Plan for Series B before Series A

December 12, 2010

At the risk of stating the obvious: capital for startups, particularly intermediate growth capital, is now harder to get.  The investor world seems to be breaking down into three strategies:

  • Invest in Series A (that’s us, the early guys),
  • Invest at Series B or C at Series A share prices (in other words, wait until the early stage guys have done the work) or
  • Invest in Series Last (where the company is near CBFE and relatively free of risk)

This is a pretty big change and results in companies that have good prospects struggling to raise their B and C rounds if those occur before significant revenues.

All of this is a challenge to the traditional startup meme –  raise money, increase valuation by doing stuff, raise more money at a higher share price, repeat till done – which maybe wasn’t such a great idea in any case. Today, the entrepreneur should really think about how future rounds may come together, how to get from Series A to Exit.  What you want to avoid it a board full of VCs that are unwilling to step up and support a good company without some other outside investor coming in and leading the next round.  Or, VCs that will step up but will use the state of  the “market” as an excuse to do a round that punishes the founding team even if the company met its milestones.

In this new world for startups (that we will likely live in for a long time), entrepreneurs should:

– Look for investors with a track record of stepping up and leading versus followers.  Going with an investor for the highest valuation might not lead to the best outcome.  Also, you might think that a syndicate with more cash at the table is good but what I have seen is that a large group will tend to follow the meekest member.  Get someone who has a track record of helping companies raise money or supporting them when the market will not.  Its easy to do some reference calls to portfolio CEOs on this issue.

– Look for investors where the board member partner can make the decision.   Otherwise plan to have to periodically pitch partnerships where the other partners don’t know your business and have to make a snap decision  –  support your company or some other company where they may know the partner or CEO better.  If your company is doing well, has lots of potential but needs a little more cash, you don’t want the investor to say “my partners are worried.”

-Make sure that your investors are likely to have the financial ability to step up and participate in future rounds.  The fact is that new investors in future rounds will have an emotional reaction to earlier investors that cannot continue to support the company financially.  For an entrepreneur, this represents a risk – your earlier investor is tapped out, the new VC wants to price at a low valuation because, otherwise, they feel that they are supporting the early investor.  This reaction from the new investors may not reflect the value that the early, but tapped out, investors brought to the table but is is there anyway and definitely affects valuations.

– Take money whenever you can (with the caveat that it needs to be from an investor that you want).  Every VC has a story of a CEO who delayed taking money because something may happen to improve valuation.  Most of the time, waiting seems to have the opposite effect and lowers valuation.  When something great happens to your company and you can raise money, go out and do it regardless of whether you need it.  When an investor offers money, have a really good reason to turn it down (like you don’t like the investor or there are too many strings).  I think that this advice applies best to later rounds. In the Series A raising way too much can put the valuation out of whack for the next round.  Also, a corollary to the “take the money when you can” is that you should try to build relationships with investors long before you need the money.  In sectors outside of the consumer internet, many VCs are taking a bit more time allocating capital an are more comfortable when they have been able to get to know the company.

– Finally, be sure that you spend money on achieving milestones that really add value to the company and don’t spend money on anything else.

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