I’ve had two conversations about inside rounds in as many days – one with a portfolio company and another with a company outside of our portfolio. Both are entrepreneurs that I admire, have known for years and with whom I can be honest. These conversations made me realize that entrepreneurs have little window into the psyche of investors when it comes to inside rounds. So here is how we VCs (or at least this one) looks at it:
There are good inside rounds, and there are bad inside rounds. (more on the use of “bad” below)
Good inside rounds are when things are going so well that existing investors want to increase their ownership by maximizing their check size and not maximizing price.
These rounds can happen at any stage, from post-seed through D. Sequoia has been known to do this often, other “multi-stage” funds are developing similar histories.
It’s obvious why an investor would want to do this, but why would an entrepreneur be willing to accept an inside term sheet – perhaps at a lower price then in a market process – when things are going well? After all, if things are going so well, wouldn’t other funds be willing to bid up the price, likely diluting the entrepreneur less?
Most of the time, yes. But fundraising the right way takes time, especially if you have not consistently built relationships over time that can quickly be called in for term sheets. So the hungry inside VC says to the entrepreneur “Hey, there’s so much going on in the business, let’s just set a fair price and get this done quickly, so we don’t get distracted.” I have said those words before. It’s not an unreasonable position, but it should always be for the entrepreneur to decide. I have also said those words.
Good inside rounds are becoming more popular as multi-stage venture funds grow larger and enjoy a decade of strong track records in their rear view. These trends mean funds want to get more money to work when they see something going well and have less need for external valuation markups to prove things are working to their limited partners.
Hunter walk sums this trend up nicely in a sardonic tweet:
2010: it was an inside round? Wow, what went wrong?
2020: it wasn't an inside round? Wow, what went wrong? https://t.co/lQhLBXQxRp
— 👨🏻💻☕️ (@hunterwalk) August 15, 2019
Bad inside rounds are when a company doesn’t have the story to raise money from a new external lead.
“Bad” is a strong word, used here for simple juxtaposition and effect. Such rounds don’t always mean the company is doing “badly”, just that progress is either difficult to judge from the outside or the post-money of the last round needs time and progress to be “grown into”, either due to a miss on plan or a shift in market pricing. Occasionally inside rounds occur only for lack of planning – a company ran out of money much more quickly than expected, before having time to go to the market to raise. There are also marginal cases, where perhaps a company has a good story, but not a great one. It can probably raise, but not from an attractive investing partner or without spending many months being distracted from growing the business.
Here’s the frustrating thing about inside rounds for entrepreneurs: In the good state, you can’t beat your insiders off with a stick. In a bad state, they may not return your calls. How annoying. What’s up with that?
In simple terms, investors want a return. If the market is telling them the company can’t attract capital from outside investors, they are thinking one or all of several things: (1) this company isn’t a great place to put money, (2) even if I think the company is good, if we fund it further and then still can’t raise new money later, that doesn’t help, (3) what do other investors see that I’m not seeing?
That said, most investors are willing to fund a company with a moderately sized inside round (call it 30-50%+ of the prior round) if the following conditions are met:
- The company has made tangible progress, and…
- The management team gets along with each other and the board, or…
- There is a(n) acquirer(s) lurking around
But here’s the catch. You usually receive only one “get out of jail free” card before the discussion shifts to a sale or shutdown instead of a second inside round. And, there’s a catch to the catch: an inside round is, of course, not “free”. Inside rounds are usually flat in valuation at best and therefore very dilutive to founders. So let’s call your one inside round a last resort, a Wild Card.
Given the above, here are general rules for how to think about inside rounds as an entrepreneur.
In the good case:
Be true to yourself on whether you want to spend the time checking external options. Good inside investors will respect that.
If you decide to take a “good” inside round, remember that if things don’t go well, there may be revisionist history on how the “good” inside round is viewed by your investors, reducing the likelihood of another inside round later. Fresh blood has its benefits.
In the bad case:
If you are on the margin between being able to raise externally and needing to do an inside round, raise externally if you can. Save your Wild Card.
If you’re going to raise an inside round, make sure it provides a full 18 months of runway. There won’t be another, so leave yourself time to make real progress on metrics… and time for an escape ramp for exit if needed.