Inside versus outside financings: the nightclub effect

At some point in the life of a venture-backed startup there typically arises a choice between doing an inside round, where the existing investors lead the new financing, or an outside round, where new investors lead the new financing. At this point interesting game-theoretic dynamics arise among management, existing investors, and prospective new investors.

If the company made the mistake of including big VCs in their seed round, they’ll face this situation raising their Series A. If the company was smart and only included true seed investors in their initial round, they won’t face this issue until their Series B.

Here’s a typical situation. Say the startup raised a Series A at a $15M post-money valuation and is doing pretty well. The CEO offers the existing VCs the option of leading an inside round but the insiders are lukewarm and suggest the CEO go out to test the financing market. The CEO does so and gets offers from top-tier VCs to invest at a significant step up, say, $30M pre. The insiders who previously didn’t want to do an inside round are suddenly really excited about the company because they see that other VCs are really excited about the company.

This is what I call the nightclub effect*. You think your date isn’t that attractive until you bring him/her to a nightclub and everyone in the club hits on him/her. Consequently, you now think your date is really attractive.

Now the inside investors have 3 choices: 1) Lead the financing themselves. This makes the CEO look like a jerk that used the outsiders as stalking horses. It might also prevent the company from getting a helpful, new VC involved. 2) Do pro-rata (normally defined as: X% of round where X is the % ownership prior to round). This is theoretically the best choice, although often in real life the math doesn’t work since a top-tier new VC will demand owning 15-20% of the company which is often impossible without raising a far bigger round than the company needs. (When you see head-scratchingly large Series B rounds, this is often the cause). 3) Do less than pro-rata. VCs hate this because they view pro-rata as an option they paid for and especially when the company is “hot” they want to exercise that right. The only way to get them down in this case is for management to wage an all out war to force them to. This can get quite ugly.

I’ve come to think that the best solution to this is to get the insiders to explicitly commit ahead of time to either leading the round or being willing to back down from their pro-rata rights for the right new investor. This lets the CEO go out and find new investors in good faith without using them as stalking horses and without wasting everyone’s time.

* don’t miss @peretti’s response.

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http://www.metamorphblog.com Matt Mireles

Here's what I don't understand: Investors do this whole “oh, changed my mind. tee hee.” thing ALL THE TIME. So why should it matter if an entrepreneur does the same??? The etiquette rules seem one-sided. #fuckdoublestandards

http://twitter.com/cdixon chris dixon

I'm not really saying the entrepreneur is changing her mind here. But certainly there is a double standard. “The golden rule: he who has the gold, makes the rules.”

AndreaF

I agree, but in the example you make, the entrepreneur is now a pretty attractive date and we know that an attractive date can do pretty much what she wants and we'll always do any 'humiliating' thing for that shot at bedding her.
http://twitter.com/vsagarv Vijaya Sagar

Alright, Entrepreneurs Of The World! Build something that ensures you have the gold :^)

http://www.victusspiritus.com/ Mark Essel

Two paths lay before you Vijaya.

One leads to an enormous pile of gold which you can dole out to others.

One leads to a stream and a grated pan. Your instincts tell you the river can be sifted for gold and create a community about it.

http://leftovertakeout.com gbattle

To continue with the nightclub theme, there's the Bouncer Effect – when the managerial gatekeepers to the deal have oversold the value, only for new investors to find that beyond the velvet ropes lies and empty club with bad music and no hotties.

http://twitter.com/cdixon chris dixon

Yes, the famous first board meeting where the new investors discover all the problems in the company – or as you say, “no hotties.”

http://adamrneary.com Adam Neary

Chris–great points.

Do you feel there's any advantage to including big VCs in a seed round that might balance this risk? e.g. if things are going well and milestones are getting hit, can their involvement in the seed grease the skids a bit to the Series A? Or do you favor seed investors hands down for seed rounds?

http://twitter.com/cdixon chris dixon

As I mentioned in my response to Nivi, if all you can get are big VCs in your seed round, go for it. But if you can choose to have all genuine seed investors, I think that's highly preferable.

http://venturehacks.com nivi

More game theory!

1. What if the insiders say “please go get a new lead but we're not waiving our pro rata.” Then what? I've got a couple possible responses but they're not that strong.

2. I don't think it's a mistake to include VCs in your seed round. There are pros and cons and you helped us lay them out on the phone: http://venturehacks.com/articles/vc-seed

I know you care about entrepreneurs and I think entrepreneurs are being hurt by the blanket statement that “including big VCs in their seed round” = “mistake”. I know a couple companies that have read your past post on the topic, thought it was gospel, and soon regretted saying no to VCs because they realized they couldn't get interest from dedicated seed-stage investors.

