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.
Last week we talked about the pros and cons of including angels in your funding round. One advantage of angel funding is that angels choosing not to participate in your company’s later funding rounds is generally not seen as a negative signal by other investors. But what do you do when one of your VCs refuses to follow-on? In this week’s post we’ll unpack that sticky situation.
First, we’ll talk about how a startup might find themselves in this situation and introduce four reasons why an investor might choose not to follow on, and then we’ll discuss strategies for avoiding this situation altogether (and how to get through this situation if it can’t be avoided).
Having later stage investors participate early in your company’s lifecycle is not without significant signalling risk.
Over the past few yeas, later stage VCs have begun participating in early stage rounds at increasing rates. For large VCs, who will make the bulk of their investments in Series A and later rounds, seed deals have been seen as lead generation. By investing early on, with a small amount of capital relative to their fund size, VCs can get a front row seat to a company’s early stage growth, and often an option on its next round of financing.
But as an entrepreneur, having these later stage investors participate early in your company’s lifecycle is not without significant signalling risk.
Your early investors are assumed by the market to have insider information on your company’s performance. Large VC funds reserve follow-on capital to reinvest in the most successful companies in their portfolio. Assuming your company is performing well, your existing investors with enough capital reserves to reinvest should want to continue to invest. If your early investors choose not to follow on in future rounds it signals to the market that something is wrong. Why aren’t they participating? What do they know that is causing them not to invest?
Here are 4 Reasons your investor might choose not to follow-on:
1. They don’t have the capital
It’s possible your investor doesn’t actually have the capital to follow-on. This is something most investors won’t broadcast very publicly. But if it is the case for your VC, other investors will be very understanding and the investor not following on would no longer be a bad signal on your company.
2. They don’t think you’re their best bet
Unfortunately, the most likely reason for their unwillingness to reinvest however is that they no longer see your company as the best investment of their time and money. If this is the case, the investor will likely push you to find an exit opportunity, rather than raise another round of financing. But companies are bought and not sold, and “seeking an exit” can often result in a firesale. That said, if your investors are adamant that you move towards and exit, it’s worth seriously considering what your options are in this direction.
3. Your relationship has deteriorated
An unwillingness to follow-on could also be the result of your personal relationship with a partner deteriorating, a change of partners within a firm, or a change of firm strategy. While some new investors might be understanding of these reasons for parting ways with a VC, most will still see these as being bad signalling. If your company was performing well enough a firm would look past any of these issues and follow on.
4. They don’t think you’re ready
The resistance could also be that your investor simply does not think your company is ready to raise its next financing round. Have you taken the time to manage your relationship with this investor since your last financing round? Is everyone aligned around the same goals and building towards a shared vision for the company? If not, you need to go back to the drawing board and rebuild your relationship to get collective buy-in. This could end up with you waiting for the company to hit certain milestones before raising the next round or with your investor getting on board and supporting the current fundraise. If you feel the investor is simply being unreasonable about milestones, or keeps changing the goal post, getting everyone truly aligned may not be a realistic expectation and you may continue to face resistance.
Your best course of action is to try to avoid a situation where your lead investor will not follow-on altogether. You can do this by:
1. Carefully managing your VC relationships
The best way to avoid this scenario is to carefully manage your relationship with your investors from day one. Talk about your investor’s interest in following on from before they invest. If they do typically follow-on, clearly understand the firm’s expectations for following on in your company and keep an open dialogue as your company and relationship with the investor grows. If you do this a lead investor choosing not to follow-on won’t sneak up on you and you’ll have the time to manage the situation if it does arise.
2. Avoiding VCs at the seed stage
If you are still at the seed stage, you can avoid this problem during your A round by not allowing any large venture firms into your seed round. Beyond just signalling risk, the other downside to having large VCs in your early rounds is that it makes it hard to get unbiased pricing on later rounds. If your existing VCs do decide to lead your next round, their incentive is to price the round lower than the market rate. Why? Because even if you did go out to shop for other deals, the VC community is very small and outside VCs would likely contact your existing investors, likely leading them to collude on a price for the new round.
3. Considering a party round
You could also mitigate your risk of getting into this situation by having a party round at the seed stage, rather than having your early round led by a single investor. While party rounds are generally looked down upon because they mean each investor is less invested in the company, a party round could be in your interest in that you’d have multiple VCs to go back to when raising your next round and are looking for a lead.
