Leading a startup funding round is often something that new corporate investors have to build up to. The pressure of leading the due diligence and pricing of a startup is not for novices. In fact, only 6% of CVCs who took part in the annual GCV Keystone survey said they preferred to lead a round, with some 45% of ambivalent and 49% saying they prefer to follow rather than lead.
But as CVC units mature and become more experienced, they do become more willing to take point position on deal. Rounds are usually led by the biggest spender, so as corporates become comfortable with writing bigger cheques, they become the ones to determine the terms of the fundraise.
Leading is more than just putting up the most money, though, there are some things you always need to keep in mind. Here are some of them:
Keep the terms clean early on
“When it’s an early-stage company, what’s important is to make sure that the terms are clean,” says Arvind Purushotham, head of Citi Ventures. Citi Ventures is comfortable either leading or following in a round, but has recently been more likely to take a lead role.
“Clean” here means terms that are relatively simple – straight 1x liquidation preferences, weighted-average anti-dilution provisions, for example – generally the same as the previous round, and keep all parties on the same page, motivated and with common incentives.
“Make sure that the terms are clean.”
Arvind Purushotham, head of Citi Ventures
When it gets to later stage rounds, the incentives tend to change the closer you get to a potential exit event. Valuations are much more important when they will more directly reflect what you’re getting back for your investment.
Other considerations also come into sharper relief, such as fundraising history, what the previous terms look like, and how much – and in what direction – the valuation has moved. If it’s a standard up round, where the valuation is increasing, you’ll want to continue keeping the term simple. If there is a gap in where counterparties would place the valuation, then the other terms can come into play to bridge that gap.
That said, as the round leader you’ll still want ample access to all available information, likely a board seat, and, if not liquidation preferences, then maybe put options in case things go south. Above all, though, what you need is trust with the management team.
“Building trust with the founders will make both your lives much easier.”
Richard Zeiger, general partner, MSW Capital
“You can have the best lawyer or contract in the world, but building trust with the founders will make both your lives much easier,” says Richard Zeiger, co-founder and general partner at MSW Capital. MSW Capital has multiple corporates, including Microsoft, Monsanto and BB Seguros, as LPs in its fund, and frequently leads funding rounds.
Survey the land
Much of the time, even as the lead investor, you’ll be coming into a situation where the existing players know a lot more about the company and its inner workings than you do. Familiarising yourself with the landscape is crucial.
What are the dynamics among the largest shareholders? Who among the shareholders are new to venture and which of them are seasoned? Are they big funds or small funds? The startup’s management team can help you learn the ins and outs there.
“In our world, at least, we don’t see a lot of confrontational behaviour. It’s very collaborative,” says Purushotham.
Think of the next round
“When you set the term sheet, think about the next round, not just this one. Think about what role you want to have in the next one straight away. More experienced VCs are setting the term sheet thinking about the exit already,” says Bernardita Araya, manager of CMPC Ventures, the investment arm of Chilean pulp and paper company CMPC. “If you’re a corporate and you decide that you lead the round, it will be expected that you come in the next round. It will be expected that you bring more value to the companies. You really have to be ready to deliver that value.”
Remember that what you do sets the stage for the next round, and future investors will likely use your terms as a starting point for their own.
“If you’re leading a round and you don’t follow on, you can kill the company.”
Bernardita Araya, manager of CMPC Ventures
“If I put a participating preferred liquidation preference, it’s very likely that the next round guy will also want participating preferred. So you’ve now set that precedent. Can it go back? It can, but most likely not,” says Purushotham.
You need to understand that your role as a round leader has implications for the future fundraising capabilities of the startup. If you lead a series A, for example, your absence from the series B would be a terrible signal for the market.
“If you’re leading a round and you don’t follow on, you can kill the company,” says Araya. “There’s a high risk you affect the growth of the company and future investments.”
It is one thing to stay a passive investor with a small amount, maybe even decreasing your pro rata holding or losing your board seat, but it’s another thing altogether to not participate at all.
When the main corporate that led the previous round drops out of the current one, it raises a lot of questions with other potential investors. Why aren’t they taking part? Is there something going on behind the scenes? Will that strategic value still be there to hitch a ride on?
If a startup is having a hard time fundraising, especially since the venture downturn, it weighs heavier on the leader’s shoulders to see if there’s a solution – perhaps through an insider round – to get it where it needs to go.
“As a lead investor and maybe as a board member, there’s a bit more onus on you to support a startup to its next external fundraise, versus if you were not leading around,” says Purushotham.
Don’t lead twice in a row
Leading a round is great, but leading the next round for the same company is less so. Right off the bat, it sends the wrong signals about the company’s ability to attract external investment. Why, after all, does the same investor feel the need to lead again? Does no one else want to? Is no one else seeing the value here?
The leader sets the price and agrees to the valuation – doing this consecutively puts the onus on you to justify yourself not just to the market, but internally. A third party needs to validate a valuation – sure, you could hire a consultant or investment bank to do it, but to really gauge the health of a company, it’s best if another investor takes the baton.
“You want to keep your participation in the company if it’s good. At the same time, if you’re the only one that is investing, then it’s not a good sign,” says Araya.
Leading consecutively also means that you’re not just keeping your pro-rata, but building on it. Not only does taking more of the pie make it less appealinging to other VCs, it also puts you in an awkward position if, indeed, you’re looking to eventually buy. From an M&A perspective, you would counterintuitively want to keep the valuation down.
It also brings up more complex compliance issues, particularly if you’re a CVC for a public company that needs to report every movement. Fixing the price of an external asset that you don’t own will draw questions.
Foster relationships with co-investors
“The other investors that comes to the round must have the same philosophy and same way of doing business in this arena. Right? They will tend to agree with the terms,” says Zeiger
This can be tricky when a funding round includes several corporates and strategic investors – especially if they come from the same industry and could overlap on the strategic value they can bring. As the one putting together the term sheet, the leader may have to juggle competing agendas and requests to change terms. When you have multiple corporates putting in different amounts, even the smallest contributors can feel like they’re the dominant corporate in the room.
Everyone wants a good partner around the table, you need to make sure everyone is on the same page. Conversations with existing investors should cover all bases in terms of what they think about the management team, if the startup has the necessary runway to reach an exit, and how best to support it.
Avoid an M&A mindset
Venture capital is a minority stake game. Even if you see that as a temporary situation, don’t let that be reflected in the terms you try to impose.
Too many onerous terms designed to maximise your control of the company can suffocate the startup or spoil the relationships and goodwill you’ve built up with its stakeholders. CVCs in emerging markets, especially, where the incumbent corporates are still getting used to not buying things outright, need to remember this.
Don’t put up too many hurdles
“One classic pitfall that I normally see is to set too many goals in order to receive the money in tranches,” says Zeigler.
Typically a tool of investors accustomed to private equity or big money investments, the hurdles are not appropriate in the context of startups, says Zeigler. Just because you put goals in place doesn’t mean that a startup can or will necessarily meet them. Progress at startups may be much less linear.
Don’t take too much of the round
Too many investors, especially in early-stage or angel-type deals, think they are getting a great deal if they manage to bag 40% of the cap table in a seed round.
“They tend to find that it backfires, because you’re going to absolutely leave the entrepreneur without any motivation to go all the way, and you probably just made the company uninvestable in future rounds,” says Zeigler.
