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

Confidential Instructions for the Founder

Scenario
You founded the company Earth Escape four years ago with the intent of revolutionizing
the public space travel industry. Earth Escape has made excellent progress as you have
personally led the development of a reusable launch vehicle (RLV) that drastically
reduces the cost and risk of suborbital space flight. Also serving as the company’s Chief
Executive Officer (CEO), you are now seeking $100 million of funding to build a small
fleet of six RLVs and develop the company infrastructure necessary to begin offering
tours of space to the general public.

You are particularly interested in receiving funding from a venture capital (VC) firm
named Aerovent Capital. You believe the firm would offer significant added value
through its focus on the aerospace industry and excellent dedication to working with its
portfolio companies. You have met with a general partner of the firm several times now
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

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upon terms will provide the basis for a detailed term sheet to be signed later this week.
You are extremely interested in receiving venture capital from Aerovent and the wealth
of expertise that would come along with it. However, you realize that if you cannot agree
on terms that protect your interests in Earth Escape while developing the foundation for a

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strong working relationship, you will abandon the deal and seek funding elsewhere.

Background on Earth Escape

Before founding Earth Escape, you worked at multiple aerospace corporations as a
management and engineering R&D (research and development) professional for over 25
years. You have always specialized in launch vehicle development, and you finally left
your corporate job four years ago to dedicate yourself to developing a reusable launch
vehicle that would make suborbital space travel economically realistic for the general
public.

Your company is now the sole owner of your proprietary design for a revolutionary type
of RLV. Though other companies are also seeking to advance the space tourism market
through suborbital flight, no other company has addressed the financial and safety issues

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 THE FOUNDER

of suborbital flight as authoritatively as Earth Escape has. 1 As a comparison, you firmly

believe that your design will immediately make the suborbital space tourism industry
significantly safer than the commercial airline industry was during its early years of the
late 1920s. Development and testing has gone smoothly as the RLV has undergone 15
tours of space to date. You have even begun selling a limited number of tickets on these
flights to individuals eager enough to partake in these early tours and able to afford the
purposely exclusive ticket price.

The RLV offers its passengers a truly unique tour of space by taking off from a standard
runway, exiting the earth’s atmosphere and entering outer space for approximately twenty
minutes at a peak altitude over 100 miles above the earth’s surface, and returning to the
same runway with a round trip time of only two hours. The exclusive perks of the flight
include the weightlessness of outer space, a life-changing view of the earth from afar, and
acknowledgment as a true astronaut.

When you were founding the company four years ago you arranged for enough startup
capital from a few wealthy individuals interested in space exploration to fund the
development of your RLV. They generously invested approximately $23 million in
exchange for common stock in your brainchild. Your company currently employs 35
individuals, but you have plans to create a much larger organization. You are seeking
$100 million in venture capital to advance Earth Escape to the next stage of its
development, i.e. offering suborbital space tours to the public with a small fleet of six
RLVs. Further in the future, you believe that Earth Escape could be the leader of a
billion dollar space tourism industry offering flights to thousands of new “astronauts”
every year.

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Alternatives to a Negotiated Agreement
In the last two weeks you have also begun discussions with two other venture capital
firms. They seem interested in Earth Escape, but you have not sat down to negotiate the

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terms of an investment with them yet, as you are about to do with Aerovent Capital. You
think they may have the means to offer competing term sheets, but you honestly do not
believe they can match the value Aerovent Capital can add through its reputation and
expertise. Though you may gain leverage by generally mentioning the interest of other
VC firms, you have been warned by other entrepreneurs not to divulge the specific names
of the venture firms you are seeking competing term sheets from. A disastrous result can
occur if the “competing” VC firms contact each other and negotiate a single term sheet
that destroys your leverage and leaves you with a single take-it-or-leave-it-offer. 2

Considering the potential term sheets you may receive from the other venture capital
firms that have shown interest, you have quantified your Best Alternative To a
Negotiated Agreement (BATNA). You may accept a minimum of 45 substantive points.

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
See Cardis, Joel, et al. Venture Capital: The Definitive Guide for Entrepreneurs, Investors, and
Practitioners. New York: John Wiley & Sons, 2001. p. 195-196.

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AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR THE FOUNDER

If you can not reach an agreement with Aerovent that meets your acceptable minimum,
you would prefer to pursue opportunities with other venture capital firms.

Earth Escape’s Process Interests

You would be extremely disappointed if your negotiation with Aerovent leaves you with
the impression that the partners view your company just as an opportunity to make
another quick financial return. You are interested in an investor who you can trust not to
sacrifice the long-term health of the company for short-term profits. You are aware that a
VC does not require overt control of a company to greatly impact its future. You hope to
avoid any future power struggles over Earth Escape by finding a venture capital firm that
you can trust even in situations when you strongly disagree over governance issues.

