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November 07, 2005

The Inside Out – Outside In Dance

When an entrepreneur has taken VC money in a first round of financing, there is almost always a second round.  Rare is the company that is able to develop a strong, sustainable cash flow positive business with a single round of financing.  When that bridge is crossed, the age-old debate begins within the boardroom:  do we do an inside round and save everyone (especially management) time and hassle or do we go outside and get someone else to price and lead the round?

Frankly, this “inside-out outside-in” dance was always a mystery to me as an entrepreneur.  And now that I’ve been a VC for nearly 3 years, I find myself still confused by it all.

If the VCs around the table love the company, why would they want anyone else to invest in it?  Why not keep investing and continue to (one of my favorite phrases) “put more money to work” (whenever I hear this oft-spoken phrase, I imagine a bunch of George Washington dollar bills slaving away in the salt mines and a VC foreman barking:  “Get me more dollar bills!  I need to put more money to work!”)?

So VCs only push entrepreneurs to go raise money from outsiders because they don’t love the company and don’t want to invest?  But if all VCs do this, then all VCs know this.  Therefore, when a VC receives “the call” from a VC buddy (sotto voice:  “I’m only exposing this to a few folks, it’s moving fast, but I wanted to get you exposed to it because you have such unique value-add and we have such a unique relationship”), the savvy VC buddy gets very suspicious.   A VC friend of mine refers to this as the “VC buddy pass”, and warned me when I got into the business to run for the hills when it comes your way.

And then there’s the famous bait and switch technique – the VC board member loves the company, but their partners are more skeptical and insist on outside validation.  So, the VC pushes management to spend an inordinate amount of time trying to attract interest from new investors, and then once the outside term sheet is put on the table, the insiders decide that they actually do want to invest and keep the round to themselves and shut out (and annoy) the outsider, particularly now that the price has been set.  This is known as the “rock fetch” (VC to entrepreneur:  “go find me a rock.”  Entrepreneur comes back panting hard with a rock in hand.  VC responds:  “No…I don’t like that rock, go fetch me another one.”)

As I said, I find it all pretty confusing.  That said, I have learned that there are mitigating circumstances.  Specifically:

  • Capacity.  There are times when the company’s capital needs are beyond the capacity of the existing syndicate.  Raising $10-15 million of fresh capital can be hard for the two original VCs, particularly if their fund sizes and average capital per firm constrain their ability to split the check while reserving adequate dry powder for another round.
  • True Value-Add.  All cynicism aside (or most of it, at least), there are times when a new, outside investor adds unique value.  This so-called strategic money can come in the form of an institutional VC, a corporate VC or a business partner with an interest in putting a few George Washingtons to work.
  • Market Validation.  As I mentioned in my VC accountability blog, an individual VC partner is accountable to their LPs and fellow partners.  If they continue to support a company on the inside without seeking outside market validation, there is a risk of eroding the natural checks and balances behind cutting off bad businesses and not allowing good money to be poured in after bad.  In my experience, this can lead to a very frustrating outcome for entrepreneurs.

My suggestion:  entrepreneurs should be proactive and have a frank discussion about the next round right after closing the first round.  Something like: “If I hit these milestones, will you continue to support the company?  If so, what is the stepped up price that we will deserve?  20%?  30%?  What if we exceed the milestones?”

Ultimately, the inside-outside dance can be an area of great and unnecessary tension and time-wasting between the VC and the entrepreneur.  As with most things, direct, open communication can mitigate the potential negativity that can result in the dance ending poorly when the music stops.

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The issue of fair pricing for the next round is not to be underestimated, even if it is an upround, especially if the inside lead has board representation.

Jeff,

Excellent post. Well articulated.

I'd second Jeff Clavier's point that
the issue of fair pricing for next round and other inter-investor issues (e.g. angels & vcs) sounds like a tinderbox of conflict.

I'd be happy to learn more about how earleir stage investors deal with conflict that sometimes happens between them selves and later stage investors.

Bravo! Fantastic post. Thanks for the insight.

while i agree with you Jeff that doing an outside round in non-sensical if you love the company, the idea of third party pricing of each round is baked into the culture of the venture business and trading good deals with other VC firms is based in part on letting your friends or guys you want to be your friends into your better deals.

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