Attracting new investors is hard enough without the added obstacle of bad signalling. But if after doing your best to avoid this situation this is where you find yourself, here is my best advice.
You may find that your lead investor will change their mind if the right set of new investors came to the table. For example, let’s say a firm like A16Z or Sequoia decided they wanted to lead your next round, I bet your current investors would quickly change their tune. Try to reason with your investors and ask them to at least publicly show their support and willingness to follow-on while you prove that there is interest in the market from another lead investor. This can buy you time and at least help you avoid a possible deal being sabotaged by the existing investor.
If all else fails, a strategy for side stepping this signalling issue would be to raise new funding through crowdfunding either on an equity crowdfunding platform like AngelList or Funders Club. Funding on these platforms tends not to be hugely affected by signalling from past investors.
Other alternative forms of financing that you might turn to if fundraising is proving unsuccessful would be bootstrapping, simply continuing to grow by reinvesting your current revenues, or corporate loans and grant financing. Control your own destiny.
From my view, if you find yourself in this unsavoury position, step one is to look inwardly at yourself, the progress of your business and the broader sector in which you compete. You chose this lead VC for a reason. Likely because you respect their opinion and experience. Are they seeing something concerning with your business or the space you are in that you aren’t seeing? From their perch, good investors see a lot and have a decent sense for the way markets are evolving and shaping up.
If you find yourself in this unsavoury position, step one is to look inwardly at yourself, the progress of your business and the broader sector in which you compete. You chose this lead VC for a reason.
Make sure you clearly understand what is driving your lead not to invest. It’s hard to do when you are in the day-to-grind of building a startup, but you have to step back, dig down deep, and think objectively. If after some serious self-reflection, and getting some advice from some people at an arms length to your business that you trust, you still believe in your company as a standalone venture-scale business then you have to act fast and aggressively to get back on course. If not, as Katherine says, you will be faced with some backup options such as having to sell your business at a sub-optimal time, or even worse, shut down. Remember, many great startup success stories hit bumps on the financing round; you are not alone.
You have to gain some allies quickly. People who believe in your vision in the same way and on the same scale as you do. I do agree that your best bet is to turn to your other prior round investors. They know you and your business better than outsiders. Work hard to get at least one or two of them to believe alongside with you and for them to commit some more money to the round you need to raise. Even a small amount is helpful and will help mitigate the bad signalling created by your lead. From there, you’ll have to network to fill in the rest of your round. Ask the other investors (the “believers”) to help you raise more of the round from their networks. They are incented to make sure your business gets the capital it needs in order to protect their past investment. Have them make introductions for you to people they are connected to that they think could be interested in investing.
Also, think hard about the type of deal you could offer your prior round investors and some new potential investors. Think about the right valuation and terms you could offer in order to incent them to participate. For instance, you may have to offer the same terms as you did in your prior round – known as a “flat round,” or even offer better terms than your prior round – known as a “down round.” At this time of uncertainty, though, the best structure is a convertible debenture, not equity. The debenture puts off the discussion around valuation which is likely in your best interest right now. You should likely offer a discount to the next round for participating investors and also a multiple on capital invested in the event of an M&A before another round occurs. These are the sweeteners for your believers.
As Katherine says, now is also the time for you to get creative about capital sources. Perhaps there is a customer or two that you have been working with for a while that has expressed interest in investing in the past. Relative to VCs, strategic investors tend to take a much longer time to decide whether to invest or not, but if you have a great relationship with them it may be worth a shot. Or perhaps you could work on getting said customer to pay their contracted revenues with you upfront by offering them a discount. Finally, look into financing your SR&ED, this type of cash is usually easy to get.
On top of getting believers on your side and being creative about financing options, it’s also time to re-evaluate your burn so as to lengthen your runway and buy time to get to your next set of milestones. Of course, there are only two ways to do this – sell more or spend less. Easy to say. Hard to do! Think about where you can get customer revenue from and again offer discounts or reduced pricing for new prospects, particularly if they agree to pay you upfront. Scrutinize your headcount and things like marketing spend. It will hurt, yes, but not as much as running out of money completely. To win the game, you need to stay in the game. Make sure you stay there.
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