Almost all good companies go through many rounds of funding to pursue innovation and growth as well as accommodate demand from investors that want in on a great deal. I recently spoke on a panel where the topic came up about getting “thrown under the bus” where new investors try to take the entire new round and prevent existing investors from investing additional capital. With many new investors active in the market that have never founded a startup, raised angel and VC funding for their own companies or worked their way up the VC ladder from Associate to General Partner, I wanted to share “old school” etiquette on this matter and give everyone a baseline of what I think is best for all parties.
When a startup is hot there will be more demand from investors for the round than available inventory in the round. This either forces the valuation of the round up and up, which will push out sophisticated investors and the least value added investors will end up taking the entire round and the company will be worse off from not having selected the best investors to support the company at a valuation they agreed to be sensible.
Often times, the new CEO is heavily influenced by the new VC coming in and the new VC has strong percentage targets of 20% or more and the founders may not want to be diluted by more than 10% and so the sharp elbows come out. Sometimes the CEO will tell existing investors that they are very sorry, but the new investor is taking the entire round and they simply will not invest at all if they can’t get their target percentage of 20%, 15% or 10%. Existing investors that want to invest more start to get “thrown under the bus”. Many early stage angels or VCs like Rubicon Venture Capital have a strategy of investing in a certain pool of companies, being very active adding value and gaining information and then making follow on investment decisions doubling down on the winners and moving more of their fund dollars into the best performing startups. This is a timeless VC strategy that typically outperforms, PE, hedge funds, the stock market and other asset classes. If new investors somehow push out existing investors it presents a problem and the early stage VCs will respond by stopping to show their deals to those new greedy or inexperienced investors. We should agree on some protocols for how these deals should be completed.
I advise all CEOs and founders going into a new financing round to always start by telling their existing investors that they plan to raise an additional financing round and talk to them about how much and when. Hopefully the CEO has been providing all of her investors with monthly updates (see my other blog post on the importance of monthly updates) and so a follow on investment decision for the existing investors should not take up too much of the CEO’s time if any time at all. The CEO should start the new financing round by asking existing investors if they want to invest additional capital into the new round and if so how much. Once the CEO knows how much capital is committed to the new round she can approach new investors and in an ideal world say “50% of the new round is committed by existing investors and 50% is available to a new investor or group of investors to join the syndicate. If the new investor wants more than 50% of the new round existing investors can play nice by going down to 33% of the new round.”
When you do this, you are sending a message to new investors that the existing investors who know more because they have been with the startup over time want to put more money in. This is a great signal to send coming out of the gates. You are also rewarding those that supported you in the early days when the risks were higher and these first investors if value added may have made lots of intros, given you great advice and you should not throw them under the bus.
We typically make a Google Doc and create an investor control schedule and list all the VCs to introduce our startup to and the other VCs and investors in the same company join that same Google Doc and together we get full coverage of all new VCs to reach out to and we coordinate who makes each intro, when and the status. This also gives us some optics into how valuable or worthless some of the other VCs are when we see them making zero intros to other VCs for the startup.
To understand your early investors if they are anything like us, they probably want to invest more into your company over time. At Rubicon we typically invest into a company for the first time at the late seed, A or B round stage. Then we try to add tons of value to the startup leveraging our large global LP network and other relationships. Over time we can see how the portfolio company responds to these intros and we can see which companies we want to put more money into. We are normally the most active existing VC in a syndicate when it comes to making introductions to other VCs and so we expect to be able to double down and put more money into a company when we want to.
When a CEO tells me that they are powerless to let us in for a relatively small check I just don’t buy that at all. That’s just not true. A CEO may not be as strong as Mark Zuckerberg to stand up to his newest investor, but the CEO should always be in charge. Even if a round is oversubscribed the CEO can make a new convertible note and essentially give us the same terms and conditions as the new greedy investor after getting strong armed by the new VC and closing without us.
New VCs that play too rough trying to prevent existing investors from investing anything into a new round will find that we do not add them to the target investor list for our other good deals or even better we add them to the target investor list for our worst performing portfolio company. Trying to screw other investors in a small valley is myopic. Young or new CEOs, angels and VCs should understand the old school etiquette that you let existing investors take 33-50% of the new round and the new investor gives outside market validation to the uptick in price for the new round and brings in some new blood to provide a new orthogonal network to help the company.
I will write soon about VCs’ ownership target percentages and why they do what they do on that topic.