Inside Vs. Outside Financing
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.
Follow us on twitter@thefastertimes
- 1 First Openly Straight Figure Skater Comes Forward
- 2 Brooklyn Man Now Living Entirely Off Own Beard Garden
- 3 “Cra Cra” Now Official Diagnosis in New DSM (DSM-5)
- 4 OfficeMax Marketing Director Struggling to Make Staplers ‘Sexy’ and ‘Conversational’
- 5 Homeless Guy Woos Silicon Valley VCs with Low-Tech Crowdfunding Startup
- 6 Area Man Tailors Life To Be More Relevant To His Hulu Advertisements
- 7 Fan Banging Furiously on Glass Could Be the Difference in Hockey Playoffs
- 8 Survey: 88% of Eagles Fans Too Drunk To Spell Nnamdi Asomugha Last Season
- 9 Attorney Actually Starting to Believe Own Bullshit
- 10 Local Mom Won’t Stop Being First Person to Like Every Goddamn Thing Son Posts to Facebook