What do you think?

http://twitter.com/cdixon chris dixon

1) Good question. if them doing pro-rata prevents a good new investor coming in because of % ownership issues then you need to fight the VCs ahead of time. If they don't give in, then they are dicks.

2) Perhaps I've painted this issue with too broad a brush. If you need to raise money and your only option is VCs, by all means do it. I encounter many situations where the round is oversubscribed and the founders could have just high quality seed investors but then consider including big VCs, which I think is a big mistake, and is primarily what I'm talking about in my posts on the topic. Does that make sense?

http://how2startup.com/ Roy Rodenstein

2) Agreed, I think Nivi is saying that of course most entrepreneurs are not in the enviable position of an over-subscribed round.

Though to that point, I know one that is oversubscribed by 30% and doing almost all seed/angel, but including a couple of VCs. He's aware of the signaling risk, but since he's oversubbed he's not that concerned, and wants to use this period to get to know them as a way to better choose who might get into the A.

http://blog.botfu.com Kevin Marshall

I think Chris is brilliant and I enjoy his posts and opinions…but anyone that takes someone's opinion or suggestions as gospel (and makes blind decisions based on it — even if it is from someone like Chris)…especially in the startup world…really isn't equipped to be playing with other people's money…

http://www.victusspiritus.com/ Mark Essel

You tell him Kevin.

We pull in opinions and information from a wide range of sources. Eventually you are forced with opportunity versus best desired paths, and choose to keep moving forward or hop off the merry go round.

http://twitter.com/Jeffbrown711 Jeff Brown

do u get back to ohio much? How can i get a concise concept in front of you?
http://twitter.com/vsagarv Vijaya Sagar

Chris,

Those who have already closed their Series A, can't use your “best solution” readily. I think, such folks should keep reminding the inside investors (say in a few board meetings ahead of Series B) about a potential conflict on this account if an agreement is not put in place well ahead of Series B.

The reminders are not so that the CEO can say “I told you so!” but to reduce the element of surprise if/when the time comes. At a minimum, the inside investors should be kept posted on:

1. The expected valuation for Series B and the amount to be raised.

2. The degree of confidence in raising that kind of money from a new VC (not sure how difficult it is to assess this apriori, but some informal talks with potential new VCs might help gauge it), if the inside investors don't want to lead the next round.

3. The approximate % which the inside investors may need to give up from their pro-rata right.

4. The long term damage that can happen to everyone, if the word spreads that this company uses new VCs as pawns in a bargain game.

5. And finally, a copy of this post of yours circulated in all board meetings

If the inside investors are reasonable (if not benevolent), they'll at least start thinking & talking about it early enough to avoid an ugly fight. There are not many options with the unreasonable ones anyway.

http://www.victusspiritus.com/ Mark Essel

Love #5 Vijaya

http://platform.newscred.com Shafqat

Chris – your thoughts on taking seed $$ from VCs have been very helpful to a lot of entrepreneurs (although I agree sometimes the brushstrokes are too broad). There simply wasn't that much material about this topic before.

To put it to you directly: would YOU invest in a startup where a VC from the seed round does not follow on? If so, under what specific circumstances?

http://twitter.com/cdixon chris dixon

Never say never, but it would certainly send a very strong negative signal…

http://twitter.com/rkteck1245 Fred T

“Never say never..”

For some reason I am coming up with a theoretical antithesis to this: The Game Effect (via Neil Strauss).

Although this situation mostly applies to a startup already given the negative signal from the initial seed round funders (Strauss calls this a neg – which in investor terms is already a laissez-faire cue for other VC's), the company will then actively try to find other means of looking for a VC who will guide them through fiduciary redemption. This is definitely high-risk, but sometimes companies have some ways of bouncing back. Apple, perhaps?

Then again, I definitely would want to stick to the guidelines, execute a proven plan, and follow with what you said above to prevent this from happening.

Beth

Chris,
Excellent summary of some of the financing dynamics that so few could understand before it is too late…thanks for sharing the “post mortum.”

One of my favorite mentors offers relevant sage advice, “If you find yourself in a hole, immediately stop digging!” I think that often parties to a contract forget the clause that says that “this contract may not be amended unless agreed to in writing by the parties.” Aaaheemm! Entrepreneurs, this is your cue. If insiders won't commit to leading and ask you to shop the next round, this is prime time to modify or amend your contract terms, as Chris suggested.

