VC:VC Follow-on rounds

After receiving a venture capital investment, a young start-up will use the funds to grow and will either need further investment or will not. Very rarely, a young company becomes so profitable using just those first dollars, that it doesn't need any more funding to go on to a successful outcome. Alternatively, some young companies fail, and hence don't need any more investments.

The majority of companies which get a first round of financing do need more, called follow-on rounds, of financing. There are basically two distinctions we make regarding follow-on rounds.

First, is it an up-round or a down-round (or flat)? Second, is it an inside-round or an outside-round?

At the time of the first round of financing, the company sells shares to the VC firm(s) at an agreed price per share. If a follow-on (subsequent) round of financing involves selling shares below the first-round price, then it is a down round. Selling at the same price gives us a flat-round, and a higher price (best of all) is an up-round.

The whole purpose of VC funding is that the company uses the funds to add more value than the dollars that were added, and so if we achieve that purpose we always have up-rounds. Everytime we sell shares there is a dilution (more of the pie is given away), but if the share price more than makes up for it, everyone can feel good. Obviously we don't feel so good if it is a down round. The earlier investors have paid more for something that is now worth less. A flat round is generally a fudge to make people feel that "at least it wasn't a down round". However, if we invested several million dollars a year or two ago, and now the share price hasn't changed, we clearly have not made great use of the original money.

VCs will "protect" themselves from down rounds with what are called anti-dilution agreements, that allow them to claw back some shareholdings in those circumstances (at the expense of management and founders). This is based on the premise that management is responsible for running the company and responsible if it does not achieve its targets.

On the matter of inside vs outside rounds, the question is whether a new investor is "leading" the round. To lead a round of investing generally requires an investor to offer a significant amount of the funds and to offer a price. An outside up-round is what we all aim for. An outsider (not an existing investor) comes in, sizes up the company and the opportunity, and with no axe to grind offers their opinion as to the value of the company, and backs it up with several million dollars of their own money. Previous investors can boast that someone from the outside has validated the growth of the company and the value that has been created. It is all still on paper, since previous investors are not selling their own shares for the new cash ... rather the company is getting the new cash to fund the next round of growth.

An inside round is where existing investors take the lead, name the price, and invest the funds. No-one can say the round comes from disinterested investors. Perhaps the price was chosen to make the company seem more valuable than it really is, or perhaps to make it seem less valuable. There are situations when existing investors could desire either outcome. Sometimes investors are so excited about the promise of the company, they prefer not to let outsiders invest, and so keep more of the ownership themselves. Sometimes investors have no choice, if they believe there is any chance of success, or don't want to give up on the company (yet), and they have to do an inside round for lack of an outsider offering acceptable terms. There are lots of complicated possibilities, but this gives you the gist.

So how does venture cycling compare to venture capital in this regard?

The first round for me was the work up to the Hazon bike ride. The follow-on has been an inside up-round. I have been cycling on my own and with friends, and have enjoyed the benefits of the investment earlier: I am fitter, faster, more comfortable on my bike - but that is basically my own evaluation.

What about the next round? My venture cycling will not take me to Israel in May 2007 because in my venture capital life we will have our annual meeting at the same time. I certainly plan to be at the 2007 New York ride, and I see that will be the next "outside round" where disinterested parties can see how I have progressed (if at all). I wonder whether it will be an up-round or a down-round?

1 comment:

Shawn Flynn said...

Nice article. Thank you