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There were some great comments on my post from Sunday titled Being Syndication Agnostic. One of them was from Kevin Vogelsang – he asked the following question:
What are the downsides to syndicating a round of financing for the entrepreneur/startup (assuming the relationship with all investors is a good fit of course)? By syndicating a deal, the entrepreneur gains access to a larger network. This seems to be a big positive. However, there must be downsides (less attention, more interest groups, etc.) Love to hear more on the topic.
While there are plenty of downsides, I’m going to take on five common ones in this post.
Too Many VC’s on the Board: Most VC’s want a board seat when they invest in a company. At the early stages this is usually manageable (although not necessarily desirable). However, once a company has raised several rounds of financing and built increasingly large syndicates, this can quickly get out of control. The largest board of a VC backed company I’ve ever been on was 11 (8 VCs, CEO, founder, one outside director). It was a completely ineffective board. Now, the board size problems can be dealt with by a strong CEO and a strong lead investor who will help the CEO organize the board in a manageable way, but it has to be done proactively.
Too Many People in the Room: This is a corollary to “too many VCs on the board.” If the VC doesn’t get a board seat, they’ll want an observer seat. In addition, most later stage VCs or strategic investors want observer seats. Suddenly even though you’ve managed the size of the board effectively, there are a bunch of people in the room. I’ve been in board meetings with over 20 people in them (I don’t know the exact max, but I’m going to guess it’s around 25 since eventually you run out of chairs.) Not surprisingly, these tend to be weak or inefficient board meetings with separate “executive committee meetings” where the real board meeting happens, and then another three hour song and dance for the benefit of the 15 other people.
Both of these are a natural result of most investors in private companies wanting to have a seat at the table. While a reasonable expectation, it’s important for the CEO and founders to set an appropriate tone and expectations with their investors early on so that there’s actually an effective board, investor, and company dynamic as the syndicate gets large.
Misalignment of Interests: With each round of investment and each new investor comes new expectations. As the syndicate size grows, the chance of interests between parties getting out of alignment increases. This is especially true when each round has different dynamics beyond price (such different preference structures, protective provisions, voting thresholds by class of stock, and various participation caps.) When everything is going well this isn’t an issue, but the minute the business goes sideways (or worse) strange things start to happen. As the situation degenerate, the knives (or flamethrowers) come out. I’ve been involved in situations that resulted in the destruction of companies that deserved to live another day because the investors around the table (which included me) couldn’t get their collective shit together.
Decision Vacuum: This is a corollary to “misalignment of interests.” It’s similar to when I lived in a fraternity at MIT and a dozen of us would stand in the hallway trying to figure out where to go out to eat. This drill could go on for a while, especially if we had a keg of beer (or, er, something else) nearby. Eventually someone stepped into the decision vacuum and said “I’m going to Mandarin – come with me if you want” (well – that was what I usually said – others had different choices). Whenever you’ve got at least four VCs sitting around a table, you run the risk of a decision vacuum forming (queue snarky jokes here). If you are a CEO of a company and you see a decision vacuum developing, grab a bunch of matter and get in the middle of it.
Lame Duck Syndrome: There has been plenty of personnel changes in the “VC business” in the past five years, including plenty of firms that are winding down, have shrunk in size (and let partners go), and have disbanded. However, they are still investors in your company and some of them still sit on your board. In some cases they are just hanging around to “protect their investment” although they have no ability or interest in putting additional capital into your company. Now – some folks in this position are incredibly helpful, but many don’t do much more than show up. And – the more of them like this around the table, the less fun it can be.
Now, there are plenty of other downsides as well as plenty of advantages of large syndicates. If you’ve got additional ideas, or stories to share (especially horrifying ones showing the downside), comment away even if you change the names to protect the not so innocent.
Bijan Sabet started it with a great post titled We Gotta Do A Deal Together and Fred Wilson followed with an equally great post titled Trading Deals, A Lost Art? I’m going to try to add to the mix with this post by describing our strategy at Foundry Group around syndication and explain a little of where it came from. Please read both Bijan’s and Fred’s posts as it’ll provide a lot of context for this one.
At Foundry Group, we describe ourselves as syndication agnostic. Specifically – we are delighted to work with a syndicate of other investors and we are equally delighted to invest by ourselves. Another way to say this is that we are indifferent as to whether or not we have co-investors in a company with us at any stage of the investment cycle. I realize this isn’t the classical definition of agnostic but I think it’s an appropriate use of the adjective form.
Here’s what this means in practice. In an early stage investment we decide whether or not we want to invest and then leave it up to the entrepreneurs if they want to add anyone to the syndicate. If so, and they are someone we like working with or would like to try working with for the first time, we encourage it. If the entrepreneurs just want to get going with us, that’s fine also.
