Negotiations between the entrepreneur and investors : a case study of Mendeley

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Negotiations between the entrepreneur and

investors

A case study of Mendeley

Author: Sergej Vujanović Student number: 10828583

Date of submission: August 24th_{, 2015}

Qualification: MSc. in Business Administration – Entrepreneurship and Innovation Track Institution: UvA

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Statement of originality

This document is written by Sergej Vujanović who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract

The primary objective of this thesis is to provide insights into how entrepreneurs negotiate with investors, based on a case study of the company Mendeley. The research is designed as an exploratory single case study, with a combination of deductive reasoning for testing existing theories in the field and inductive reasoning for new theory development. Through a combination of archival research and interviews with two of the company’s founders, 4 different negotiations are described and compared with negotiation theory. Based on the comparison, new theoretical proposition are developed about the entrepreneurs approach to negotiating with investors. The first proposition deals with the ground rules to which the entrepreneur diverts when negotiating with the investors – 1) insisting on a joint gains framework, 2) expecting fairness and 3) trusting external standards and experts. The second proposition is centered on the entrepreneurs ability to observe and analyze mental models and biases (both his own and those of the other party). The quicker the entrepreneur can come to an accurate observation, the better his chances are of reaching a favorable negotiation outcome. The third proposition concerns knowledge – the entrepreneur possesses negotiation street smarts, being able to use strategies and tactics intuitively, without explicitly identifying them as such. The fourth and last proposition deals with how the entrepreneur evaluates possible solutions: Pragmatism is his forte – practicality outweighs theoretical considerations.

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Introduction

Before we start talking about negotiations, we should define the term itself. The Oxford Dictionary defines negotiation as a discussion aimed at reaching an agreement. We can effectively say that negotiating is a part of everyone’s daily life – but some do it more often and with greater success than others. The entrepreneur would seem to fall into this category. If we think about it, negotiations are present both in the process of starting a company and later on while managing it. Before a person decides to become an entrepreneur, they have to disentangle their own conflicting feelings and thoughts about whether starting a company is really a good idea. This is done by considering possible tradeoffs that would follow from such a commitment, or in other words - negotiating with oneself. Am I prepared to drop my existing job to start this company? Will I be able to find enough time to spend with my loved ones? Can I really make it work? Some, if not most questions are impossible to answer upfront and so require a leap of faith – I believe I can do it. After convincing yourself, there comes the task of convincing others – family, possible coworkers, investors, customers and so on. If you succeed at this, and people decide that they want to be a part of what you are trying to create, the next step is to define their engagement and negotiate their compensation.

Your best friend, who is a software developer, agrees to become a co-founder in your company and after a few conversations you agree to a 50:50 split of the ownership. After a while it becomes apparent that in order to make the product as good as you want it to be, you will have to hire some additional brainpower. Because your revenue is practically nonexistent, the only thing you can offer your prospective employee is a meager salary and an ownership stake. After you manage to negotiate good term on employment contracts, you realize that you will soon run out of cash and the search for investment begins. Because your company has all the requirements to make a big

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splash in the market, you attract quite some interest. 3 venture capitalist firms agree to meet with you and discuss the terms of possible collaboration. What are you willing to offer in return for their investment? How will you leverage your strengths in order to get what you want without giving too much away? Such questions are highly practical and a lack of understanding on how to negotiate can cause you to miss valuable opportunities. Here, as in all other fields, combining theory with practical experience can increase our understanding and improve performance. In order to shed light on the questions mentioned before, we will look at the negotiation process between a startup company called Mendeley and their chosen (as well as non-chosen) investors. Because the company had multiple rounds of gathering finance from venture capitalists and was later on successfully acquired by Elsevier, an in-depth look at how negotiations between these parties were performed could enable the testing of existing theories of negotiations, as well as the formulation of new propositions. In order to do so, 4 negotiation cases will be examined from the perspective of the entrepreneur.

The primary and secondary research questions are as follows:

- How did Mendeley handle negotiations with potential and existing investors?

- Which negotiation strategies and tactics did the negotiators representing Mendeley use? - Did they use them knowingly or intuitively?

- Did their negotiation process become more organized and systematic with time and more practice?

- To what extent can the negotiation process between Mendeley and their potential investors be described and explained by existing negotiation theories?

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The remainder of the thesis is structured as follows: First, the research design and method are described, providing insight into the selection process of the case as well as how the research was conducted. Next, a chapter on negotiation theory is presented, including a description of relevant concepts. The third part describes the 4 chosen negotiations in more detail and compares the events with theory, while in the Discussion the theoretical knowledge is combined with the insights from practice to form new propositions. Lastly, the Conclusion highlights the major findings of the study, discusses its limitations, and provides recommendations for future research.

Research design and method

The company Mendeley was chosen because it provides a good source of investment rounds both in terms of frequency and diversity. The primary and secondary units of analysis in this study are the entrepreneur and the management group that participated in the negotiations, respectively. A case study approach has been noted as valuable for studying situations with a large number of variables where the boundaries between phenomenon and context may not be entirely clear (Yin, 2014). As such, it is a suitable method to explore the complexities of the negotiation process. In order to enable the reader to assess the transferability of the findings of this study, a detailed description of how the research was conducted is presented next.

The research was performed as an exploratory, singe case study with a focus on qualitative analysis. An inductive approach was applied to search for patterns and build theory from the collected data, while deduction was used for testing the explanatory strength of existing theories. The study details 4 distinct and separate negotiations from a longitudinal perspective, comparing them with one another in order to shed light on how the different elements that are present in the negotiations influence the final outcome.

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An open interview was conducted with Victor Henning, the CEO of Mendeley and one of its founders, to determine which negotiations are to be studied and to receive insights about other possible sources of data. The negotiations that were chosen are presented in the chronological order in which they happened. First, the negotiation between the 3 founders of Mendeley and a business angel, who was their first investor, is presented. Second, the Series A fundraising, which included an investment from the previously mentioned business angel and 2 other VC funds is examined. The third is an unsuccessful Series B negotiation with a VC fund, while the last one focuses on the negotiation with the company Elsevier, which acquired Mendeley in 2013.

