Entrepreneurs Dislike Signaling; VCs Dislike Free Riders

I was thinking more about my post from yesterday titled Addressing The VC Seed Investor Signaling Problem.  There were a bunch of good comments that caused me to realize that I wrote the post from the perspective of a VC, not an entrepreneur.  As I mulled the comments over, I realized something very specific.

If a VC invests in a seed round but then doesn’t invest in the next round, there is a signaling problem, regardless of what the VC does with their investment.

When I read the post carefully, I realized that I implied that the VC firm’s strategy of selling back their seed investment might address part of the signaling problem.  In hindsight, it doesn’t address this at all.  It addresses a different problem – the free rider problem.

Most VC’s hate when other VC’s act as free riders.  A free rider is defined as someone who invests in an early round but then doesn’t participate in future rounds.  Note that I explicitly said “other VCs” and not angel investors.  Most VCs expect that angel investors will only invest in the first round or two, so they get exempted from free rider status.  I also exempt “super angels” / “seed-only VCs” from this – if you clearly define your role as an investor in the first round or two, and you never participate in later rounds, then you won’t end up being classified as a free rider.  But, once you start participating in later rounds, the expectation of your financial participation changes.

Early stage VCs are often expected to play at least pro-rata in following rounds.  When companies are successful, the early investors often (but not always) back off their pro-rata.  But, when companies go sideways or struggle, the early investors are often expected, by their co-investors – to continue to participate pro-rata until the company either succeeds or fails.  In many cases, the consequences for not participating are significant and you can get a taste for this from the post on the term Pay-to-Play that my partner Jason and I wrote in 2005.

The firm that I mentioned in the previous post addresses the free rider problem by saying “look, we’ll make it easy, we don’t support going forward so we’ll sell back our equity to the company, entrepreneurs, or angels and get out of the way for new VC investors.”  While this doesn’t address signaling, it does eliminate the free rider – in this case the VC that is not going to participate going forward.

When things are going great, none of this matters.  But when things aren’t, they matter a lot.  If I shift from the perspective of a VC to the perspective of an entrepreneur, I would only want VCs as seed investors who have a proven track record of consistently following their seed investments with future investments.  This will never happen 100% of the time – there are definitely seed investments that don’t make it. In addition, there are often cases where the entrepreneur doesn’t have choices and has to work with whoever shows up with a check.  But to hand wave over the issue is illogical.

Now, as a VC, I don’t want to co-invest with free riders.  I’m exempting angels, super angels, and “seed-only VCs” from this.  But if I co-invest with someone, I want to know that they are going to work with us to continue to fund the company, not walk away 50% of the time “because” – well – whatever “because” means.

The collision between signaling and free riders is what creates a lot of dissonance.  In the current wave of seed and angel investing activity, we haven’t hit a hard down cycle yet.  We will.  When we do, these two issues are going to pop to the forefront.  Anyone who participates in the early stage investment ecosystem (entrepreneurs, angels, and VCs) should make sure they spend some time thinking about this and incorporating it into their own strategy, before it is upon them.

  • Bill Mosby

    This is off topic, but it's good to hear from you. I hope the fires are leaving you alone, or that at least you and your wife stay safe.

  • hdemott

    A good rational look at this issue for sure.

    However, I disagree with one point here that crops up over and over again in the VC world, and that is this issue with free riders.

    It would seem that it is almost an unwritten rule of the game that if things go well – you do your pro-rata – or back off for additional investors to come in at higher valuations, but if things are going sideways, and one party wants to continue – the other should naturally follow along – and if they don't – they are somehow tainted and labeled as a free-rider.

    I think in any given investment situation, rational people will disagree with each other about the investment merits of a company – and what their risk appetite is for the investment. These differences can arise solely as a function of the company in question – be it performance related or personal issues with the team running the business – but they can also occur due to a market viewpoint, competitive investments in the same fund made afterward, other opportunities that the fund is seeing, a lack of additional funds to invest and on and on.

