At its essence, venture capital is the business of application of heuristics at speed, with the occasional (often not enough!) self-checking of logical fallacies and biases. To this end, at Reinventure, we are inspired by the concept of ‘mental models’, best articulated and internalised by Charlie Munger, perhaps one of the world’s greatest investors.
Reflecting on years of working in business development, mergers and acquisitions, startups and venturing, I have come to see that, more often than not, a hard deal ends up being a bad deal. This has become a mental model I now check future investments against.
A hard deal can possess any combination of a number of unwelcome characteristics: both parties struggle to find a middle ground; at least one party focuses on the minutiae; unreasonable amounts of time is spent negotiating scenarios that are commercially remote; negotiations drag on without conviction or urgency; agreements are built on shifting sands where key terms are re-litigated mid-deal. The list goes on and on.
Perhaps unsurprisingly, the ‘ hard deal is a bad deal’ rule of thumb applies to all kinds of deals — business development partnerships, employment negotiations, early-stage investment and M&A transactions alike.
For me, there are two key factors sitting under this mental model that are worth extrapolating. One is an economically rational root cause. The other is a function of personality.
The economically rational cause can be represented in a venn diagram. Good deals have a high degree of overlap between the parties — both have a lot to gain from the deal and there is high intrinsic motivation for making it happen. A classic win-win. By contrast, a hard deal occurs when there is a high degree of uncertainty about the authenticity (or its pervasiveness across an organisation) of that intrinsic motivation, or when it is based on optimism, rather than empirically observable validation.
From a personality standpoint, what is really going on is the testing of the power dynamic between the two sides of a deal. To a degree, this is a normal occurrence between negotiating parties. There is an element of thrust and parry as both sides try to negotiate an advantage. This is the healthy part of the dynamic. A former business partner of mine used to say (his version of a mental model), “you haven’t gotten the right deal until someone kicks over a chair and calls the other person a #!$&*”. There is an element of truth in this, but it needs to be distinguished from another, more unhealthy deal friction.
This is the core of my hypothesis as to why a hard deal is a bad deal. The power dynamic present during a deal remains well after it’s done. A hard deal is symptomatic of an asymmetric power struggle or lack of genuine overlap in intrinsic motivation.
The lack of overlap in intrinsic motivation rarely magically manifests post-deal. The asymmetry in the power dynamic, where one party is trying to assert themselves unreasonably over the other party, is also unlikely to change post-deal. This asymmetry will show up in commercial terms, performance against expectations, unreasonable on-going requests, grist in the mill……shit that just eats away at your soul.
So why do so many good entrepreneurs, venture capitalists and business development folk do bad deals? Have you ever heard the analogy of the boiling frog?* Place a frog in a pot of boiling water, and it will immediately jump out to save its life. Put it in a pot of cold water, heat it gradually to boiling point and the frog will remain in the pot to its death. It can be difficult to recognise that a deal is turning bad while you are in it, as it gets chipped away one piece at a time. Sunk cost bias can also come into play here — it can feel like an easier choice to accept a bad deal (with the optimism that it will get better after the event), than to walk away from a big investment in time.
Entrepreneurs by nature have an optimism bias. This places them at greater risk than most of assuming that the dynamics underpinning a bad deal will disappear post-deal.
The other reason bad deals are accepted is the presence of a ‘no real power’ dynamic in the deal. You do the bad deal because you have to, and you have no other choice. The same former partner of mine also used to say, “never enter a room you can’t walk out of”. Perhaps a mental model we can explore another time…
So what is my advice for anyone doing a deal? At key points in the process, you need to sit back and ask yourself, “is this a hard deal, or an easy deal?” If it’s hard, why is it hard? Is it because you are doing something genuinely new with lots of challenging concepts to work through, or is it because it is just hard? If it is just hard, you need to take the time to consider what hard will look like in the long term.
A hard deal is a bad deal. Don’t do them.