After the 4 negotiations have been chosen, an analysis of the documentary and archival data, which included blog post by the entrepreneur, past interviews and some internal company documents, was performed. This analysis served as a building block for preparing a series of semi-structured interviews with Victor Henning and Jan Reichelt1_{, both of which were aside from being}

co-founders also part of the management team. The series of interviews was centered on obtaining in-depth information about the negotiations, resolving contradictions in the data, and elaborating on the negotiation specific knowledge gained in each of the chosen negotiations. In order to ensure for greater credibility, the study was presented for review to all the interviewees that contributed to it. For greater dependability a case study database was established, storing all important documents used during the research process such as interview notes, transcripts of the interviews and tabular materials. However, because most of the materials used are of a confidential nature, external auditing to ensure dependability and credibility of the study is somewhat limited.

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Because we were unable to look at the exact deal structure (in the form of a contract) due to confidentiality issues, it was harder to identify possible use of negotiation tactics and strategies by the parties involved. Thus, we mostly had to rely on indirect evidence, such as the recollection of the person involved in the process. To mitigate for the possible biases of the participants we utilized cross-checking questions, both between the participants (posing the same question to the two different participants) and between interviews of the same participant (posing two similar questions in different interviews to the same participant). After 5 interviews, data saturation was reached. The conceptual model of the study is a simple linear model that flows chronologically from the first to the last negotiation. From the interviews with both co-founders we have come away with new insights, which were either explicitly or implicitly communicated to the researcher. Based on these insights, new theoretical propositions were developed. The 4 negotiations differ from one-another in terms of at least one major element, which implies that the theoretical propositions emerging from them will have a lower transferability across different negotiation arrangements (a deficiency that is somewhat inherent in a single case study design). However, when such propositions are applied to negotiations that are similar to those described in this study, we expect their explanatory power to be high2_.

The other aspect of this study – the testing of existing negotiation theory – is specific to each negotiation as well. Because diversity both in terms of setting and outcome was the primary factor when deciding which negotiations to include in the study, the potential for testing various theoretical propositions was increased. It should be noted that the term “testing” refers here

2_{This is of course just a hypothesis, which should be tested by conducting quantitative studies based on the propositions}

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primarily to a test of credibility, focusing on whether past theory and the theoretical propositions developed in this study fit together in a sensible way.

Figure 1: Conceptual model

Context 1 Context 2 Context 4 Comparison with theory Comparison with theory Comaprison with theory Comparison with theory Deductive reasoning - Theory testing Inductive reasoning - Theory building Theoretical and practical implications Context 3 Negotiation 4 Negotiation 3 Negotiation 1 Negotiation 2

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What follows is a section on negotiation theory in which the various variables that influence negotiation outcomes as well as some possible negotiation strategies and tactics are examined.3

Literature review

Studying the negotiations between entrepreneurs and investors brings together two streams of research – the one focused on the negotiation process and the other on relationship between the two sides. To start, let us look at the negotiation process. The first theoretical inquiries into the negotiation process can be traced back to the 1950's with the introduction of game theory by authors such as Von Neumann, Morgenstern and Nash. Most early game theory models presupposed that negotiations take place between ultra-rational individuals, with clear and unchanging preferences. As such, they relied heavily on mathematical calculations of equilibriums - the expected outcomes of such negotiations, where each party tries to maximize its own utility (Nash, 1950). Because these models have very limited application possibilities in the factual world of not so rational individuals, a new stream of though emerged based on the psychology of those that do the negotiating. This shift towards a softer perspective is accredited to Howard Raiffa. He proposed his views of how even limited formal analysis combined with ethical and moral considerations can better the negotiation practice in his book entitled The Art and Science of Negotiation, published in 1982. While the book itself does not contain a lot of psychological considerations, it nevertheless provided a stepping stone for future research in that direction. This new stream was called the behavioral decision-making perspective. It focused on how and why individuals in negotiations make decisions, adopting the view that the individual is only semi-rational, and prone to mistakes and inconsistencies in cognition. Most of the theoretical propositions in this stream have been

3_{The literature on negotiation is vast and a thorough examination of it as a whole is beyond the scope of this paper.}

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tested separately in a quazi-laboratory setting without much research into how they might combine and interact in practice. The reason for this is the complexity of the negotiation process, which is influenced by a myriad of variables. These range from environmental ones, like the characteristics of the meeting room, to those concerning the relationship between the negotiators, like power discrepancies and reciprocity.

In recent years a new lens for investigating negotiations has been added – social psychology. In this stream the individual is also regarded as only semi-rational4_{– his choices are determined by}

his personal attributes, the environment around him and the rules of the negotiation game. As such, the individual is never in complete control of the situation, but has tools at his disposal for managing it better. One of these tools is tactics – a system of one or more tasks geared towards a specific result. While many influence tactics have been identified and explored (see Kipnis et al., 1980), the most prominent one is the so called reciprocal or exchange tactic. Its logic can be explained as follows: you get what you give. If your opponents are using this tactic, they will be more likely to concede to your demands if you concede to some of theirs. Another tactic is to use the first offer as an anchor. It has been shown by Galinsky & Mussweiler (2001) that the first proposed offer usually determines the framework in which the negotiation will take place. As such, the decision of who is to make the first offer is itself an important negotiation issue. These and other tactics can be used by a skillful negotiator to support any type of strategy - a detailed plan to achieve a specific goal in the future. While strategy and tactics share some characteristics, the first is generally a broader term and encompasses the second. If for example our strategy is to frame a

4_{This assumption is shared with the behavioral decision-making perspective, which was the chronological and logical}

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negotiation as a zero sum game, we can achieve this by using the tactic of the first offer as an anchor.

Social psychology has added a valuable part to the overall understanding of negotiations by combining internal and external factors to form a more holistic view on the negotiation process. While such a holistic approach might suffer from insufficient depth of analysis, it can provide clues for the discovery of new patterns which are specific to a given combination of factors. With this in mind it is time for us to look at the negotiation game itself.