This negotiation is the ideal setting to discern how future conflicts will be resolved. You
realize that your expectations should not be one-sided though. You will have to invest in
the future of this relationship just as actively as the venture capitalist. Your process goals
are to establish an open flow of communication based on mutual respect and to
understand the primary interests underlying Aerovent’s positions. By standing by
commitments made and negotiating fairly, you hope to convince the venture capitalist
that you are interested in as equitable a process as possible and that the opportunity to
work with Earth Escape should not be neglected. You hope that you can achieve such
process goals while agreeing to a term sheet that champions your interests in Earth
Escape.

To gauge your ability to achieve your process goals, the VC will complete a process
evaluation based on his or her experience during the negotiation. The evaluation will be

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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:
ƒ Trust: How much does the VC trust you?
ƒ Respect: Did the VC feel respected during the negotiation?

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ƒ Equitability: How fair does the VC believe the process was?
ƒ Regard for Other’s Interests: How much did you attempt to understand the
VC’s interests?
ƒ Interest in Future Collaboration: How interested is the VC 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.

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AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR THE FOUNDER

CONFIDENTIAL
Negotiable Terms for the Founder

The following confidential information regards eight negotiable terms you will discuss
with the venture capitalist. 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 your interests, e.g. financial
concerns, risk profile, personal preferences, 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 venture capitalist.

Term #1: VC Equity Percentage

Aerovent Capital will receive equity in Earth Escape for the $100 million investment.
You would like to give as small an equity percentage to the VC as possible. In your
previous meeting with the VC you both agreed that a $100 million investment is the
appropriate amount to help Earth Escape reach the next stage of its development. To
determine an approximate percentage of the equity the VC deserves you have considered
your valuation of Earth Escape. The equity percentage and valuation are related such
that the higher the valuation you attach to the company, the smaller the equity percentage
the VC deserves for the fixed $100 million investment. 4

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You have used a number of techniques to objectively value Earth Escape. From a variety
of detailed revenue projections and comparisons to other aerospace companies, you have
concluded that Earth Escape deserves a post-investment valuation between $250 and

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$300 million. In which case, Aerovent Capital would receive between 33% and 40% of
the company for its $100 million investment. 5 Your analysis has shown situations in
which the company could be valued even more aggressively. Overall, you think an
equity percentage between 33% and 40% more than fairly compensates Aerovent because
the firm could easily earn a multiple of ten return on its investment in five years if the
company develops as planned. Furthermore, the company has already grown through its
most vulnerable stage by developing a launch vehicle that has proven to surpass all
industry standards. Now, it is just a matter of implementing the business plan.

Though you may be willing to negotiate a higher VC percentage than 40% in exchange
for other terms in your favor, you do not want to give up shareholder control of your

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
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.
5
Assume percentages of the company are on a fully-diluted basis post-financing.

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AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR THE FOUNDER

company. Earth Escape’s bylaws detail that for governance issues requiring a
shareholder vote, a simple shareholder majority is required for approval. 6 You have built
Earth Escape from the ground up and you strongly oppose giving control to a VC at this
point in the company’s development. Therefore, you are extremely hesitant to accept any
term sheet that gives the VC 50% or more of the company’s equity. The lower the VC
equity percentage you can negotiate without damaging the future relationship the better. 7

Term #2: Type of Stock

You also must agree on the nature of the security Aerovent Capital will receive for its
investment. You are considering three forms of stock for Aerovent’s equity share:
common, convertible preferred, and redeemable preferred.

You would prefer to issue Aerovent common stock. Up to this point, all investors in
Earth Escape have received common stock and you would like to maintain equality
among the investors. Common stock would give Aerovent no liquidation or conversion
preferences. However, you would be willing to concede common stock because you
expect that Aerovent will be highly resistant to investing without preference, and you are
more concerned with other terms.

Your second choice is to issue Aerovent shares of convertible preferred stock. In the
event of a liquidation, convertible preferred shares would give Aerovent the right to
recoup the full value of its investments from the liquidation proceeds before you or any
of the other holders of common stock receive anything. Furthermore, Aerovent would
have the option of converting its preferred shares into common stock, which the firm
would likely do if the value of its equity share exceeds its initial investment. 8 You would

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rather issue common stock, but convertible preferred is acceptable to you because you are
highly confident that the value of Earth Escape is going to increase such that Aerovent
would convert its shares to common stock anyway.

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The stock you would least like to issue is redeemable preferred. 9 Shares of redeemable
preferred would overcompensate the VC by allowing the firm to double dip into Earth
Escape’s proceeds. Aerovent would be allowed to fully redeem its initial investment in a
liquidation event and also take its full equity percentage of any remaining proceeds. You
find it unreasonable that in the event Earth Escape does well for all its investors,
Aerovent would be allowed to essentially get its money back and keep its investment.

