Too Much of a Good Thing? Sizing your B Round.
Many have raised alarms about the significant shortage of early stage capital in the venture industry and, as Nate wrote recently, the Federal government is riding to the rescue with a proposed $2B funding mechanism. Whatever one might think of the risks and benefits of the Federal bond program, it is an apparent recognition of problems in the angel and A round communities, problems which we impliedly cannot ourselves solve. There is some question in my mind as to whether there is, in fact, a shortage. After several years of severe over-funding, and now two plus years of market correction, it might be too soon to know if the current level of funding is too low or just about right (I am speaking now not about job creation, of course, but about funding levels to support sustainable economic returns). Many of the ideas we see and fund do not require large amounts of capital, and certainly nothing like the capital required by the successive huge venture waves relating to telecom, wireless infrastructure and the internet land grab. It is quite possible that the available capital is not too far from the right amount. That said, there are extraneous forces that have made fundraising extraordinarily difficult, and in an environment where liquidity is king, raising early stage venture money, with its long maturity cycle, is nearly impossible.
We can, however, safely assume that the A sector is significantly underfunded relative to later stage funds. This imbalance has led to some interesting market dynamics which pose challenges for our companies and for A investors. These challenges are particularly acute in the enterprise software companies in which we invest, which tend to have modest lifetime capital requirements. We now see a common pattern. Early stage companies that break from the pack and show meaningful promise are inundated with later stage investment offers, offers which almost uniformly proffer two to three times the amount of capital identified as needed by the company. The amount of capital, in other words, is driven by fund economics, not company requirements. One might think that the offer of so much unnecessary capital would be ignored as too dilutive by the target managers. But these large offers are feeding a second trend that has become prevalent in the last few years. More and more founders want to cash in a portion of their chips early. The result is a spate of later stage funds offering to invest capital in the company while buying a portion of founders’ shares. A perfect solution – the company is not overfunded, and the founders achieve partial liquidity.
Unfortunately, the solution is rarely perfect. We are not at all opposed to founders and early investors (sometimes even us!) achieving partial liquidity in appropriate circumstances; often times this further aligns the interests of the investors and entrepreneur, particularly with respect to the timing of exit. But there are real costs to closing on a large later stage round that need to be carefully evaluated.
Here are the primary concerns we discuss with our boards and managers:
- Higher valuations plus large investments for new investors equate to a higher required valuation for exit. Assume the founders own 30% of the company after raising $3-5m of early stage capital. At a $50m exit, the founders will take home $15m, and the investors will have achieved a roughly 7x return, a great result for all. If that same company raises $15m at a $45m pre-money valuation, the new investor (who now owns 25% of the company, assuming no founders’ shares were purchased) will look for two outcomes.
- Outcome one: On the upside, a 5x or better return would be targeted. Taking the low end of the range, a 5x return to the new investor requires a sale of the company at $300m. This means that the company will have to ramp up its spend and its burn and, ultimately, assume much greater risk to meet its revised goals. This might be wholly appropriate for many great companies, but it is not for all. The point is, that taking more capital than is clearly needed can mean taking on more risk, not less.
- Outcome two: On the downside the new investor might insist on a 2x or 3x liquidation preference to justify the high valuation. With a 2x liquidation preference, the first $30m of proceeds goes to the new investor, and the $50m exit is now worth $6m to the founders. The break-even point for the entrepreneur is a sale of the company at $80m; at that point, the new investor gets $30m to satisfy the 2x preference, and the entrepreneur gets the $15m referred to above. The new investors request is not unreasonable. My point is that, again, risks have gone up for the pre-existing investors. [Note – these numbers all shift to some extent is the buyout includes the purchase of some insiders’ stock].
- When the company clearly is going to need the larger amount of capital over some period of time, then we remind ourselves that the world is a fickle place and that it takes a very brave investor/board member to turn down ready money on reasonable terms. In this case the discussion is really about dilution. If we are extraordinarily bullish on the company’s prospects, should we take just what we need now and raise funds at a much higher valuation a year from now? We try to distinguish between the bullish and bull here. If the next 12 months revenues are already booked, or major new relationships are inked that will drive those revenues, there may be reason to be bullish. But if it is a matter of extrapolating a positive growth line from the last six or eight quarters, well, we don’t mind a little dilution. Most companies have a major hiccup or two along the way, and if we haven’t had one in the last two years we might just be due. In other words, if there is a use of proceeds during the next 24 months (instead of the usual 12-18) that justifies the larger investment amount, we are often amenable. It does not pay to be greedy.
- On the other hand, what do we do if the company does not really have a need for the capital, or in any event can’t identify the need without a fair amount of creative thought. We know that a company’s goals and expenses inevitably expand to match resources. We worry when the driver is founder liquidity and not company needs. Our comfortable pattern is reversed. We like it when (a) a company defines goals and therefore capital requirements and (b) it raises the capital. We get very nervous when (a) capital finds a company and (b) the company defines its goals to use the capital. In this circumstance, and particularly with the extra motivation of a partial liquidity event, most managers have no trouble coming up with marketing opportunities, new product extensions and target acquisitions that justify the large capital infusion. We do not oppose the liquidity event for the managers, but we are very reluctant to overfund a company to achieve an otherwise acceptable goal.
- These conversations are sensitive and require an honest reckoning with our managers, including a recognition that our interests may be inherently in conflict. As investors without short-term liquidity requirements, we are better off if the company raises no more than it needs and the founders give up on a near term liquidity event. We are rarely sellers ourselves in these circumstances, and although we welcome later round investors for both their capital and their wisdom, their need to get so much capital to work often re-risks a company we had put in the clear “win” category. Thus, we usually push the new investor to lower the minimum capital they have to invest. The conflict is exacerbated by the fact that we often want to invest further dollars in our best companies, which either drives up the size of the round or pressures the outside investor to invest even less.
- Finally, we are quite sensitive to the new investor’s long term appetite for investing in the company. Often the new investor hopes to have a significant follow-on round, which creates the exact same dynamic again with even more potential for complexity and conflict around the boardroom.
Note that I have not mentioned valuation at all. The best companies are not only being offered more capital than they need, but also at valuations that are relatively rich. Dilution is not really the issue here.
During my first 10-15 years in the venture business, it was largely a given that you did not want your entrepreneurs to sell any of their shares prior to a shared exit event. That rule eroded over time, for a variety of reasons, and partial liquidity has become almost commonplace. It is helpful to have a conversation prior to investing with managers about their expectations and needs with respect to shorter term liquidity. In truth, these expectations and needs evolve over time, and the conversation will accordingly evolve. However, even if striking the right balance cannot be done in advance, it is helpful to agree what should be on both sides of the scale.