Variations of the negotiation game

There exist many different variations of a negotiation game. The simplest one is a negotiation with a single issue and two sides, like a husband and wife discussing where to go for dinner. We can add complexity to this by 1) including more sides, 2) raising the number of issues, 3) making the sides internally heterogeneous or 4) combining all of the before-mentioned steps in various ways. While options 1), 2) and 4) are pretty straight-forward, the third one requires a bit of clarification. In the example of a husband and wife negotiating about dinner, the two sides are internally homogenous, because there is only one member on each side. If we instead imagine two countries negotiating a peace treaty, it is easy to see how they could be internally heterogeneous. While the general populace of a country might desire peace, the military industry might not. The negotiation objectives and goals of the government would then be determined by the influence that each internal party can exert upon the government. When we are evaluating the homogeneity of a negotiation side which is comprised of different parties, the dimension of internal power relations5

5_{It is important not to confuse this with the notion of internal (i.e. psychological) factors that influence an individual’s}

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is added to that of external power relations, which are present in every negotiation. Such power relations also matter on a smaller scale. When a management team of a startup is negotiating with investors, it faces the same issue of first having to consolidate their objectives and goal internally. We will look at how this consolidation process works when we discuss mental models later in this chapter.

There are other ways to differentiate between negotiations besides the ones mention above. One of the divisions present in most of the literature is that of distributive (or zero sum) and integrative (or joint gains) negotiations (Raiffa, 1982; Thompson, 1990; Miles, 2013). As the naming suggests, distributive negotiations occur when the participants perceive the size of the pie as fixed and therefore focus on getting as much of that fixed sum as possible. In this type, the use of power and coercion is more frequent, because the negotiation is framed as a fight between the two parties. Integrative negotiations on the other hand arise when participants see a possibility of enlarging the pie, thereby increasing the gains for both sides. Cooperation and reciprocity dominate in this type as the parties try to work together to discover joint gains.

While the theoretical distinction between the two types is clear, establishing it in practice is hard. Participant’s judgment on whether joint gains are possible can only be completely precise if both parties reveal their reservation prices and tradeoffs to each other (Raiffa, 1982). There are two major reasons why this rarely happens. The first one is that revealing ones objectives is a high-risk move that swings the power in your opponents favor. A proposed way of dealing with this is that both sides reveal their preferences simultaneously, for instance by writing them down and passing them on. While this solves the problem of neither party wanting to reveal first, it does not deal with the second problem – there is no way for the parties to know if what was revealed is in fact true. Because of this, no significant advantage can be derived for either side from simultaneously

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revealing and therefore this agreement is seldom used (an exception to this can be a negotiation between close friends, where a quick resolution of the negotiation is sought).

In practice, most negotiations entail both issues of the zero-sum variety and those of the joint gains variety. A negotiator thus requires knowledge of how to deal with both. An interesting twist to the division between zero sum and joint gains issues can be achieved by adding additional proposals to the package. Such an added proposal can change a zero sum issue into a joint gains one. Let us look at an example. A rich business man is trying to buy a piece of land owned by an old couple. They have not quite agreed on the price – the business man is willing to give 200.000 € while the couple wants 220.000 €. Because it does not seem that they will reach an agreement, the couple propose that the business man pays them 200.000 € for the land and gives the additional 20.000 € to a charity active in their neighborhood. The business man, being a proud philanthropist, agrees. While the land itself was not enough to persuade the business man to pay the additional 20.000 €, the opportunity to support a good cause was. What we have stumbled upon in this example is the notion of saving face (Raiffa, 1982). The business man did not want to raise his final offer while the old couple did not want to lower theirs. By proposing another solution, the couple gave the business man a way to complete the deal without feeling like he is being forced into making a concession. That way he maintained his image as a skillful negotiator (in his own eyes as much as in those of others). Saving face can be an important motivator – people want to be perceived as capable and intelligent, and are willing to go to great lengths to insure that this is the case.

As we have shown, the participants can never be completely sure that a particular negotiation could have joint gains. This point has been further stressed by Raiffa (1982) when discussing the ability of one party to determine the reservation price of the other. In order to elaborate on his argument we first have to explain the term reservation price (or bottom line). Imagine a negotiation between

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a second-hand bike shop owner and a potential buyer of one of the bikes. When they start discussing a particular bike, each of them has a bottom line amount in his mind, which he wishes to either obtain or give for the bike. Let’s say that the owner wants a minimum of 400 € for the bike, and the buyer is willing to give a maximum of 450 €. These, respectively, are the reservation prices of both parties. In this particular negotiation a deal is possible because there is a positive difference between the reservation price of the buyer and the reservation price of the seller. If in their negotiations they reach any price between 400 € and 450 €, the transaction will be made. But that does not mean that they will always reach an agreement. As Raiffa (1982, p. 55) points out: “When

inconvenience, transaction costs and risk aversion are taken into account, it might never be possible, even after the negotiation, for one party to determine the reservation price of the other.”

A situation like this is easy to imagine. Our bike seller could misrepresent his reservation price as 500 € instead of 400 €. Why? Because he believes that the buyers reservation price is actually somewhere around 550 €. If throughout the negotiation process the buyer cannot better convey his real reservation price (without reveling it of course), or if the seller simply does not understand the clues he has been given by the buyer, the deal could go down the drain. In such a case, there is no positive difference between the minimum that the seller wants and the maximum that the buyer is willing to give – there is no possible zone of agreement.

Because reservation prices can sometimes be too restrictive and disable the negotiator from recognizing possibilities for an agreement, another concept can be used – the Best Alternative To a Negotiated Agreement (BATNA). First introduced by Fisher and Ury in their influential book Getting to Yes (1982), the concept helps the negotiator better determine whether to walk away from a sub-optimal deal or not. As such, it functions as a standard against which every possible deal should be measured. If the buyer of the bike in the previous example used BATNA instead of

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(or in combination with) the reservation price, his reasoning could go something like this: I would like to get this bike for 450 €, but if the seller insists on a price of 500 €, I can still go to the bike shop around the corner and get a slightly better bike for 470 €. Knowing that he has this alternative, he can then bargain with the seller more effectively. In fact, bargaining power is mostly determined by the alternatives both sides have to reaching an agreement – the party that has the better alternative is less dependent on the success of the negotiation and is therefore the one with more bargaining power.

What is fair?

We can see now how even if both parties have a general interest in making a deal, their inability to identify their opponent’s preferences and tradeoffs can be detrimental to their efforts. In this identification process the perception of fairness plays a big role. Negotiators have been found to adopt a framework of fairness that favors their position (Thompson & Lowenstein, 1992). This bias is referred to as egocentrism and it increases proportionally to the ambiguity of a situation. As such, obtaining additional information that does not specifically favor any party increases the egocentrism of both, since each molds the new information into their own preconceived framework of fairness.