Term #3: Dividends

6
Regardless of the type of stock agreed upon in Term #2, Aerovent shall have shareholder 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 Aerovent’s representation on the board of directors as a
separate term.
7
You may use the company’s valuation to negotiate this term, but settle on the specific equity percentage
for the venture capital firm.
8
Assume a one to one conversion ratio.
9
Redeemable Preferred stock would be issued along with common stock equal to the agreed upon VC
equity percentage.

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AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR THE FOUNDER

You have already established with Aerovent Capital that paying cash dividends while
trying to grow an early stage company is unreasonable. However, the option of granting
dividends payable in equity (commonly referred to as payment in kind) that accrue until a
liquidation event still remains. You think that Aerovent should be satisfied with its basic
equity percentage and concentrate more on increasing the value of Earth Escape for all
its investors.

Furthermore, overcompensating the VC with equity may misalign incentives with the
other stock holders. If Aerovent receives too much of Earth Escape’s equity, it will
actually be a detriment to Aerovent because the employees and other stock holders of
Earth Escape will be overly diluted and their incentives diminished. If you choose to
grant dividends, negotiate them as a percentage per annum of the original VC owned
equity and aim to keep them as minimal as possible. 10

Term #4: Antidilution Rights

You will also discuss antidilution rights for Aerovent. 11 An antidilution provision can be
included to protect the VC’s equity interest in the case of additional rounds of financing.
The provision you will be discussing is the VC’s right of first refusal. If Earth Escape
requires additional capital in the future, the right of first refusal would give Aerovent the
right to buy the additional shares of equity before they are offered to another party.

Some CEOs in your position might prefer to limit a VC’s future investing rights as much
as possible, but you would actually prefer Aerovent to have the right of first refusal. It
seems reasonable to you that the VC have the right to reinvest before the option is given
to additional investors. You also stand to benefit from Aerovent maintaining a strong

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equity position with Earth Escape. You realize that if Aerovent’s equity is overly
diluted, the firm is less likely to consider your company a priority for Aerovent’s non-
financial resources. Additionally, you hope to build trust with the VC by agreeing to a
right of first refusal. You must negotiate this term as either “VC Right of First Refusal”

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or “No Antidilution Rights.”

Term #5: VC Appointed Board Members

You are negotiating the number of members that Aerovent Capital may appoint to Earth
Escape’s board of directors. The board currently consists of three members: yourself and
two independent directors. When founding the company you beseeched two aerospace
executives you had met during your career to join Earth Escape. They agreed and
brought a wealth of diverse, strategic knowledge to the young company.

The board of directors has many responsibilities that affect the future of your company,
such as setting strategic goals, reviewing management’s performance, approving major
financial transactions, etc. You have always intended to keep the board a manageable
size and have no interest in dealing with a large, unwieldy board.

10
Assume cumulative annual compounding of dividends.
11
Dilution refers to a reduction of Aerovent’s fractional ownership of Earth Escape.

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AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR THE FOUNDER

Aerovent may not be aware that you would actually prefer Aerovent to have at least some
board representation. A single board member appointed by Aerovent would be a great
conduit to the firm and broaden the board’s perspective. You would even accept two VC
appointed members, but you can not accept the VC appointing three members and
controlling half the board. You also recognize that if you receive financing in the future
from another VC firm, that firm will also likely expect board representation. Therefore,
you have decided that you will not accept any term sheet that grants Aerovent more than
two board seats.

Term #6: Vesting of Founder’s Shares

The VC may want to agree on a vesting schedule for your shares in Earth Escape. The
proposed vesting would require you to give up your entire equity share in Earth Escape
when the $100 million investment is made and you would earn a portion of it back each
year that you continue to work with the company. Vesting of your shares would reassure
the VC that you will not be able to immediately sell your equity and leave the company.
For this term, you are discussing how many years, if any, until your stock is fully
vested. 12

You find it ironic that Aerovent would feel the need to make you temporarily give up
your equity share in the company you created, especially because you fully intend to
dedicate yourself to Earth Escape throughout the company’s maturation. You wouldn’t
mind agreeing to a short vesting schedule, such as three years or less, if it helps you
establish trust with Aerovent or offers you leverage for other terms you are more
concerned with. However, you cannot fully predict the dynamics that will be acting on
the company years from now, and you do not want to be controlled by a lengthy vesting

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schedule. You deserve your equity share more than anyone else associated with this
company and would like to satisfy the VC of your long-term commitment to the company
through trust, rather than binding legal documents.

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Term #7: CEO Replacement Provision
Apparently Aerovent has some concern with you retaining your title of CEO. You think
this is ridiculous and personally offensive. You have done an excellent job running the
company to this point and have held numerous management positions overseeing R&D
projects during your corporate career. Indeed, you finally left your last job so you could
run your own company, and who better to oversee Earth Escape than the individual that
understands the technology and market more intimately than anyone else. You have also
pointed out that you are not a serial entrepreneur that will start another company in a few
years. This is your one shot at running a company.