Now, assume there is no syndicate for the seed or Series A financing (e.g. it’s just us). Well in advance of when the company needs to raise the next round we’ll decide whether or not we’ll make another investment. If we are supportive, we are direct with the company, figure out a price we are willing to do it at (we are willing to invest by ourselves at a higher price if we believe the progress of the company merits it), and give the company the choice of having us invest in another round by ourselves or add another investor to the mix. Again, it’s up to the entrepreneur, but we signal our intent clearly and early, are willing to put a term sheet down, and lead the financing with or without a new investor.
Two things make this strategy work for us. We only invest in software and Internet companies. We have a deeply held belief that we can figure out “if things are working” by the time $10m is invested in a company. As a result, we are willing to invest up to $10m on our own to play out the early to medium stages of a company. By the $10m point we have to make a theoretically harder decision, although ironically it’s usually a pretty easy one. The company is either unambiguously on a success path, at which point adding additional investors to the syndicate is easy (since it’s a highly desirable later stage investment) or it’s a tough situation that’s not working out. Occasionally it’s in the middle (e.g. unclear and ambiguous), but not very often.
Some recent examples help illustrate this:
Next Big Sound: We led the seed round and co-invested with Alsop Louie (Stewart Alsop) and SoftTechVC (Jeff Clavier) – two VCs that we love to work with. We could have easily invested by ourselves, and Next Big Sound had a long list of VCs that wanted to invest (more than 5, less than 10). The founders chose the syndicate.
StockTwits: The seed round was led by True Ventures. We decided proactively that we wanted to invest in StockTwits as part of a new theme we are developing and approached Howard Lindzon (the founder/CEO). He was in the midst of closing a follow-on with True. We have enormous respect for True but hadn’t done a direct investment with them (I’ve personally invested in several companies with them) so were extremely interested in doing something together. They reciprocated and we put together a bigger financing than planned (although still a relatively modest amount as Howard isn’t interested in raising a lot of capital) that allowed everyone to be happy with their stake in the company.
Cloud Engines: Cloud Engines had raised some angel money (from well respected angels) prior to our investment. We did the first round by ourselves and recently did a second round by ourselves. We did this quickly because we were thrilled with their progress and this allowed the company to ramp up production to meet demand. We left the financing open for a strategic co-investor although we are perfectly happy to take the remaining piece for ourselves.
The common two themes from this for us is: (a) we only co-invest with people we like, trust, and respect and that like, trust, and respect us and (b) we view it as our responsibility to make a decision about whether or not we want to invest independent of any other investors (VC or angels) at the table.
For completeness, we love investing with Union Square Ventures (we are co-investors in Zynga) and Spark (we are co-investors in AdMeld) and we hope to make additional investments with both of them in 2010.
Ultimately the syndicate is the entrepreneurs’ choice. And our goal is to make the discussion simpler, cleaner, and crisper, so the entrepreneurs aren’t having to guess, or jump through bizarre hoops, or play a difficult VC-centric game as they finance their company.
Three of my VC friends (Santo Politi, Mark Suster, and Kate Mitchell) were on Fox Business’ Capitalist Ad”Ventures” series. The underlying theme of this segment was the characteristics of entrepreneur that VCs look for.
Fox doesn’t seem to have embeds, so you’ll have to use this URL to watch “The Future of Venture Capitalism”.
While Santo, Mark, and Kate weren’t the maniacal crazy people (although I’m sure some will argue that), they were clear about the ones they are looking for. Nice job gang!
VCs say a lot of stupid things. I’m guilty of it plenty and whenever someone calls me on it I try to acknowledge and change. One that I try really hard not to do is say “my company” when referring to companies I’ve invested in – I think it’s one of the most annoying things a VC can say.
I was talking to a VC the other day about a few companies he had invested in. By the third time he referred to one of the companies as “my company” (as in “My company is working on X”, “My company would like to talk to Company Z about thing Y”) I felt myself starting to react. I didn’t really have a relationship with this VC, but I knew that he had never run a company (investment banking post college, MBA, then VC). I realized I wanted to stop him at some point and say “dude – it’s not your company – you are merely an 18% shareholder in the business.” I bit my tongue and had the conversation, but I’ve been thinking about this in the back of my mind ever since.
One of the great lines from TechStars is “It’s your company.” That’s the way David Cohen and I remind the TechStars’ founders that ultimately all the decisions are theirs – the mentors (and us) are providing data, feedback, thoughts, and insight – but not telling them what to do. Sure – a lot of our (and the mentors) language is directive (e.g. I just sent an email to a TechStars CEO that said “you should do thing W right now”) but ultimately the decision as to what to do is the CEO’s.