While symmetry is usually a part of fairness, the choice of a focal point (or question) determines the framework of fairness a person adopts. Taxation provides a fertile ground for discussing this issue. Imagine a distributive negotiation game between a poor and a rich person in which the goal is to divide 100 € between the two. The question is - what would be a fair division? If our focal point is to ignore the specifics of each participant outside of the negotiation and divide the money as if the two parties were equal, each would get 50 €. If our focal point is the difference in utility that each can derive from the money, then the majority of it should go to the poor person, for he

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needs it more. But if our focal point is after-tax income the rich person should get more, because he has to pay a bigger percentage of the acquired sum to the tax authorities. As we see, what is fair is mostly a subjective judgment, based on the focal point one adopts6_.

By discussing fairness, we have moved from external and objective determinants of a negotiation game to internal, subjective ones. These includes the emotions, perceptions and mental models of the individuals that are negotiating. We will continue their exploration with a look at how the rules of the negotiation are shaped.

Who makes the rules?

As mentioned before, most of the research on negotiation was done using a quasi-experimental design, where participants were put into a predefined and fixed game framework. However, that is not the way negotiation works in practice. There, the rules of the game are just as susceptible to bargaining as the later division of spoils within the game. To better understand how this framing of the game happens, we will first introduce the concept of mental models and then look at possible cognitive errors that influence such models.

Bazerman et al. (2000, p. 287) define a mental model (in an negotiation framework) as a “cognitive

representation of the expected negotiation, a representation that encompasses understanding of the self, negotiator relationships, attributions about the other, and perceptions and knowledge of the bargaining structure and process.” Such models can be studied on the level of the individual

or broader. For us, the most interesting one is the process by which two individuals with different mental models about the negotiation at hand adapt to co-create a converging one that enables them to reach a favorable conclusion of the deal. Ross & Ward (1995) provide an interesting example

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of how strong these models can be. Just by changing the name of the negotiation game in their experiment the perceptions of participants about the nature of the negotiation were changed. They contrasted the results of two games, one named the “Community game” and the other the “Wall Street game”. In both cases it was a simple prisoner’s dilemma game with 7 consecutive rounds. As it turned out, the participants in the Community game were twice as cooperative as those in the Wall Street game. This has important implications for how people frame their mental models. When trying to understand a new situation, people have been shown to rely more on surface similarity than on structure similarity (Gentner & Markman, 1997). Concretely, this means that the participants in the above-mentioned example evaluated the game based on its name, rather than on its rules. Why and how does this happen?

The notion that there is a large number of systematic cognition errors that affect our decisions has been stressed and explored extensively within the behavioral decision making perspective. As Malhotra & Bazerman (2008) have shown, there are many possible inferences we can make from such errors. From understanding the influence of the status quo bias or that of overweighing social comparisons (as in the case of the Community/Wall Street game mentioned above) we can provide insights into how they can be used by a skillful negotiator. If, for example, we are aware of the role that scarcity plays on demand, we are better equipped to set the rules of the game in our favor. Thus, when the entrepreneur and the venture capitalist are discussing possible dates for their first meeting, the entrepreneur should provide a limited number of dates, which will signal to the other party that his time is valuable and in demand and that this demand might quite possibly come from other venture capitalists (Malhotra & Bazerman, 2008). Of course, being able to defend oneself against such tactics is just as important. The first line of defense that one can muster is acquiring as much knowledge as possible about the bargaining tactics and strategies that could come into

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play (Cialdini, 2001). The non-explicit rationality behind this statement is that if we are knowledgeable about such tactics and strategies, we are more likely to discover them while we are negotiating. Whether this is indeed the case seemingly depends not only on our knowledge, but the knowledge of the other party as well. If the opposite side presupposes that we are familiar with negotiation tactics and practices, it might try to hide its incentives by applying strategic misrepresentations or some other counter-move (Raiffa, 1982).

The second line of defense is to understand what tactics we are most susceptible to by being aware of our own mental models. When casually looking at a computer in a store and still deciding whether we need it or not, we are more influenced by a salesperson that provides us with information about why we need a new computer, than by the one describing why this particular computer is better than the one next to it. Knowing your own and your opponents mental models and biases can therefore protect you from falling prey to your opponents influence attempts (Malhotra & Bazerman, 2008).

An example of a frequently occurring bias is the so called confirmation bias. When looking for data we are generally not aware that the information we choose is already determined by our values and goals and that we tend to disregard information that conflicts with them. If the information we have is skewed to our advantage, then the goals and parameters we will produce out of it will also be skewed in the same way. We also generally perceive ourselves as better than others on desirable attributes. Kramer et al. (1993) found, while conducting a study on participants in a negotiation class, that 68 % of them predicted that their bargaining outcomes would fall into the upper quadrant (the best 25 %) of the class. This optimistic attitude can in part be explained by the negotiators overestimation of their ability to control uncontrollable events. Combined with a need to rationalize

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their own failure in negotiations, these positive illusions can increase the chances of conflict and subsequently lower the chances of adopting a joint gain’s perspective.

Linking this to the afore-mentioned mental models, we could see the negotiation game as a straightening out mechanism of skewed mental models of the participants. The opposing sides smooth out each other’s perceptions by providing the other side with information that is conflicting with their preexisting mental models. If the opponents are willing to adapt their models, which depends on both external (e.g. power) and internal factors (e.g. their mood), a solution can be found and the negotiation ends successfully for both sides.

Emotion and mood in negotiations

The role of emotions in negotiations has not received an overwhelming amount of attention. The researchers that do consider them focus mostly on how strong emotions - such as anger - influence the negotiation process. As might be predicted, anger makes us more egocentric and inhibits our ability to recognize profitable outcomes (Bazerman et al., 2000). However, instances when a person experiences strong emotions are rare. Moods, in comparison, are much more frequent (one could even claim that they are ever-present) and might therefore have a more pervasive, although mild effect on negotiations. Forgas (1998) has shown that positive moods increase the chances of adopting a cooperative strategy by participants. The mood that someone is in can be affected by many factors both outside and inside the negotiators control. The choice of the environment where the negotiation is to take place is one such factor, and a negotiator can change it depending on the nature of the talks. An example of this would be the proverbial Silicon Valley cafes, where entrepreneurs meet with venture capitalist in hopes of securing an investment. By choosing such a location, the VC presents himself as being down to earth while at the same time getting the opportunity to examine the entrepreneur in a more personal setting, where the formal differences

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in power and position are less apparent then for example in a conference room at the headquarters of an investment firm.

