Ask an Investor: How do I manage an oversubscribed round?

Canadian money

Welcome to a new BetaKit weekly series designed to help startups and entrepreneurs. Each week, investors Roger Chabra and Katherine Hague tackle the tough questions facing founders today. Have a question you would like answered? Tweet them with the #askaninvestor hashtag, or email them here.


Well, first off, congrats! Having an oversubscribed financing round is definitely an admirable place to be in!

It’s flattering to have many offers to invest and it is tough to turn down money, especially in today’s financing environment.

Think long and hard about whether you really want to take extra money and/or shareholders into your cap table. There are pros and cons to taking more money and increasing the number of shareholders. Weigh this carefully. It’s flattering to have many offers to invest and it is tough to turn down money, especially in today’s financing environment, but remember, it is ok to say no (or not now)!

Assuming you do decide to go ahead, the most straightforward option is to simply increase the size of your financing round. Of course, this will mean increased dilution for you as a founder, so you’ll need to weigh the benefit of doing this very carefully. Consult first amongst your founder group and, then, soon after, with your lead investor about how they feel about the prospective investor’s potential value-add and about increasing the size of the round. You’ll need to get your lead investor onside with this early in the process, as they too will be facing additional dilution that they did not originally contemplate when you signed their term sheet.

If you and your lead share a view that bringing in an additional VC or Angel is valuable to the company then work on a game plan. In many cases, you and your lead will just agree to take the extra dilution and honor the pre-money valuation and terms of the original term sheet (with, at minimum, a modification on the size of the financing being injected, in effect, a higher post-money valuation). In discussions with your lead, you could also consider increasing the pre-money valuation, thereby lowering dilution to yourself, your co-founders, and other early supporters/shareholders. Of course, this will mean a reduced ownership stake for your lead, so tread carefully on this topic, as you don’t want to upset the chemistry and momentum you’ve built up with them. Just know that it is an option available to you and it is possible to do this.

Another common way to accept new investors into a company is to do what is known as a secondary financing. In this scenario there is a separate transaction (or set of transactions) that accompanies the actual financing round you are contemplating (known as the primary financing). This type of offer can be made to any current shareholders in your company, whether that is founders, early current employees, departed employees, earlier round investors (VCs or Angels), etc. The full mechanics of doing this is beyond the scope of this post (consult your lawyer!) but, put simply, the new investor wanting to come into your company makes an offer to purchase all, or some, of the shares of an existing shareholder or groups of shareholders. Recognize that doing a secondary financing adds a layer of complexity to your primary financing transaction, and complexity can slow you down, so again, evaluate the benefit carefully.

Importantly, in a secondary financing, the money from the share purchase is given to the shareholder themselves, and NOT the company (meaning you will not be able to use this money to finance your business). In this type of transaction, the existing shares being held by the seller are simply transferred to the new buyer. In addition, the shares being sold are typically of a subordinated or “lower” class (usually common shares or preferred shares from a previous round) than the new shares that will be issued in the primary financing. For this reason, there is often a negotiation about the price the buyer is willing to pay for these shares. Sometimes the price can be negotiated to be at the same price as the primary, but in some cases, the buyer will look for a discount. The thinking is that these shares are not worth as much as the new shares that are being issued in the primary because the primary shares will often carry terms such as liquidation preferences (note: there is a way to convert the lower class of shares being purchased into the same class as the primary shares being issued, consult your lawyer to discuss). I’ve simplified to reflect the scope of this post, and this can all be a bit confusing, so again be sure to discuss with your advisors and lawyers if you are unclear.

lawyer

Considering secondary financing? Consult your lawyer!

Secondary financing adds a layer of complexity to your primary financing transaction, and complexity can slow you down.

So, if you are not getting money to fund your business why would consider doing a secondary at all?

There are a few reasons. Firstly, this may give you an opportunity to get a valuable investor into your company without taking on additional dilution. For an early stage company, this is the primary reason for considering a secondary.

Secondly, a secondary can provide some liquidity (i.e. cash!) for yourself, your co-founders and/or your early investors. Selling your hard earned equity (equity that could be much more valuable down the line) is not an easy decision, and typically, founders won’t sell their existing share holdings until at least Series B financings. However, your Angels, or less often, your earlier round VCs with smaller fund sizes, might be quite happy selling at rounds before Series B. Typically, these investors have invested in your company at a very low valuation and if your current round valuation offers them a good return on their investment, they may be more than happy to get a multiple on their cash and move on!

Finally, a secondary may give you an opportunity to “clean up” your capitalization table and reduce the number of shareholders you need to handle going forward. This is especially true if you are replacing a number of individual shareholders with one investor or one investment firm. This can result in a material reduction in administration and information needs going forward, freeing your team up to focus on more value-add activities.

Bonus Tip: in addition to being a mechanism to allow new investors into your cap table, you can also use a secondary financing as a way of getting more ownership for your lead primary investor(s). There may be a scenario where your lead investor may want to increase their ownership in the company in conjunction with the new money they are putting into your company. A secondary provides a lever for you to do this without taking on additional dilution for you and your founders.


Katherine’s Take:

Katherine HagueBeing oversubscribed is a badge of honour. It makes your deal appear to be in very high demand. Simply saying you’re oversubscribed will attract more investors to your deal.

Because of this dynamic, a lot of founders will low ball the amount that they are raising, so they can get to being oversubscribed faster. For example, they will tell prospective investors they are trying to raise $750,000, when they really want $1 million. By having a lower public goal, they can hit their target faster, and then use the increased demand that comes from being “oversubscribed” to raise the remaining $250,000.

This tactic is very similar to the tactics used by companies raising on Kickstarter. Many will set low funding goals, so that they can hit the goal in the first couple days of their campaign and then start talking about how much past their goal they are, how fast they hit their goal etc. Success attracts attention and attention often leads to more success. It’s a virtuous cycle.

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Roger Chabra

Roger Chabra

Roger Chabra is the CIO at TribalScale, a global provider of digital products & companies for mobile & emerging technology platforms with offices in Toronto, Los Angeles, Dubai, San Francisco and New York City. You can follow Roger on Twitter at @rchabra