    In these cases what you are saying is that if I do not agree with you for any reason – then I should sell my shares back to the company – or to a new investor coming in and get out of the way.

    Of course, what you are really saying is either: a. if you are not with me, then you should not get any benefit from the optionality in your original investment and thus you should get out or b. when I invest in a syndicate deal, I only want to invest with people who have similar though patterns to myself and my partners, and are essentially willing to abdicate their fiduciary responsibilities to their investors to whomever wants to continue investing in a deal going forward.

    I think both of these statements are wrong, and anybody who signs up for such a program is a madman underserrving of investors capital.

    Free riding is simply a fact of life in the investment world – which should not be necessarily punished, but accepted for what it is – a decision to accept dilution while waiting for the company to grow into the next round – or hit the exit.

    By trying to get a free rider to sell stock back – what you are really doing is trying to protect you own economics by limiting dilution by a new investor – rational, but not necessarily fair to the original investor who was there at the beginning with you.

    In an ideal world, I agree with you in principal – but it is rarely an ideal world. Given the typical VC structure – with annual management fees and incentives on top of that – it rarely makes sense to exit an investment unless you really believe it is a no hoper – and in those cases – I doubt you will get much push back from investors. From the point of view of the founders – of course you want blind support at every level – because it preserves the status quo at the board level and limits fund raising time – both of which are essentially necessary evils – but again, this is rare in reality, particularly with stratified funds (early stage, B stage, late stage etc…)

    I'd love to hear what you think – or perhaps I've hear it – in the post.

    • davidlukas

      On a one-off basis, it is hard to disgree with your logic here. But I think what Brad is getting at is that if you consistently play your pro-rata, overcoming impediments like not being 100% on board with the terms or valuation or something else, then you win the confidence of others. As a result, it becomes easier to find other co-investors, and companies are more willing to accept your term sheet. Because it's a "repeated game," you ingratiate yourself to the whole early-stage ecosystem, and in so doing, you better fulfill your fiduciary responsibility to your LPs.

      • David – well said. There are definitely exception cases, but behavior over the long term matters a lot, at least to me.

      • hdemott

        Sure, if you can find like minded investors then great. If you all agree – then by all means go along. And if you don't then you should probably make every effort to come to some sort of middle ground.

        Ultimately, I don't think it is so much about going along – but ultimately succeeding. If you make good investments and get good exits people will go along with you – and companies will want your involvement.

    • Reasonable push back but I think you are over-interpreting my position. I'm clear that I don't want to invest with free riders – this will impact my future behavior (or – more specifically, lack of interest in syndicating with them again.)

      When someone disagrees with me on the prospects of the company at a funding point, this is very important information that I always listen to and explore. However, given constructive open communication between investors throughout the entire entrepreneurial process usually results in none of these discussions being a surprise. I love investing with people that have different thought patterns than I do – I just expect us to talk about it regularly so there aren't surprises.

      There are several different financing approaches to non-participants in future rounds that are regularly used – the pay-to-play is the most common. This is very different than having "an expectation that the VC will sell their shares back to the company for $1" – I never expect someone to do this. I was simply using this as the example that the investor in my previous post used as how they were dealing with the signaling problem.

      Finally, I think your assertion that "free riding is simply a fact of life in the investment world" – while true, misses the point. If you are a VC investment with an illiquid minority position in a company and you've decided not to continue to support the company when it needs additional capital, you are likely going to take a larger economic impact than just some dilution. You might get a lot of dilution, you'll lose your preferences, and you'll may lose any control provisions / governance rights / board seat that you might have.

      In a happy world where everything is working, this rarely comes into play. But, as I point out, when things hit big speed bumps, as they always do, this stuff matters a lot.

      • hdemott

        I understand your position completely, and I do understand the issue of free riders – both from the standpoint of those who would like to ride for free and the consequences for those who try.

