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Series B Venture Capital Strategies – Building Businesses or Building Buzz

Nate Lentz
April 14, 2014

In the last couple of months, our team at Osage has met with a number of serial entrepreneurs who speak of very similar, painful lessons they learned as venture backed CEOs in a period from 1998 to 2002.  If you sum it up, they raised too much money in too many rounds with too many different lead investors; they spent the money too quickly at the behest of the investors; they had significant board conflict as each new lead investor drove a change in board dynamics; they were forced by the later stage investors to turn down exit opportunities at values that would have changed their lives; the world changed and business conditions followed; they exited at values well below their preferences and walked away with little if anything.

With a portfolio of companies all thinking about funding strategies and value creation approaches, we also hear a lot of different philosophies from co-investors and potential follow-on investors.   If I had to characterize the two distinct camps into which the philosophies on the post-Series A round would fall, they would be “Buzz &Run” or the “Inside Round”.

Buzz & Run goes something like this.  A fund argues that inside rounds are bad for reasons including they hurt the brand, they signify weakness, they undervalue growth companies, and that  any company with momentum can always find a new investor to lead a round.  They state that their fund never does inside rounds.  They state that each round should bring in a new lead who adds to the brand stature of the syndicate.  They support increased spending and look for accelerated growth while accepting higher cash burn rates.  The perspective is that if revenue can double every three quarters, there is little limit on how much the net burn should be.  For the investors there is one additional benefit – every time there is a new high priced round of capital, the funds can write-up the investment (on paper of course) and show their own investors how well the fund is doing.

The Buzz & Run models have yielded some excellent outcomes and we read about those.  The winners win big and get the press associated with having strong branded backers.  For some companies, especially those playing off of market excitement in the buzz cycle, this is exactly the right strategy.   Of course, expectations ratchet upward with each round of capital and the newest capital often controls the decision on when to sell.   Challenges can emerge as soon as growth slows or becomes more expensive, typically seen through an increase in customer acquisition costs (CAC), a contraction in customer lifetime value, or a rise in churn.  Dashed expectations tied to an impatience for triple digit growth often leads to board disharmony, especially with different investors at different places in the waterfall – this makes it even harder to raise more capital once the “bloom is off the rose,” as the previous valuation is far too high and the level of preferences becomes an obstacle.  When all is said and done, if things unwind there is often little left for the common investors, even at a $50M median industry exit.  The investors are generally fine as they have a portfolio of investments to manage (along with their position on the preference stack).  You, the entrepreneur, may feel that you have been buzz sawed much as did the Y2K entrepreneurs discussed above.

Buzz and Run – They create buzz and either the valuation runs up or the investors run away

On the other hand there is the Inside Round.   This is the antithesis of the buzz & run.   The nay sayers argue that companies do inside rounds to enable bad assets to be propped up by stubborn investors and contend that an inside rounds signifies where good money goes after bad.  Clearly this can be true – but very often there are many good reasons as well for an inside round.

Why do companies do inside rounds?   Well, my friend Gil Beyda of Genacast Ventures did a good job in a recent blog post summarizing the reasons, which include:

  • Investors want to own more of a great company.  If a company is doing well, existing investors will lead an inside round so as not to share the deal with outside investors and dilute their ownership.  Outside investors are sometimes shown the company anyway to get a market price (valuation) and then the deal is done internally
  • If the board of directors, investors and company work well together sometimes it is best not to “rock the boat” by bringing in outside investors and board members.  Internal company dynamics are a delicate ecosystem that can be a great asset to a company but also a liability.  An inside round would preserve good working relationships with these key constituents
  • Raising capital is time-consuming.  A CEO is on the road for months, flying from coast to coast and meeting with dozens of investors.  This is a distraction for a CEO who is not able to focus on the company.  Taking an investment from existing investors who already know the company, perhaps even sit on the board, is much less time-consuming and can typically close in a few weeks.  Little diligence is necessary and the last investment documents are used.  The downside for the company is that without outside competition the valuation is sometimes lower than market

I am not opposed to externally-led growth rounds – we had two of them last year with great new co-investors and we will likely have 2-3 in the next eighteen months.  What I am opposed to is didactic views that every round must be led and priced by a new investor.  This takes away optionality and often leads to a crowded board table too early in the business lifecycle, too much capital being raised, and deep misalignment between the common shareholders (including the CEO) and the most recent high priced round of investors.

Osage portfolio company SevOne completed a $150M private equity recap in 2012 allowing all investors and common shareholders to sell 60% of their holdings.  For Osage, it was a 15x return with 40% of our stock still riding on SevOne’s future success.  For the entrepreneurs, it was an even greater win.  SevOne raised two rounds of capital with one institutional investor – Osage.  The inside round Series B was 18 months after the Series A and was aggressively priced showing meaningful appreciation in value.  We liked the business, the management, and the prospects and we wanted to own more of the company.  No one ever questioned whether the inside round hurt SevOne.  Of course, they never needed another round as they achieved positive cash flow while also sustaining high double digit and triple digit growth rates.  There is a lot of buzz about SevOne, but not because of the venture capital strategy.  The buzz is driven by what the business continues to achieve in the marketplace.

As Dan Primack wrote recently in Term Sheet in his opening “Random Ramblings”

Shortly after Facebook agreed to acquire mobile messaging company WhatsApp for a record $19 billion, I spoke to Sequoia Capital partner Jim Goetz about why Sequoia was the only venture capital firm to have ever invested in WhatsApp.

To paraphrase Jim’s answer: Because it could. Ultimately the entrepreneur has final say on new investors (or lack thereof), but Sequoia didn’t fight for a minority investor on the Series A or outside lead on the company’s Series B or Series C rounds. If WhatsApp needed more capital, Sequoia was more than happy to write the check solo.

In almost every other case, a company like WhatsApp would have had multiple investors by the time Facebook came calling. Sometimes the multiple investors are a reflection of capital requirements. But, most often, it’s rooted in the concept of social proof — a validation protocol that has the effect of making risk look…well, less risky. After all, how bad could an investment be if someone else is willing to do it too?

Sometimes social proof manifests itself in seed-stage rounds, particularly via online platforms like AngelList. Sometimes it’s in early-stage deals, either with co-lead investors or a single lead who brings in other institutions for smaller stakes. But, most often, it’s in follow-on rounds like Series B or Series C. Here is how venture capitalist Rob Go recently explained it:

“Most VC’s buy their ownership in a company relatively early.  They would like to increase it over time in their winners, but they also like getting external validation that they have made a good investment by getting another firm to mark-up their investment. Basically, this means that another VC invests at a higher valuation, making the early VC seem really smart and able to show unrealized gains. This tends to make LPs happy and make the lead partner look good among his or her colleagues”.

But Sequoia didn’t fall into this trap on WhatsApp. It saw something great, didn’t fight to bring in a partner and is now reveling in the largest-ever sale of a VC-backed company. This has got to cause other VC firms to take notice. Right?”

At Osage, we bring in outside investors when management believes it is the right thing to do or when the capital requirements suggest that our fund can’t get the company to where it needs to get to without more dry powder around the table.  Validation comes from company performance not from another investor blessing our deal and anointing it Buzzworthy.  Viva the Inside Round (in the right circumstances, of course)!