Now that we have cleared the question of how prior knowledge, biases and emotions can affect the negotiation process, let us explore the influence of previous practical experience.

Does practice make perfect?

The question on whether previous practical experience has any influence on negotiation outcomes was most comprehensively answered by Thompson (1990). With a help of an experiment he was able to confirm the notion that previous experience with negotiations has a positive influence on future negotiation performance. An additional expansion of this theme was the question of how experience in distributive negotiations would influence the ability of participants to perceive joint gains in integrative negotiations and vice versa. The results indicate that experience in distributive negotiations does not negatively influence one’s ability to recognize joint gains. However, because the study only compared two successive negotiations, its results on this subject are inconclusive. It is possible that those professionals that primarily deal with distributive negotiations for a longer time period – say 10 years – will be more likely to adopt a zero-sum game perspective at the beginning of a new negotiation and therefore have more trouble identifying joint gains then those who has spent most of their professional careers dealing with integrative negotiations.

Thompson (1990) also finds no correlation between the ability to perceive joint gains and the knowledge that one’s relationship with the other party will be a longstanding one. This finding is again constrained by the particular design of his experiment – basing a longitudinal study on just two time points is not considered good practice and diminishes the generalizability of the findings (Yin, 2013). The question of how the possibility of a longstanding relationship influences the

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negotiators therefore remains open. With the overview of negotiation theory not complete, we will proceed to shed some light on the specific relationship that this research is focused on – the one between the entrepreneur and the investor.

The relationship between the entrepreneur and the investor

Entrepreneurs can attract capital from various sources. Family and friends tend to chip in at the start, while larger institutional investors are more inclined to invest in the growth phase. Financing in the gap between start and growth is usually supplied with the help of business angels or more recently, crowdfunding. But that does not mean that each investor-profile should be kept in just one phase of the company’s life-cycle. As Rasmussen & Sørheim (2012) point out, a proper combination of investor-profiles may keep the overall cost of capital low. For the sake of maintaining focus we will look at only 3 investor-profiles: the business angel (BA), the venture capitalist (VC) and the acquiring firm.

Business angels

“Business angels tend to be private individuals, who often have started their own successful firms

in the past and are now looking to invest some of their money and experience gained into a small entrepreneurial firm.” (Van Osnabrugge, 2000, p. 92) Because the BA’s investment potential is

usually small in comparison to a VC in terms of available capital, they are more inclined to invest in the early start up phases of a company. As Van Osnabrugge (2000) points out, BA’s have less contractual control over their investment and are therefore more engaged in post-investment monitoring than VC’s (which do most of their screening pre-investment). As such, the BA maintains a closer relationship with the founders and the personal fit between them becomes an important factor of success.

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Venture capitalists

While the relationship between entrepreneurs and VC’s after the investment has been well examined in the literature (Shepherd & Zacharakis, 2001; Zacharakis et al., 2010; Koskinen et al., 2014), the relationship (or rather relationship-building) in the process of negotiating the deal has received less attention. In this limited scope, the majority of researchers have focused on the bargaining power of the participants (Heughebaert & Manigart, 2012; Bienz & Hirsch, 2012). To the outside observer, the distribution of power between the negotiating parties is usually only visible ex post, by for example, looking at the gained investment sum as contrasted by the lost ownership stake (from the entrepreneurs perspective). Such an analysis can create the wrong impression that bargaining power is static, while in fact the exact opposite is true. The final deal reflects only the settling point but tells us nothing of how this point was reached. A longitudinal analysis of the negotiation process can give us insights into the process and enable us to perceive the relative swings in bargaining power from one party to the other. As we have mentioned before, the most commonly recognized way in which an entrepreneur can increase his bargaining power is to convince the VC he is currently negotiating with, that his company is receiving a lot of interest from other VC’s as well (in other words, that it has a good BATNA). Of course, this tactic holds true no matter who the entrepreneur is negotiating with.

The contracts between entrepreneurs and VC’s are usually complex, with multistage investments released to the company based on its performance against predefined goals (Bowden, 1994). Additionally, the ownership stake that the VC fund acquires can be represented by various equity options such as preference shares or a convertible loan. The deal can also include numerous clauses that will impact not only the round of financing that is currently being negotiated, but also the next ones (for example the anti-dilution clause, which protects the VC from losing too much equity in

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the next investment round). It is important to note that while the entrepreneur and the VC are on opposite sides when the deal is being negotiated, they both profit only in as much as the deal benefits the entrepreneurs company. Because their relationship in case of a successful investment will be longstanding, both have an incentive to compromise. However, it is up to each side to make the other do so – a task for a prudent negotiator.

The acquiring firm

The last investor profile that we will look at is the acquiring firm. Just like every budding entrepreneur in the 1990’s dreamed of an IPO, so today’s entrepreneurs’ dream of being acquired by the likes of Google or Facebook. As Jemison & Sitkin (1986, p. 145) pointed out it the 1980’s

“Acquisitions are an important vehicle for corporate strategic redirection and renewal.” Since

that time, the reasons why acquisitions are performed have increased in number – from keeping the competition at bay by buying potential threats, to taking control of the supply chain. The success of an acquisition largely depends on strategic and organizational fit (Jemison & Sitkin, 1986). The first refers to how well the target company’s competencies complement the strategy of the acquiring company, while the second refers to the fit between the culture, administrative practices and personnel characteristics of the two companies.

It seems that since the three investor-profiles discussed have different reasons and incentives to invest, the entrepreneur’s negotiation strategy and tactics should be adapted to each one in order to achieve the best results. In order to see whether this was indeed the case, the next chapter will present each of the 4 negotiations in more detail.

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Negotiation 1: Business Angel

Context

Before we look into the negotiation between Mendeley and their first investor, we will shortly describe the circumstances that led to it.

