13 Like convertible
preferred stock you would have a liquidation preference that allows you to recoup your
investment before common shareholders receive anything. The additional benefit of
redeemable preferred is that in the event the company is worth more than your initial
investment, you are allowed to fully redeem your initial investment and then also split the
remaining proceeds above your investment with the common shareholders pro rata.
Thus, you are not choosing between recouping your investment and sharing in the equity.
Rather, you may do both. Redeemable preferred shares are your first choice because they
best compensate you for the risk you are taking.
13
Redeemable preferred stock would be issued along with common stock equal to the agreed upon VC
equity percentage.
14
Assume cumulative annual compounding of dividends.
15
Dilution refers to a reduction of your fractional ownership of the company.
Copyright © 2007, 2010 by Nicholas E. Sabin. All rights reserved. Distributed with permission. (Rev. 5/10) 6
AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR VENTURE CAPITALIST
You are negotiating the number of directors that Aerovent Capital may appoint to the
board. The board currently consists of three members: the founder and two independent
directors selected by the founder. You emphatically want to appoint at least one member
to the board, but the more you appoint the more influence you would have over Earth
Escape. 16 If the founder is receptive to Aerovent appointing multiple board members,
you would like to appoint as many as possible for the benefit of the company and your
investment.
16
Decisions made by the board rely on a simple majority approval. Split decisions are broken by the
chairman of the board.
Copyright © 2007, 2010 by Nicholas E. Sabin. All rights reserved. Distributed with permission. (Rev. 5/10) 7
AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR VENTURE CAPITALIST
To protect your investment interests and allow the founder a chance to retain the CEO
title, you have suggested the use of performance benchmarks. If an agreed upon annual
benchmark is not met, Aerovent Capital will have the right to immediately replace the
CEO with no further negotiation. Vesting of the founder’s stock would not be affected
by a CEO replacement if the founder continued to work for the company as a member of
the board of directors, which you sincerely hope would be the result.
For this term you are negotiating the performance benchmarks that will be used to
determine if the CEO should be replaced. You have suggested that the benchmarks be
the very revenue projections that the founder presented to you in your first meeting. The
founder presented three potential scenarios categorized as conservative projections,
moderate projections, and aggressive projections. The scenarios detailed annual revenue
projections for the next five years. You are most interested in agreeing to the aggressive
projections because the founder will likely not be able to meet them year after year, in
which case Aerovent would have the option of replacing the founder as CEO. If the
founder is capable of meeting the aggressive projections, so much the better for your
investment. The moderate projections would be acceptable, but you are extremely
hesitant to accept the conservative projections as benchmarks. If only the conservative
projections are met, you will not achieve your required rate of return on the investment.
You aren’t sure if other firms are interested in Earth Escape at this point, but you realize
the devastating effect even one misinformed VC can have if it offers overly generous
terms. From your experience you have seen deals easily spin out of control when
multiple VCs begin offering competing term sheets, with valuations doubling and all
leverage going to the entrepreneurs.
For those reasons, the no shop provision is an important term for Aerovent. Without it
you might have to renegotiate all the other terms, and you might even have to walk away
from the deal if overbidding occurs. You hope to make it clear to the founder that the no
shop provision is not intended to be detrimental to Earth Escape. Though other VC firms
might offer the founder a higher valuation, they cannot match the value added that
Aerovent Capital provides its portfolio companies through its close working
relationships. You must negotiate this provision as simply “included” or “not included.”
Copyright © 2007, 2010 by Nicholas E. Sabin. All rights reserved. Distributed with permission. (Rev. 5/10) 8
AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR VENTURE CAPITALIST
Point Points
Substantive Terms Options Allocation Awarded
25% or less: No Deal
26% to 34%: 2
35% to 39%: 3
40% to 45%: 6
#1: VC Equity Percentage 46% to 49%: 9 ________
50%: 11
51% to 59%: 15
60% to 69%: 18
70% or more: 20
Common: 0
#2: Type of Stock Convertible Preferred: 8 ________
Redeemable Preferred: 12
No dividends: 0
1% to 3%: 3
#3: Dividends 4% to 7%: 6 ________
8% to 9%: 9
10% or more: 12
No Antidilution Rights: 0
#4: Antidilution Rights ________
VC Right of First Refusal: 6
0 members: 0
1 member: 3
#5 VC Appointed Board Members 2 members: 5 ________
3 members: 7
More than 3 members: 10
Less than 4 years: No Deal
4 years: 8
#6 Vesting of Founder’s Shares ________
5 years: 12
More than 5 years: 14
No provision: No Deal
Conservative Projections: 6
#7 CEO Replacement Provision ________
Moderate Projections: 10
Aggressive Projections: 16
Provision NOT included: 2
#8 No Shop Provision ________
Provision included: 10
Copyright © 2007, 2010 by Nicholas E. Sabin. All rights reserved. Distributed with permission. (Rev. 5/10) 9