In addition to the Freemium + upsell model that SpiderNet has implemented, you have also decided to pursue a strategic partnering/OEM model. You’ve brought on a world-class Business Development executive with the objective of getting major ecosystem players to adopt your free, base software into their distribution and enable them to upsell above that base. The model will enable additional deployments of your free software, providing additional opportunity to monetize the user base.
The new BD executive has been active for several months, targeting large players with massive distribution capabilities and $100+ billion market caps. A deal with any one of the “elephants” would be a game changer for SpiderNet.
Recently, one of the “elephants” finishes their evaluation of the SpiderNet product and wants to do a deal. After several rounds of negotiation, the terms they offer are:
- 50/50 net revenue split on all products upsold from the integrated free base;
- Pay SpiderNet $5 million in up-front cash;
- Five-year contract length;
- All current and future products;
- Exclusive distribution rights;
- First right of refusal if SpiderNet gets an offer to be purchased;
- Rights to source code if SpiderNet gets acquired by a competitor
You realize that some of these terms are not very favorable to SpiderNet, but this deal has the ability to fundamentally change the future for you. Having one of the largest ecosystem vendors in the market bundle and upsell SpiderNet products will be a huge win. Do you agree to these terms and quickly move to lock down a deal, or do you negotiate further, possibly losing the deal to a competitor? And if you do negotiate further, what would you propose to change?
For a small company, the allure and perceived value of a large strategic deal often results in a deal where the relationship is heavily skewed to the benefit of the larger company. Because these deals often create a “halo” effect by blocking competitive companies and providing a high degree of credibility, the temptation to accept a collection of unfavorable terms is quite natural. In the beginning, the smaller company will likely “need” the big company more than the big company “needs” the small company. The larger organization often recognizes this asymmetric condition and will rightfully apply their leverage in the negotiation. It is not right or wrong. It just is.
While a smaller company may need to accept a set of unfavorable terms, the question becomes “how unfavorable”? At what point does a collection of terms effectively result in a “box car” acquisition of your company?
The Box Car Acquisition
In the case of SpiderNet, the above terms proposed by the larger company are interesting in that the first few terms make the deal seem quite appealing. SpiderNet will split all revenue with the larger company, get paid $5 million up-front and have this condition exist for five years. However, the next set of terms, when combined, result in the effective acquisition of SipderNet by the larger company—my definition of a “box car acquisition”.
Let’s take a look at the terms and understand some guidelines for how to avoid some of the pitfalls with each term.
50/50 revenue split. While on paper this looks like a great term, the gotcha is how much net revenue the larger company will generate. Suppose the large company gives away the SpiderNet product for free or charges much less for the upgrade than SpiderNet plans? In such a case, the net revenue might be very low and splitting would be quite disappointing to SpiderNet.
Advice to SpiderNet: Propose a minimum floor payment (yearly or per unit) that the larger company must pay, such that SpiderNet is always guaranteed an acceptable payment.
$5 million up-front. Up-front payments are certainly beneficial from a cash flow standpoint. However, it is often the case that the larger company will only propose an up-front payment to get better terms elsewhere in the agreement. In this particular example, is it possible that the $5M has been used as a trade for the other (bad) terms in the deal? Has the larger company not just purchased SpiderNet for $5M?
Advice to SpiderNet: Construct a deal that represents a stable arrangement, without a pre-payment option. Then, possibly apply a pre-payment, such that SpiderNet understands exactly what they are getting in exchange for the up-front cash.
Five-year contract length. It may seem that longer contracts are better, but remember that the contract length locks in the asymmetric condition for the length of the agreement. In my experience, shorter contract lengths (two years) are far more advantageous to the smaller organization since the dependency shifts.
SpderNet advice: The shorter the term, the more quickly SpiderNet can re-negotiate key points in the agreement. By the way, the larger company also realizes this and they will want a long contract period. (Two- to three-year contracts are standard outcomes). Do not agree to a five-year term.
All current and future products. Giving all future products away makes no sense. Who knows if the new products are even applicable to the larger company? If the larger company is unsuccessful with the initial products, why offer future ones, especially under the same terms as the initial products?
Advice to SpiderNet: NFW. Show stopper. Do not agree to all future products. Limit agreement to existing product line. Full stop.
Exclusive distribution rights. Very often the larger organization will want to “help build” the small company’s distribution capability by proposing that they become the exclusive channel. While this may seem appealing, the downside is that the large organization maintains full account and customer control, effectively cutting the small organization out of the distribution loop. This is a very dangerous situation, as that smaller organization will be 100% dependent on the larger organization for generating users and revenue.
Advice to SpiderNet: Another show stopper. Do not agree to exclusivity. If necessary, allow the larger company a period of exclusivity (six months) to get started, but reduce the distribution concentration as quickly as possible.
First Right of Refusal. Giving a first right to the larger company means that they can always trump any offer that might come in. Agreeing to a first right effectively prevents other offers from coming in since no other company will want to spend the time or energy on giving a term sheet with this condition in place.
Advice to SpiderNet: If SpiderNet needs to agree to something, then agree to notify that an offer has been received but without having to name any of the terms of the offer. Give the larger company 24 hours to respond.
Rights to source code on change of control (CoC). In all software companies, source code is the key intellectual property. Giving this to the larger company on CoC materially changes the strategic value of the smaller company to any acquirer, especially if the larger company and the acquirer are competitors. Why would another company pay full value for the smaller company if their key competitor gets the IP for free?
Advice for SpiderNet: This is another show stopper. Upon CoC, allow the larger company to terminate the agreement and execute a reasonable wind-down, but never give away the source code.
As can be seen, the terms being proposed to SpiderNet are not acceptable to proceed without negotiation. If you lose the deal to a competitor, and they have agreed to such terms, then it will be a problem for them over time. Getting key terms structured correctly will avoid a dangerous and crippling “box car” acquisition.