An amendment or modification should address the central game theory issue here. Think of a set of scales with “delegation” on one side and “discretion” on the other side. If the insiders wish to delegate more responsibility/authority to you find outside investors to lead the round, then you should condition that (yes, contractually condition that) with reducing their discretion to lead the round and perhaps even participate pro rata.

Beth
Healy_Jones

Chris, as I've seen this played out (from the VC side; yet to raise a second round of financing as an entrepreneur) the outside/new VCs first call the existing/inside VCs and say, “hey, I might be interested in this company. If I make an offer will you let me in; I was thinking X.” And this usually happens w/o the CEO knowing.

Downside, existing VCs are even more controlling than the company thinks. Upside, the CEO doesn't have to look like a jerk because the existing VCs are the ones who bounce the new VCs.
http://hdemott.wordpress.com Harry DeMott

What always amazes me about these situations is the power of signaling by investors. If Sequoia is in – everyone piles on. Does Sequoia's investment really signal that the company has a better chance of success? Is their batting average (and not their slugging percentage which is a completely separate thing) really that good? (And I am using Sequoia generically – could be any well regarded investor)

The worry for me as an investor – would be the amount of financing the company might need relative to whether or not you think the inside guys are going to keep participating. If they don't (for whatever reason – which could be as straight forward as they hate the company, to as complex as the partnership changed – or they are out of $) then you really have a double whammy: bad signaling from insiders (who presumably have more information than you) and a financing hole which leads the next investor to take control of the negotiation – as without insider participation – you have no negotiating power as a company.

I do agree with you Chris, that early stage companies should try to take angel money or seed fund money as often as they can – simply because of the inane power of signaling. That said, there are angels – like yourself – that have built quite a reputation – and so you unwillingness to participate in a follow on round might be just as strong a signal as Benchmark – or am I wrong?

http://twitter.com/cdixon chris dixon

The difference between me and a big fund is no one expects me to *lead* the next round since we have a small fund. At best they'd expect us to do pro-rata. The key is our economics are driven by our seed investment, whereas a big fund's are driven by the later stage rounds.

http://hdemott.wordpress.com Harry DeMott

Fair enough. But the question remains, if you were the initial investor and then did not do your pro-rata – does that produce a highly negative signal for potential investors? My guess is that it does. Truth is – if anyone doesn't participate it send out a negative signal – the issue is whether management can sell their story as if there were no existing investors and get people excited about the story just as if they were going out for their first round. If they can do that – if figure the signaling problem is not a big deal. It always seemed to me that VC's frowned on inside rounds – as they wanted outside validation to mark up both their books for potential investors in their funds, as well as their egos. To me, outside validation is irrelevant – the only thing that matters is what you paid for an asset – and what you get when you actually have a liquidity event.

http://twitter.com/cdixon chris dixon

Thus far we've always done pro-rata or more in the A round. Only times we did less was when new investor fought for bigger allocations. I think it would be a pretty unusual situation where we don't (or a Series B or later where we just don't participate ever).

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rjjohnston

Awesome thanks chris!
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http://eastagile.com kenberger

>> the nightclub effect*. You think your date isn’t that attractive until you bring him/her to a nightclub and everyone in the club hits on him/her. Consequently, you now think your date is really attractive.

Funny how the inverse is so much more common, yet the opposite conclusion tends to hold true only re the girl and NOT the startup in the (typically quixotic) founder's mind !
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http://marklogic.blogspot.com dave kellogg

I like the nightclub metaphor and agree with the dynamics you describe. There are three other factors, in my experience (as CEO of a Sequoia-backed company that's done an insider-led round). The first is the CEO's and board's obligation to get a fair / sufficiently high value for the newly issued shares. This is why people usually end up “using” other VCs as stalking horses — to pseudo-price the round. The second factor is the time/speed advantage in due diligence (it's hard for an existing board member to say he needs deep diligence). Where management time is a scarce resource, this time is worth something. The last factor is board size. In my opinion, fewer VCs on the board are better than more, and doing (a series of) inside rounds can avoid the-5-VCs-on-the-board problem.

And all that's not to mention minimizing some of the conflicts between the VCs who led different rounds.
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the issue is whether management can sell their story as if there were
no existing investors and get people excited about the story just as if
they were going out for their first round. If they can do that – if
figure the signaling problem is not a big deal. It always seemed to me
that VC’s frowned on inside rounds – as they wanted outside validation
to mark up both their books for potential investors in their funds, as
well as their egos Jogos para celular – Download filmes

Chris Dixon