Mendeley was founded in 2007 by three friends - Victor Henning, Jan Reichelt and Paul Föckler - primarily out of necessity. While working on their PhD theses, they became increasingly frustrated with the lack of a tool that would help them organize, manage and share the academic papers they were using. To solve this problem, they developed a software that combined a file management component (think of iTunes or Evernote) with a social network platform. In order to make the software as good as possible, they contracted the company Itransition to build a prototype for them. It cost the founders most of their savings but fortunately everything went smoothly and with a working prototype in their pocket, they started looking for investors to help them grow the business. Henning and Reichelt contacted Stefan Glänzer - a serial entrepreneur and for a time the chairman of Last.fm - who they had met when the latter was giving a guest lecture at the university both were attending. Because Mendeley and Last.fm were so similar (essentially, what Last.fm did for music, Mendeley did for research articles), they had high hopes and rightfully so - Glänzer was intrigued by the product and decided to invest.

As Henning recalls, the meeting with Glänzer was very informal both in setting (they met at a members club and later on in a café) and in terms of communication. Because the founders were elated about the possibility of Glänzer joining their company, they were willing to go along with his proposed investment amount, even though it was below their initial wishes. Glänzer’s willingness to invest more at a later stage, if need be, played a part in them accepting the offer as

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well. As Henning pointed out it was “basically a handshake deal”. The only thing that they had to agree upon was how much money Glänzer would have to invest to get the specified ownership stake in the company.

Comparison with theory

As is apparent from the above text, the complexity of the negotiation was minimal. No systematic analysis of possible negotiation outcomes was conducted. However, the founders did have a BATNA, albeit a weak one. As noted by Henning: “[The other possible investor] was by far a

distant second choice for us, so we really wanted Stefan, because we also knew him as a guest lecturer and we knew his past successes.” Because of a strong willingness of both sides to reach

an agreement, there were no major issues in the terms proposed. The founders positive assessment of Glänzer and general excitement about the situation (Henning recalls the process as being a “big

adventure”) contributed to the creation of a joint gains negotiation framework. The concession that

the founders made regarding the sum that Glänzer was to invest, points to the fact that the fit with the investor (both personal and strategic) was more important to them than the amount invested. On the other side, Glänzer made a concession by taking his ownership stake in common shares instead of preferred shares - a move that investors rarely make7_{- showing his good intentions.}

Negotiation 2: Series A

Let us move on to the next negotiation – this time one with VC’s. The previously mentioned investment by Glänzer enabled the trio to move to a new office in London and start raising the next

7_{Preferred shares have a higher claim on assets and earnings than common shares. What this means in practice is that}

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investment round, which included negotiations with many different VC funds, providing a rich set of circumstances and outcomes.

Context

In 2008, Mendeley started raising its Series A8_{. Glänzer, with his connections in the industry,}

spearheaded their efforts in this regard – he got the founders in touch with one of the best VC’s in Europe, which, however, did not turn out as everyone had hoped. Henning and his co-founders trusted that Stefan’s stellar reputation and his recent role in the Last.fm exit (worth around 280 million dollars) would be enough to get a good term sheet from the VC, and therefore decided not to pitch others. When the interested VC found out that he was the only taker, he adjusted his offer, essentially offering less money for the same equity stake. Because the founders had almost no leverage in the negotiations, their only two options were to take the deal as it was, or drop it and try to find some other interested party. After consulting Glänzer, who believed that there would be enough interest in the market, they chose the latter and started anew. As Henning recalls: “We

turned that down and I started pitching every VC in London. Literally, every VC in London.”

Among the parties most interested in investing were Macmillan/Nature Publishing Group, a large publishing company, and the investment fund Ambient Sound Investment, set up by the founders of Skype. Both presented a unique opportunity for the young startup: Macmillan was a well-established player in the academic publishing industry, while Ambient Sound Investment had experience in the software space. While Mendeley could certainly use the expertise of both, the final decision came down to more operational factors. If the Macmillan offer were accepted, Mendeley would remain an independent company, but their need to continuously innovate could come into conflict with Macmillan’s business model. The founders deemed such an arrangement

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as undesirable for a startup entering its growth phase and decided to take the offer of Ambient Sound Investment instead. On February the 25th 2009, Mendeley received a combined investment of approximately 2 million dollars from Ambient Sound Investment, Stefan Glänzer and Alex Zubillaga (Wauters, 2009).

The negotiations with VC’s were a lot more formal than those with Glänzer. The pitching would usually take place in one of the meeting rooms of the VC funds offices, which looked for the most part typically corporate. Henning described the whole process of approaching the investors for the Series A as extremely repetitive and stressful. The toughest part was creating and maintaining the right mindset – you should appear and act as if you were being approached by the investors, not vice-versa. “I've personally found it very difficult to be in that mindset of, you know, I'm doing

them a favor by letting them invest in my company.” (V. Henning, personal communication, May

27, 2015). If we look at this from a theoretical perspective, we could describe it as an attempt to influence the other side by behaving in a way that conveys a sense of strong bargaining power. Even if the entrepreneur does not possess a strong bargaining position (which could, for example, come from already receiving a term sheet from a different investment firm), he should nevertheless act as if he does. The entrepreneur was encouraged to exhibit this attitude even when he himself did not strongly believe in it. In simple negotiation terms, this would be described as a deceiving move. But in this specific situation, there is an added layer of complexity – the potential investors in fact expect the entrepreneur to exhibit this attitude. The logic behind it is that even if the entrepreneur does not have a strong bargaining position, he should still be able to present it as though he does. In short, the pitch is not only a test of the idea, but also of the entrepreneur – in this specific example it is a test of his ability to persuade. In order to make a favorable impression,

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the entrepreneur has to be able to control not only his own emotions and moods, but also those of the investors. He tries to convince them that his company is the real deal not only by showing the numbers that support the claim, but also by displaying the confidence that should come along with it.

There was also a difference between negotiating with a business angel and a VC in terms of the form of the final agreement. While the deal with Glänzer was a handshake one, the deals with VC’s was based on a specified document called the term sheet. Usually, if the first pitch was successful, there would be a second pitch where the whole funding team as well as more members of the VC fund would be present. If this second meeting was successful as well, then the VC’s would prepare a term sheet and send it to the startup. When the startup received the term sheet, a more detailed discussion took place on specific terms.

