By: Paul A. Jones
Every now and again, you hear about an entrepreneur achieving a solid exit after a single “A” round of venture capital financing. More often than not, however, venture-backed entrepreneurs go through several rounds of venture financing on their way to achieving the cash-out exit of their dreams. That said, the dynamics of “B” and other “follow on rounds” do not get as much attention in the entrepreneurial press as the dynamics of “A” rounds. Thus, some thoughts here on follow on rounds of venture financing.
The first thing to know about B rounds is that seasoned entrepreneurs begin thinking about them in the days immediately after (or even before) the closing of the A round. That means thinking about – on an iterative basis in the days, weeks, and months after the A closing – how much capital will be needed at the next round to accomplish what milestones; what the circumstances of the next round are likely to be (in terms of the company’s performance and market conditions); who the potential investors are (focusing on who the credible lead investors are, among both A round investors and investors who were not in the A round); and understanding and managing the expectations of your current investors. If a founder/CEO who has closed an A round does not already know that raising new capital, and managing existing investors, will be the most time consuming and ultimately mission critical part of his job, he will learn it in the run up to the B round.
In thinking about the B round (or any follow on round), the entrepreneur should focus first on identifying plausible lead investors for the round: investors who are willing and able to set a price; help close other investors; and serve as the representative of the investor syndicate in the negotiation and closing of the round. Note the use of the plural in the last sentence. No matter how certain the entrepreneur is regarding potential leads for the B round, don’t reduce the field to one candidate until the last possible moment, and certainly not until a negotiated term sheet is in hand. More particularly, no matter how good your relationship is with your current investors, and how certain you are that they will step up at the B round, never assume that will happen.
If identifying multiple plausible lead investors is task number one, understanding the special dynamics of follow on round negotiations is a close second. The salient special dynamic is this: to a greater or lesser extent, depending on the circumstances of the B round (up, down or flat pricing; new investors or just current investors involved; specifics of the A round deal) the B round negotiations put the A round deal terms back in play. That is, while the A round negotiations generally involve two principal parties (the company and the A round investors) follow on round negotiations involve three principal parties; the company, the follow on investors, and the previous round investors. Going from a two-party to a three party negotiation is a big step up in terms of complications. Throw in, now and again, a new C-level management hire, and the dynamics get even more complex.
In the case of an up round consisting of solely prior round investors (not usually the best scenario, from the company’s perspective: more on that below), the prior round terms might not be much of a factor in the negotiation of the terms of the new round. On the other extreme, in a down round consisting only of new investors, amending the prior round terms is quite often central to the follow on negotiations, all the more so if a new C-level manager is part of the deal. One point to keep in mind in either case: whoever is participating in the follow on round, and particularly if a new investor is leading the follow on round, the investors in the follow on round are generally more interested in keeping management happy (at least those managers they see as important to the company’s future success) than they are in keeping either prior investors who are not writing checks, or no longer critical founders/employees, happy.
Now let’s return to my suggestion in the last paragraph that in most cases entrepreneurs are better served in a follow on round that includes new investors, and particularly a new lead investor. There are two reasons for this. First, a new lead sends a message to the market that the deal is a bona fide arms length transaction; that is, that the deal stands on its own merits and is not the product of insiders at least partially motivated by protecting their prior investments. This is not a huge concern, but neither is it trivial. Second, a new lead from outside the current investor syndicate maximizes the entrepreneur’s leverage in the three-way negotiation dynamic noted in the previous paragraph. Finally, a new lead brings another source of capital to the table, and, all other things equal, the more potential sources of capital around the table, the better off the entrepreneur in the event the company subsequently hits a bump in the road.
My intent here is not to suggest that entrepreneurs approach follow on round negotiations as a take no prisoners exercise. Ideally – let’s say an up round scenario where all the current investors are happy with the entrepreneur and his team and blessed with lots of dry powder, and multiple potential new investors are anxious to get into the deal – negotiating and closing a good follow on round can be a more or less pleasant and amply rewarding experience for all concerned. And even in the worst case – a very down round with only new investors participating – a still valued entrepreneur is usually well served by remembering the old Wall Street advice that it is ok to be greedy, but don’t be a pig. Because, of course, once the deal closes, there will be the next round to think about, and the dynamics will shift again.