        I think my comments stem more from reading the constant conversation about "who is signaling what" and whether angels or super angels should get a free pass on this issue etc…. Why should an angel be allowed to be a free rider – and not a VC? How is anyone with more information than you not investing not a bad signal – no matter who they are?

        The truth of the matter is that you are in the investing business on a professional level (be that VC, angel, super angel or whatever hybrid structure you come up with) – and all things being equal it is great to work with constructive partners who all have similar viewpoints, communicate regularly, and are easy to get along with. It is great to support the companies you are involved with – and I certainly advocate it completely.

        But it just doesn't always work out that way – and there are a lot of different ways of dealing with those differences – however, I don't think that people should feel forced to play along just so they don't get crushed in a pay to play round, or to make people feel like they are going to be great partners all the time.

        I guess what I am saying is that when people disagree on an investment – for whatever reason – there should certainly be good discussion about it – so everybody understands – but then move on. Truth is, if a VC continually gets "cold feet" their record will ultimately reflect this in the form of plenty of strike outs and "crushed in the pay to play rounds" and their IRR's will dwindle as will their assets.

        Being in the professional investing business myself, being a bad partner is certainly something that gets around pretty quickly – and you don't want to get stuck with that label in any way. It's too small a world.

  • As an angel investor, always try to save 2x to 3X of your initial investment for future rounds–just in case. You want to establish a reputation that you will be there in good times–and in hard times.

  • Dan

    I think VCs are being unnecessarily defensive about the whole signaling issue. If this is in reaction to super-angels, I think the issue is exactly the same for them, if not worse. The question is not only whether super-angel X is investing in follow-on rounds out of his/her own resources, but also if X can tap into his/her vast network to complete the deal. If X does not put out a full-court press, this also is a bad signal… and if the full-court press comes up dry, even worse.

    • Sort of, but I think most VC investors don't expect angels to play past the first round or two. A few do, but it's rare. However, I think most VCs expect most other VCs that invest at the seed stage to continue to invest in future rounds.

      That said, I agree that the signaling issue is now generating more noise than signal! But I think it's important to try to bring a few different perspectives to it, which is what I'm trying to do.

  • Am I understanding you correctly that VCs are expected to participate in follow on rounds regardless of performance… as long as a round happens at all? Which I guess is why oftentimes VCs will insist on an outsider leading the round, to get outside validation? Because at some point you're throwing good money after bad, right?

    • No, I'm not saying that. I'm saying that if a VC doesn't participate in future rounds and other VCs do, the non-participant should expect to lose a meaningful portion of their economics.

      There's a different phenomenon that occurs which is that VCs often end up with a least common denominator effect – where each of the VCs sitting around the table get convinced to participate because everyone else participates – e.g. "ok – just a little more money – let's see if that works." That's not a particularly healthy dynamic either.

      As a firm, when we think something isn't working, we take action early (well before the company runs out of money), work aggressively with the company and the other investors to figure out what we think the best course of action is, and hopefully implement it. In some cases we decide not to continue participating and we'll correspondingly "take our medicine" – whatever it is.

  • LenWilliams

    Great post, probably also completing an earlier post about the super-angel problem, from the entrepreneur's point of view, of course. The critical eye of the entrepreneur catches both free-rider VCs that take the place of angel investors and super-angels aiming at becoming micro-VCs. It is definitely not a fight between angels and VCs, it is just something that describes so well the puzzling 21st century trends. What if it's all connected to "grab the money as fast as you can and hit the road?" Again, for entrepreneurs this free-rider trend that you mentioned when talking about some VCs probably reveals a lack of respect for the other's vision and expectations. However, these are exceptions, we can still raise venture capital from serious VCs.

  • reading a post like this is yet another reminder why i'm thrilled that we have a few co-investments with you guys and hopefully more on the way !

  • Anonymous

    I have to say, I dont know if its the clashing colours or the bad grammar, but this blog is hideous! I mean, I dont want to sound like a know-it-all or anything, but could you have possibly put a little bit more effort into this subject. Its really interesting, but you dont represent it well at all, man.
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