Because the contract has an established structure based on industry standards, there is not much to be negotiated. Even if there are instances of disagreement, if both parties are genuinely interested in making the deal work they are quickly resolved. As Henning explained: “I think it was pretty

straightforward. There's lots of small legal details which you have to agree upon, but even there, there are conventions that you follow.”The one issue on which the two sides took some more time

to come to an agreement on was whether the investors should get a one-time non-participating or a one-time participating liquidation preference9_{. The investors were pushing for a participating}

liquidation preference, which would give them a larger share of the pie if the company were successfully sold. The founders on the other hand were against it – the amount they would receive

9_{An investor with a participating liquidation preference would, in the case of a sale of the company, first receive back}

the amount he or she originally invested and then be entitled to a part of the leftover amount based on his or hers ownership stake. On the other hand, an investor with a non-participating liquidation preference would only be entitled to a payout based on his or hers ownership stake.

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from the sale of the company if the investors had a participating preference would be considerably lower than if they had a non-participating one.

In the end, the founders conceded to the demands of the investors. Henning described it as a “luxury

problem” – the company was still very young with no guaranty of survival, let alone success – and

arguing about who gets what in case of a sale seemed premature. As Henning noted: “One-time

participating is pretty standard as well, so it's not like that was an outrageous demand.” The issue

was thus resolved by attributing a lesser importance to it, which made the founders less reluctant to concede, and a compliance to the industry standard. In this way, the founders adapted they own mental models to accommodate for the demand of the investors. As Henning recalls, they (the founders) were at the time not fully aware of the implications of accepting the participating liquidation preference. What they did not realize was that the Series A functions as a guideline for the other investment rounds, making it harder to propose different terms to subsequent investors. We have come across a peculiarity in the negotiation process between the entrepreneur and the investor – the terms of previous rounds of investments act as anchors for the next one. I this way, when the entrepreneur negotiated with investors about the series A term sheet, he was in fact negotiating with all of his next investors, albeit in an indirect way. Thus, conceding to their demands in the first investment round made it harder not to concede in the next. All of this of course depends on the information that the next investor has about the previous terms. In Mendeley’s case a lot of investors were of the recurring type, meaning that they invested in more than one round. This almost completely eliminated the chance of the “new” investor being misinformed about the previous terms. In fact, the only time that Mendeley was able to change the participating liquidation preference into a non-participating one, was when all the investors in the financing round were first time investors.

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Negotiation 3: Series B

Context

In early 2011 the startup started preparing for the series B fundraising. This time, they wanted to attract VC’s from the US in order to increase their presence in what they saw as an important market. Their main focus were investors in Silicon Valley along with a few East coast firms. After consulting the board, it was decided that the startup should go into the negotiations with a relatively high starting valuation, which would signal to potential investors that the company was primed for a big growth spurt. However, the strategy proved to be for the most part ineffective – the majority of the VC firms they approached were not intrigued by their offer and while the founders did garner substantial interest from one of the top Silicon Valley firms, the deal would later fall through in due diligence over a few metrics. After realizing that the US VC’s were not particularly interested in their offer, they turned back to Europe, where they were soon able to find a willing conversation partner. Even though they had by now abandoned their high valuation goal, the proposed deal with this venture firm was still predicted to slightly raise the valuation from the previous round. While this was not the result the founders had hoped for at the beginning, after a tiring 6 months of unsuccessful pitching, they were willing to accept it.

The negotiations on the term sheet went smoothly at first, but the progress was slower than expected. The other party came back again and again with new changes to the document, trying to squeeze as much as possible out of the deal. The founders were getting annoyed with the situation, and after unsuccessfully trying to mitigate the differences with the company, they decided to pull the plug on the negotiations.

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This particular negotiation shows us one of the underlying expectations that the entrepreneur had about the nature of the relationship with the investor – there has to be a genuine desire on both sides for collaboration and fairness. This means that as soon as the potential investors started behaving as if the negotiation was a distributive one, the entrepreneur would warn them that this is not the relationship his company is looking for and would, in so doing, try to turn the structure of the negotiation game into a joint-gains one. When the potential investor did not heed their warnings, the founders walked away from the deal, even when it meant going against the wishes of the board. The question that begs asking is why the entrepreneur is so opposed to a zero-sum game framework? The answer lies in the nature of the relationship that the startup and investors are trying to build. In order to be successful, they will have to work well together in the future – the relationship will be a long-standing one. Both sides know this and therefore present themselves as cooperative. However, because the investors usually hold more bargaining power than the startup, they can try and wrestle some benefits away from the latter. As explained by Henning: “There's a

famous saying in Silicon Valley which goes: You set the valuation, I set the terms.” What this

means is that even though the entrepreneur makes the first offer, the power still lies with the investor, who is in charge of putting together the actual term sheet. Because of this, we can say that the entrepreneur’s first offer is actually an incomplete one (it does not propose terms), therefore making it less effective as a game-framing tool.

The reason why the entrepreneur accepts such a condition is exactly because he expects, as mentioned before, that the investor will comply with standards of collaboration and fairness. And although he puts his trust in the investor, he does not do so blindly – in the case of Mendeley a law firm was hired to consult the startup and prevent it from entering into a bad agreement.

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One of the reasons why this particular negotiation did not go as planned can be found in the manner of communication. Reichelt recalls that in comparison with their other negotiations, this one involved less face to face negotiation. This is in line with the argument that face to face negotiations are more efficient and less likely to entail rough behavior by the party with more bargaining power – it is a lot easier to squeeze and swindle over the phone or email than when the person is sitting right in front of you (Raiffa, 1982, p. 262).

Negotiation 4: Acquisition

The last negotiation that we will look at is the one between Mendeley and possible acquisition partners. After the unsuccessful Series B, the company’s existing investors agreed to provide a bridge loan that would enable a transition either into raising a new round of venture capital or an acquisition.