During your last meeting with the VC this issue was definitely a point of conflict. To
compromise on the issue, the VC has suggested that you remain CEO of Earth Escape on
a conditional basis contingent on the company meeting annual performance benchmarks
over the next five years. If an agreed upon annual benchmark is not met, Aerovent
Capital will have the right to immediately replace you as CEO with no further

12
An equal percentage of the founder’s initial equity shares will vest each year until 100% vested, e.g. if a
three year vesting schedule is agreed upon, 1/3 of the founder’s shares will vest each year.

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AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR THE FOUNDER

negotiation. They have suggested that, in such a case, you could serve on the board of
directors and continue to work with the company. 13

For this term you are negotiating the annual performance benchmarks that will be used to
determine if you are replaced. The VC has suggested that the benchmarks be the very
revenue projections that you presented to the firm in your first meeting with them. You
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 prefer no CEO replacement provision whatsoever, but the conservative projections
as benchmarks might be acceptable. You are uneasy agreeing to even the moderate
projections though, because you know all the projections you made were admittedly
aggressive. You were advised that venture capitalists love to see impressive numbers that
border on unrealistic. Furthermore, a CEO cannot control all the factors that affect a
company, and you do not think you should be replaced as CEO if certain market forces or
unavoidable delays cause revenue to be slightly below target levels for one year. You see
accepting the aggressive projections as basically submitting to resign as CEO because
unless everything progresses flawlessly over the next five years, Earth Escape will likely
fall short.

Term #8: No Shop Provision

If a term sheet is agreed upon, Aerovent Capital will likely take one to two months to
perform due diligence on Earth Escape before becoming legally bound to the investment
by signing a formal Stock Purchase Agreement. In the meantime, you have the right to

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solicit term sheets from other VC firms unless a “no shop” provision is included on your
term sheet with Aerovent Capital. A no shop provision would prohibit you from talking
with other potential investors once the term sheet is signed. If the no shop provision is
included, Aerovent Capital will have the right to exclusive negotiations with Earth

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Escape for sixty (60) days, after which the provision will expire if the Stock Purchase
Agreement has not be signed.

You believe a no shop provision stopping you from contacting other VC firms is overly
restrictive. Accepting such a provision would create a situation greatly biased towards
Aerovent. If reasonable terms can be agreed upon, working with Aerovent Capital is
your top choice because of the value its partners can add to Earth Escape. However,
determining if the terms of the investment are acceptable is contingent on understanding
what terms the venture capital market will bear, and you clearly must discuss term sheets
with other VC firms to gauge the market’s interest. Therefore, if Aerovent Capital insists
on a no shop provision you do not believe they are engaging in fair play. You must
negotiate this provision with the VC as simply “included” or “not included.”

13
If you agree to a vesting schedule, being replaced as CEO will not affect the vesting of your stock if you
remain on the board of directors.

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AEROSPACE INVESTMENT: CONFIDENTIAL INSTRUCTIONS FOR THE FOUNDER

Confidential Score Sheet for Founder

Instructions: When an agreement has been reached, circle the agreed upon options and record the results
in the Points Awarded column. You may negotiate the VC Equity Percentage and Dividends in terms of
any whole percentage. Note that receiving zero points for an item does not equal No Deal, unless No Deal
is specifically noted.

Point Points
Substantive Terms Options Allocation Awarded
60% or more: No deal
56% to 59%: 4
50% to 55%: 8
47% to 49%: 16
#1: VC Equity Percentage ________
42% to 46%: 18
36% to 41%: 20
31% to 35%: 22
30% or less: 24
Redeemable Preferred: 2
#2: Type of Stock Convertible Preferred: 5 ________
Common: 6
8% or more: 0
5% to 7%: 5
#3: Dividends 3% to 4%: 8 ________
1% to 2%: 12
No dividends: 16
No Antidilution Rights: 0
#4: Antidilution Rights ________
VC Right of First Refusal: 3
More than 2 members: No deal

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#5: VC Appointed Board Members
2 members:
1 member:
0 members:
6
8
2
________

6 or more years: 3

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#6: Vesting of Founder’s Shares
4 or 5 years:
3 or less years:
No vesting:
Aggressive Projections:
8
10
12
No deal
________

Moderate Projections: 7
#7: CEO Replacement Provision ________
Conservative Projections: 14
No provision: 19
Provision included: 2
#8: No Shop Provision ________
Provision NOT included: 12

BATNA: 45 Substantive Points

(Total Possible Substantive Points: 100) Total Substantive Points Awarded: ________
(Possible Process Points from Evaluation: 50) Total Process Points Awarded: ________
(Possible Grand Total Points: 150) Grand Total Points Awarded: ________

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