For many less experienced entrepreneurs, the search for that first round of outside capital is so all-consuming and stressful that it is hard for them to imagine that a subsequent capital campaign could be any more difficult. More experienced entrepreneurs know better. Now, a hot company in a hot financing environment may indeed find existing and prospective new investors tripping over themselves to provide capital at outrageous valuations. Just ask Facebook. Far more typical, however, is the company that is more (or less) on plan, but running out of cash and confronted with a soft risk capital market. For entrepreneurs in that scenario, getting the next round done can make getting the first round closed look like a relative cakewalk. This post explores how, for the “it’s not going so good” to the “it’s going fine, but not great” entrepreneur, the second (and possibly third and ..,) round financing challenge shapes up from a negotiations perspective.
The first thing to know about follow on financings is that there are more people at the table than there were in the first round. The relevant players in the first round are generally limited to the founders and the first round investors (usually represented by a lead investor). When the second round comes along, however, there are three key players – the founders, the new investors and the original investors. While it may seem as if the original investors “made their deal” when they did the first round and now just have to live with that deal, in fact they did not so much make a deal when they signed on to round one as put a stake in the ground. A stake that includes a long list of rights, almost always including the ability to block a future round of financing that gives a new set of investors any priorities over the earlier investors – including at least some priorities which just about every credible new investor will insist on. The bottom line: you probably can’t make a deal with new investors without the cooperation of the prior investors – and the new investors are often going to ask the prior investors to revise, to their detriment, some of the rights and privileges they fought so hard for at the first round negotiation.
And this is where it gets tricky for a lot of entrepreneurs – and even some less experienced first round investors. Because while de jure (in law) the first round of investors likely have a veto over any financing that puts a new investor ahead of them in terms of rights and privileges, de facto (in fact) that veto is not quite as big a stick as it first appears. Unless the original investors are able (and willing) to provide needed funding on their own, at terms that reflect fair value (i.e. that do not attract lots of third party interest), they will want at least some new deal to get done rather than see the company run out of cash. It can be as if they have a big stick, in the form of protective rights built into the original financing terms, but lack the strength to wield it with maximum effect.
In practice, the position of the prior investors can be further complicated by differences of opinion within their own ranks. While as a group the original investors were probably on pretty much the same page when they made the initial investment, the chances are pretty good that over time their attitudes towards the company have changed, either based on their analysis of the company’s prospects or for internal fund reasons (e.g. dwindling capital reserves). While the lead investor from the earlier round is the obvious candidate to manage any such fracturing of opinions or capabilities, the lead could be one of the investors with a change of perspective. Or the lead may see the diverging of interests/capabilities among the original investors as an opportunity to gain advantage over one or more of the other original investors. The complexities can be maddening for the entrepreneur, as the task of raising needed new funds becomes, in large part, the task of making the old investors happy without turning off the new investors or – and this does happen – taking the hit himself to bridge any gaps between the two investor groups.
None of this is to say that a modestly down, flat or modestly up round has to be a trial by fire. If the company has maintained a good working relationship with its early investors, and approaches them in a thoughtful (but not philanthropic) frame of mind, with a good appreciation for the practical realities of the bargaining powers of the various parties, a good deal for all parties can often be done with – well, realistically, let’s say about the same level of stress as a typical first round.
As noted, hot companies in hot markets often find the experience of closing a follow on round more exciting than stressful. But for the rest, which is to say for most entrepreneurs, the best way to think of the first round, once it is in the books, is in terms of Finance 101 – a good introduction to the material, and a fine jumping off point for Finance 201.© MICHAEL BEST & FRIEDRICH LLP