Context

At the beginning of 2012, Mendeley enlisted Torch Partners, a London-based investment banking firm to help them manage the so called dual-track process of entertaining offers from possible acquiring companies and other investors. During the next couple of months, the startup attracted interest from quite a few prominent companies in the publishing industry, one of which was the Dutch company Elsevier. The existing investors saw this as proof that there was definite interest in the market, which made them more willing to reinvest in case none of the possible new investors would join in. By the end of the same year, the talks with Elsevier were progressing nicely and the founders felt increasingly excited about the opportunity. They were reassured that the publishing giant had learned its lesson from their previous fights with the open science movement, and that they shared Mendeley’s vision and would back them in order to make it a reality. Because the

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negotiations lasted longer than expected, Mendeley raised a small investment round from a couple of angel investors in order to give themselves more breathing room. Besides reassuring the founders on the strategic compatibility of Mendeley and Elsevier, the latter also increased their initial offer, and on Monday the 8th of April 2013 it was confirmed that Mendeley was acquired by Elsevier for somewhere in between 68 and 100 million US dollars (Lunden, 2013).

That Elsevier would in fact raise their initial offer was a gamble made by the board of Mendeley, but it did not happen out of the blue. As Reichelt, who was in charge of the negotiation, explained:

“We rejected the offer knowing that this was not the end of the story.” Based both on his perception

of the value of Mendeley as well as of the ability of Elsevier to offer more, he felt confident that there was more room upwards. Ultimately, Reichelt’s estimation about Elsevier’s reservation price was correct, but it was not like he was just a detached bystander – he made sure to influence the other side as much as he could in order to make his prediction a reality. The way that he communicated to Elsevier that their first offer was rejected was in line with the adoption of the joint gains framework. As he recalls:

“I said [to Elsevier]: If you want to be really serious, you have to step up your offer. Give me something meaningful that I can get the existing investors excited about, and then I can help you make that deal happen, because I think it would be useful and valuable for the company.” (J.

Reichelt, personal communication, June 26, 2015)

In positioning himself as an intermediary between the existing investors and Elsevier, Reichelt created a framework of joint problem solving as opposed to one where each side digs themselves in on their respective position. Both Henning and Reichelt felt that the negotiation with Elsevier was the one where they had the least bargaining power. However, they made sure that Elsevier was

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kept unaware of this. This time explicitly, Reichelt was aware of the intricacies of the negotiation process: “It's not necessarily about which position you are in, but what the other party knows about

the position that you are in.” Interestingly enough, the Elsevier offer provided the founders with

more bargaining power on a different front: that with their existing investors. As mentioned before, because the existing investors were now convinced that there is interest in the market, they were willing to reinvest and grow the business further. Recognizing this, the founders hinted to them that they would be willing to take their offer, but only if certain conditions were met. In this way they again used their strong BATNA (the Elsevier offer), as a way of getting a better offer from their existing investors.

Now that we have presented the 4 negotiations in more detail and discussed they theoretical implication separately, let us look at the subject in a more general way.

Discussion

External negotiations

The co-founders did not use any systematic negotiation analysis in any of the mentioned negotiations with investors. The reason for this is that the entrepreneur did not deem such analyses necessary and therefore did not acquire the knowledge to perform them. Therefore, their negotiation analyses did also not become more organized and systematic from one negotiation to the next.

The first negotiation was a simple one. There were only two parties – the founders on the one hand, and a business angel on the other – and a single item to consider (the valuation). The other three were more complex, with more parties (in all the negotiations there were multiple investors) which were less monolithic. Already in the beginning, the startup was internally heterogeneous (three

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founders), but became even more so after the Series A financing when the board was created. On the other side of the table, each VC investment fund was comprised of more than one decision maker and in every round there were at least 2 different funds (or individuals) investing together, adding to the complexity. The acquisition process proved to be even more complex due to the fact that Mendeley was negotiating with multiple interested parties at the same time. It has been noted by Raiffa (1982) that a systematic analysis of a negotiation in such complex settings becomes increasingly difficult and time consuming. The latter might be the main reason why the founders did not perform such analyses - they simply did not have the time. The literature on negotiation (especially in the early game-theory and behavioral streams of thought) treated the negotiation process as a self-containing entity that can be separated from other activities and studied individually. From what we have seen throughout the study, this assumption was later rightfully dismissed in the social psychology stream of research. Negotiations do not happen in a vacuum, and when complexity and time scarcity combine, the person dealing with such a situation usually diverts to easily applicable ground rules, to help him or her make decisions. From this we derive our first proposition - While negotiating with investors, the entrepreneur follows 3 ground rules: 1) insisting on a joint gains framework, 2) expecting fairness and 3) trusting external standards and experts (such as i.e. industry standards for term sheets and hiring law firms) in order to mitigate for his or hers time constraints and weak bargaining position.

Internal negotiations

Just as important as the external negotiations were the internal ones. They can be divided into two groups: a) negotiations between founders and b) negotiations within the board. Both of these shared some characteristics – they were inclusive in terms of letting every participant speak his mind and functioned more on the basis of consensus than majority voting. As such, the desire for a joint gain

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between the participants (the common goal being the success of the company) enabled the negotiations to run as a discussion as opposed to each side digging in and not listening to the other. Although each founder can be categorized as an individual investor as well, we will not examine how they negotiated between themselves, because they did not perceive themselves or each other as investors (at least not primarily) and therefore followed a different rationale when discussing issues than an investor would. The second group - negotiations within the board – however, fits with the overall purpose of this study. Let us look at it in more detail.

Each board meeting would usually start with a presentation by Henning and others from the management team about the performance of the last period. In the beginning the meetings were happening once a month but later on, on the wish of Henning who though that the preparations for the meetings were taking away valuable time from working on the actual business, this was changed to once every 3 months. As Henning (personal communication, May 27, 2015) recalls:

“I did always find the board meetings very stressful, because they are your bosses ultimately. They are not present during the day to day but then every three months you have to justify what you’re doing and how you’re doing and it’s like an exam.”

The primary focus of investors was on the KPI’s. If these were good, then the meeting would go smoothly; otherwise a discussion would develop on how to better reach the targets. These discussions were not always fluent – the investors on the board were very successful people in their own right with a lot of self-confidence, which sometimes caused friction. Being aware of the mental models and emotions of the investors on the board helped Henning deal with such situations.

“Sometimes it is about managing the egos and their interaction in the board room, rather than focusing on the task at hand.” (V. Henning, personal communication, May 21, 2015)

Negotiations between the entrepreneur and investors : a case study of Mendeley