Photo: Hsing Wei via Flickr
If there is one consistent knock against the venture capital industry, it is the opacity of the fundraising process.The rise of the highly-insightful, ethical and transparent venture investor blogger, e.g., Brad Feld, Mark Suster and Fred Wilson, has helped shed some light from the VC perspective, and the recent article by Mike Lazerow on the Buddy Media fundraising experience is one example which further illuminates the issue from the entrepreneur perspective. All of these people are gold and their teachings should be considered very carefully by both investors and founders alike.
When it comes to raising capital, most guidance has been directed towards either the seed round or the first institutional round. This includes valuable input on who to talk to, how to speak with them, and how to best choose the right investors for the company. However, where venture investing and entrepreneurship become most stressful – and potentially most valuable – is in the grey zone between “Do we really have something here? Do we have the right team to move things forward?” and “Let’s step on the accelerator; we’re rocking it.” In Josh Kopelman’s parlance, this is the zone in between “proving and disproving the business thesis.” In Fred’s post yesterday, he referred to this moment in time as “investing in the mess.” Messes can often lead to contentious discussions between investors and management, and holds the potential for mis-alignment of motives. Danger lurks everywhere. Do the current investors show support and express willingness to put more money in, or do they turn their backs and force management to spend their time scrambling for bridge cash while the development team continues to build in an uncertain environment? Frustrated investors and frustrated entrepreneurs coupled with fear and time-pressure is a recipe for disaster. Sadly, this is a situation I’ve seen mis-handled far too many times.
How investors and management deal with messes is often indicative of how they are as professionals – and as people. It doesn’t necessarily follow that if a VC elects not to lead a bridge round that they are bad or unethical people, but how they handle it probably does. And if management is super-stubborn, head-strong and unwilling to face into the gravity of the situation (by demanding unrealistic terms, valuation and amount), then they can be faulted if they are unsuccessful in attracting the capital necessary to continue pursuing the mission. So both sides need to come to the table in an open, honest and collaborative manner, and to leave all weapons at the door. Because once the weapons are flashed, the outcome is almost always a bad one for both sides.
These intermediate situations can happen in the face of a product with many positive data points, but not enough to warrant a significant raise at the desired valuation uptick, or where a product is yet to be delivered in finished form but customers communicate a willingness to buy – when it is ready (but no promises, of course). Management’s position is often “We’ve built a ton and achieved a lot since the last raise; we deserve to take in capital at a meaningful step up from the prior round,” while the VC will generally counter with “You haven’t achieved what you set out to achieve with the original raise, and/or it is taking longer than you represented. We should simply re-open the last round and view fresh capital as an extension of the original financing.” Easy to see both sides, right? Also, the Board is frequently concerned about doing a small, priced round as a precursor to a proper follow-on round, as the signaling to future investors can often look less than favourable. Often convertible notes with caps are used for this intermediate stage, but not all the time. I’ve seen both priced and un-priced deals in exactly the same circumstance. Complicated, right?
In my experience, as with the original financing round, the prudent investor will analyse the new investment with the same degree of discipline. Investing at scale simply because is it already an existing portfolio company is bad business, and can often lead to poor risk/reward trade-offs. Much of the money that was lost in venture in the past decade was due to bad follow-on decisions, not bad original investment decisions had discipline been applied to the subsequent financing. Investors need to go in eyes wide open, truly owning their decisions and being partners with management regardless of their own actions. Assuming that the current investors see real value in the company, believe in its product road-map, early customer validation and likes the team, then the desire to participate in an extension/bridge financing is often indicated. But to arrive at a reasonable set of terms, the mind-set of both entrepreneurs and investors need to be a mutual desire to “get to yes.” Short and sweet. Quick due diligence is performed. The investor offers a set of terms. The company responds. One iteration. Done. Deal sizing is generally in light of the amount of incremental runway the financing provides and the milestones that can be achieved with the benefit of additional capital. Because if all goes according to plan, the subsequent round financing can be done at an attractive valuation because the company has been able to demonstrate product efficacy and customer traction, shifting from a “proving the model” mode to a “grow the business” mode. Getting this done is a delicate dance that requires a great deal of trust between the investors and the entrepreneurs. A positive dynamic and a shared sense of win/win couldn’t be more important.
There are times, however, where the investors and the entrepreneur sharply diverge in their perception of the company, its value and its evolution. In those circumstances the investors, even if they are unlikely to lead a bridge financing, should be supportive and try to help the entrepreneur find the right investor(s) for the situation. Unless there is an awful rift, e.g., fundamental lack of trust, between the parties, the original investors should generally commit to some amount of follow-on investment if a new lead is found. But the main thing to remember is that even if the investors and entrepreneurs don’t see eye-to-eye on the follow-on round, they are still partners and should treat each other as such. Nobody wins by getting angry, hostile and negative. Never.
Mike Lazerow in his article talked about doing an inside round to help hit some of those intermediate milestones before raising a monster round at a high (and justified) valuation. He was very clear with the Buddy Media Board about the milestones he and the team expected to achieve with the incremental capital, and how it would put the company in a much better position to raise its growth capital round on its terms. And boy, was he right. Fortunately, Mike had cultivated a fantastic relationship with his Board, as did his Board members with him (Eric Hippeau, Karin Klein, Ian Sigalow, myself, and subsequently Jeff Berman). It took hard work but we – the collective we – got there. This is how it should work. Mike wasn’t elated with his bridge deal. The investors were ok with it, but certainly weren’t looking to jam more money into the company for the sake of doing so. But a fair midpoint was reached and off we went.
Investor/entrepreneur relations are a tricky thing. But they are really no different than any other relationship in business or in life. Honesty, transparency and partnership are paramount. With these three elements in place, almost any obstacle can be handled with honour, integrity and fairness.
This post originally appeared at Information Arbitrage and is republished with permission.
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