Five Years Too Late

December 12, 2008

Go to War with the Army You Have

Filed under: venture capital — Tags: , , , , — fiveyearstoolate @ 12:18 pm
Stuart Ellman

Stuart Ellman

Eric Wiesen

Eric Wiesen

We recently had the opportunity to talk about the current funding environment with a bunch of smart people at a brown bag lunch hosted by our friends at Betaworks. A lot if important angles were discussed, including best practices for entrepreneurs, the mindset at different VC funds and tactical suggestions for getting a funding done in the current climate.

One point that’s worth stressing was raised by several people (including us): When you raise money, make sure you have investors who are prepared to continue to support you the next time around.

Backing up somewhat, let’s acknowledge that when times are good, fundraising usually follows a fairly standard pattern. An investor or group of investors funds a company at the Series A level for a given amount. When the company has reached sufficient proof points in the business and when new capital is needed, the company will raise an additional round of financing. A new investor usually leads this round, with participation (on a pro-rata basis) from the existing investors. The new investor is brought in for a number of reasons:

• This investor may be more oriented toward a later stage of the business and can add additional value;
• New investor may bring needed capital for future rounds of funding; but most importantly
• A new investor can set the price for the company. Prior investors may have conflicts relating to the prices of prior rounds.

When a new investor can’t be found, then the current investors face the choice of whether or not to do an “inside round”, meaning fund the company themselves. The point today is that many if not most follow-on financings are being done as inside rounds right now. The new investor who comes in and prices the company and puts in fresh capital is, in many instances, very hard to find. They are either trying to figure out how they are going to fund their own portfolio companies (and doing inside rounds for them) or they are struggling to raise their new fund and aren’t making investments in new companies.

All of this rolls up to the original point: when you build your syndicate for your Series A round, make sure you have a group of investors who will continue to support you when you need to raise more money. It’s fine to have an investor involved whose charter is solely to make Series A investments and then participate pro-rata down the road, but you should ALSO have an investor who is comfortable making Series B investments. Because as a lot of startups raising Series B and Series C rounds are learning, new investors are very hard to come by right now.

At RRE we are currently looking at funding two very promising early-stage deals. In both cases we could easily (given the amount of capital being raised) take the entire round ourselves, but we aren’t just thinking about today. Both of these companies are likely to raise more money later on, so in both cases we are bringing in partners who can both add value to the company, and who we believe will help us ensure that the company continues to be funded should the current climate last longer.

They say you go to war with the army you have, and the same is true for your venture syndicate. If at all possible, bring in investors you think can go the distance with you. It can make a big difference.

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  1. Great post, and I agree with it for many reasons. I do have a question though, about this statement: A new investor can set the price for the company. Prior investors may have conflicts relating to the prices of prior rounds. Could you explain this more? My guess is the conflicts stem from the fact that by significantly increasing the valuation of the company, the prior investors also inflate the value of their original investments. Is that right? Are there any other conflicts?

    Comment by Tim — December 12, 2008 @ 4:16 pm

  2. @Tim,

    The value in a new investor pricing the company is almost exactly what you intuit in your comment. For accounting purposes investors like to be able to show a markup to their investment. So if I invest in your company at a $10M valuation, I’d like to be able to show that my investment has done well over time. The challenge is that the primary “mark-to-market” events for these companies are subsequent rounds of financing. And as you note, it’s a fairly conflicted transaction for insiders to revalue the company and then mark up their investment. So a new investor is viewed as being sufficiently objective to provide a “market” price, and allow current investors to show a gain in advance of a liquidity event, which in today’s market can be seven or eight years from the the of initial investment.

    Comment by fiveyearstoolate — December 12, 2008 @ 5:39 pm

  3. Stu, Eric – On a related note, can you comment on any guidelines/best practices on when it is appropriate to bring in strategic investors?

    Is it ever too early (or too late) to bring in strategics and how is that decision affected by the current economic environment?

    Comment by jgannonwp — December 16, 2008 @ 11:53 pm

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    Pingback by Things That Influence Your Startup’s Value | KillerBlog — December 17, 2008 @ 2:31 pm

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