While I’ve got plenty of rights as an investor, I’m very aware that I’m “an investor.” If you are a CEO or an entrepreneur, I can’t imagine anything more annoying than hearing one of your investors refer to the business as “his company.” Now, if the investor owns more than 50% of the company, I guess this is a legitimate legal perspective, but it’s still an incredibly demotivating position to take.
So – to all my friends out there in VC-land – let’s try to change the language. Some of the VCs I respect the most – like Fred Wilson – diligently refer to investments they make as “portfolio companies” (as in “our portfolio company X"). I often refer to them as “our investment” or “our portfolio company”. Regardless of the approach you take, think about the language you use, especially the impact on the people who are working their asses off every day to make “their company” successful.
Sorry if this feels pedantic to you. It’s now out of my head and on this blog so I can move on. As someone I love likes to say “my work here is done.”
Mark Suster, a partner at GRP Partners, has an outstanding post up this morning titled VC Seed Funding is Dead, Long Live VC Seed Funding. Mark started blogging recently and has quickly turned into my second favorite VC blogger (after Fred Wilson) – if you don’t subscribe to his feed, you should.
Mark just did his first seed deal, a $500k investment in a company called Ad.ly, and his post is a long essay on how he’s thinking about seed investing these days. He makes the appropriate warning (and differentiation) between VC investors who view seed investments as “options” on future rounds (e.g. they toss a little money in and then generally ignore the company until the next financing) and “active seed investors” (like First Round Capital, SoftTechVC, True Ventures, Union Square Ventures, and O’Reilly AlphaTech) who view the seed investment as their first round of several as they help get a company up and running.
I’ve been making seed investments since 1994. I don’t know the actual number that I’ve done, but as a VC (starting in 1996) it’s probably more than 25. In our most recent fund (Foundry Group) that we raised in 2007, we’ve made six seed investments (AdMeld, Gnip, Lijit, Next Big Sound, Standing Cloud, and Trada ) out of 17 investments in the fund to date and have one more that we expect to close this week. Interestingly, we did only two of these by ourselves; the other four included co-investors such as First Round Capital, Spark, SoftTechVC, Boulder Ventures, and Alsop Louie.
In my world, there is no real difference between a seed investment and a “Series A investment.” Ironically, when I started doing this, seed investments were the Series A investment; at some point in the last decade a bunch of VCs started saying “we only do Series A investments” so the seed investment became “less than the Series A” investment, although it never got relabeled so you see a lot of Series A (seed) and Series A-2 (the next round after the seed) investment rounds these days. Regardless, in my world, a seed investment is the first round – when I make a seed investment I’m committed.
VC’s keep reinventing seed programs. In 1994 when I was first making angel investments with my own money that I got from selling my first company I encountered several VC firms that had “seed programs.” These firms had an accelerated way to invest $250k in an entrepreneur to help him get up and running quickly. These investments were always convertible debt that converted into the Series A round at a discount. The entrepreneur quickly got $250k, the VC got a seat (usually a controlling seat) at the table for the next round, and off they went. I participated in a few of these – some that worked (e.g. a new VC came in and led the next round) and a few that didn’t (no new VC showed up, the entrepreneurs and the seed VC watched tensions escalate, and eventually there was an unhappy ending.)
Over time, I soured on the “convertible note seed funding” approach. I’ve written about this in the past, but at the minimum I think it misaligns the entrepreneurs and the early stage VC. More importantly, in my experience, it’s a signaling device – the seed VC isn’t as committed in a convertible note round as they are when they price a seed round and do it as a typical VC preferred financing, albeit with lighter terms.
One key thing for an entrepreneur to test with a potential seed round VC is whether or not the VC will invest in the next round by themselves. The specific question is “Do I need an outside lead for the next round, or will you do it yourself?” While either case is fine, this sets the ground rules clearly for financings going forward. In our case, we are perfectly happy to do the first few rounds of financing ourselves. Some other great seed investors, especially those with smaller funds need a new investor to lead the next round. Then there are traditional early stage VCs who have specialized seed programs where the rules of engagement are that there needs to be a new investor to lead the next round. Knowing where you stand and what the ground rules are before you consummate the seed round is important.
With the emergence of pre-seed programs like TechStars I’ve had more visibility into VC seed investing activity from other VCs. In Boulder, we just finished year three of TechStars and while plenty of the TechStars companies have their first round of financing include angel investors, I think six of the ten companies this year have (or will) close VC-led seed rounds. I haven’t decided if there is actually more seed activity in 2009, or if VCs are focused on hunting for seed deals in more qualified places. Regardless, being a great VC seed investor isn’t a no brainer and I encourage entrepreneurs to make sure they know how their VC investor is going to behave when it comes time to raise the next round.