Five Years Too Late

October 6, 2008

Good Money After Bad?

Filed under: venture capital — Tags: , , , , — fiveyearstoolate @ 4:42 pm

Eric Wiesen

Stuart Ellman

Lately we’ve been talking about how VCs respond to the current climate in terms of hurdles for new deals, fundraising and focus on specific sectors. But we’ve also been thinking a lot of about how to keep our current portfolio companies running effectively and successfully. Venture-backed companies almost always need additional rounds of financing, and turn first to current investors to provide that financing. Sometimes, the decision whether you continue to fund new rounds is easy. For example, imagine you funded a Series A company with a great CEO. He (or she) took the first round of financing and built a great product in a growing market that looks like it will have overwhelming demand. So when the time comes to fund again, you take (at least) your pro rata share in the new round of financing. Everybody is happy.

Unfortunately, the picture is not always so rosy. Let’s take a different and more difficult example. Let’s say your portfolio company previously raised a Series B round at a valuation of $30 million (your piece was $6 million) to roll out the new, exciting product. The company discovers that demand for the product is significantly less than budgeted. The CEO realizes that the product is in trouble and lays off much of the staff. He has a new idea for reformulating the product and offering it in a different market. But he needs $6 million from his existing investors to take on that market. On a pro-rata basis, it means a $2mm check from RRE. What should we do?

This is an issue that keeps VCs up at night. On the one hand, we want to support our existing portfolio companies, and we already have $6 million in this theoretical deal. If we don’t participate in this new financing, our equity position will be “washed out” (diluted into oblivion by the new money). The question we ask ourselves is: Are we putting in “good money after bad”? In other words, was our thesis good the first time but turned out to be wrong and are we just throwing money away now? On the other hand, was the original plan flawed, but the new one fixed the issues and it will now turn out to be a great business?

Guilt always plays a role in this decision. The company will likely go out of business if we don’t hold up our end of the syndicate. The other venture capitalists in the deal will scream and yell that we have tanked the company.

There are a number of reasons why we should invest our pro rata here:
• The new money will keep the company alive for another day.
• By continuing to fund, we don’t lose our previous investment in the company by getting washed out.
• We maintain good relationships with the other investors in the company, rather than being viewed as the firm that didn’t play and brought the company down.
• Funding maintains our relationship in the community as being VCs are who supportive of our portfolio companies.
• We’d like to maintain a strong relationship with management, particularly if it’s a team we’ve backed before and/or would like to back again.
• And lastly (but most importantly) whether we think the new product or strategy is going to make money.

The harder decision, which is often the right decision, is not to fund. Each time a VC makes a follow-on investment, it is a new and independent IRR decision. The money that went in previously is a sunk cost. In the above example, the product you invested in did not work, the money to create and market that product was wasted, the people that you relied on to make the product a success have failed or left, and the company did not live up to its expectations. You have to look at an old deal’s “new idea” as if it were a new company looking for funding in your office. That is the economic decision you are making for your limited partners. Trust me; you are looking for reasons to say yes to fund your existing deals. It is really hard to say no to them. But you have to be objective.

For us, just like with new deals, it comes down to markets and management. First and foremost, do we believe and trust the CEO? If it is the same CEO that sold us the last business plan that did not work, what led him to make his decisions all throughout the process? Do we still trust his judgment? Does he still have credibility within his company and in the marketplace? Has he done the right things in a timely fashion in reaction to marketplace changes? Second, what happened to the market? Was the company just wrong about the market or did the market change quickly? Where is the market now? Is the new product really compelling for the new market? These are tough questions, and questions that must be answered.

When financings are buoyant, new rounds are often led by new VCs at higher prices. When financings get tougher, there are more rounds that need to get done by the insiders and more companies that have missed their projections. Whether to re-invest in existing portfolio companies is a question that more and more VCs will struggle with in the upcoming year. Over the last 15 years, we at RRE have built a reputation for always trying to do what is right for our companies. We are clear to them, have open lines of communication and do everything we can to come up with reasons to support them. However, sometimes, the right thing to do is to not fund them. Prolonging the eventual demise of a company is not better for anybody in the long term.

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