I recently met with two very experienced CEO’s who ran into the one of the most challenging startup situations: their current venture capital investors would not re-invest in an upcoming round of financing. Both CEO’s had previously attracted financing from venture capital firms.
After several years of operations, the CEO’s knew that additional financing was needed, but the investors decided that they would not participate in any future financing of the company.
Why is this such a challenging situation for a start-up CEO?
1) Signaling: Existing investors not re-investing is a red flag for new investors. In every VC presentation, the entrepreneur will be asked if their VC’s are investing in the new round. If the entrepreneur says, “No,” the new investors immediately wonder what the problem is. If the company is a good investment for a new investor, why wouldn’t the existing investors want to re-invest? There are good “structural” reasons for the current VC not to invest, like the VC is at the end of their fund, the partner on the deal left the firm, or the start-up changed business plan and is now competitive with another investment. In general, if the CEO does not have a structural reason for the VC not re-investing, this is a bad sign to new investors.
2) Blocking: Existing investors actually can prevent additional financing. VC investors generally receive preferred shares. Preferred shares allow a VC to get their money out of the company prior to the common shareholders (generally the entrepreneur and the employees) and also have voting rights or blocking rights where the preferred shareholders must approve a new round of financing. So, in theory, an existing VC can prevent a new round of financing if the investor does not like the new terms on the investment.
3) Time: Negotiating a “down round” is complex and time-consuming. A “down round” is any financing that comes at a valuation which is lower than the previous round. A “cram down” happens when new investors force existing shareholders to convert their preferred stock into common stock to reduce the liquidation preference, making the common stock less valuable. As you can imagine, current investors don’t like the prospect of a down round or cram down, even when they have decided not fund the company. Time is the major asset that any VC has. So when a venture capitalist has the choice of spending time on a new deal or your deal where investors who will have to accept a down round or cram down AND can potentially prevent a deal, most of the time the VC will choose spending time on a new clean deal.
4) Sale process: Existing investors will often put the company into a “sale” process. The prospect of a down round or cram down will often prompt investors to see if the company can be sold. In this way, investors can get back some of their money. Since preferred investors can prevent a new financing, the CEO has little choice but to start a sale process. The process of selling a company can be very time consuming for the CEO, and the Board of Directors will want to hold-off on discussions of financing until they know how the sale process turns out. Often the company will run out of money to pursue financing while distracted with a sale process.
5) On your own: The CEO is on his or her own. In general, your venture investor provides validation for your business plan and provides referrals to other investors who may be interested in your company. When your VC is not re-investing, you don’t have access to an interested audience of investors. Quality referrals are a currency of venture investors. Venture investors like to bring other top tier VC’s into their best deals so that they get the opportunity to invest in the other VC’s good deals in the future. Because your VC is not re-investing, you are actually swimming upstream against the VC referral network. Unless your VC believes in you and your business plan, your VC will not want their top tier co-investors to invest in the deal.
What is a start-up CEO to do? This is a common, but treacherous situation for a CEO to navigate. Both CEO’s I spoke with ended up resigning after trying to raise financing and/or sell their companies.
I asked many entrepreneurs and VC’s for their opinion on how a CEO should handle this. Most provided advice, but wanted to remain anonymous as this is a tricky situation on both sides of the table.
Tips on Raising Financing When Your VC Won’t Re-invest:
1) Pre-negotiate a deal with investors: Entrepreneurs and VC’s agreed that the best course is to have a frank conversation prior to raising additional capital, particularly if it will be a down round and there has been a lot of capital raised. New investors will not want to spend time on researching the investment if it is going to be messy and the likelihood of a deal getting done is low. Key points of discussion must include valuation, ownership percentages and existing liquidation preference. The new investor and the entrepreneur might want to pursue a cram down to make the investment more attractive for a new investor and to keep the management team motivated. This is likely to be a delicate and emotional discussion. The existing investors do not want to see the company shut down as this is the worst scenario for everyone involved. Existing investors may want to put a token amount into the new round, just to help ease the fundraising process and prevent a complete write-off on their balance sheets.
2) Buy-out your investors: A more aggressive scenario is to buy out your investors. If the investors do not see value in the current company, this is a good opportunity for an aggressive CEO to actually buy shares back from the investors for a reduced or token amount. This would free up the future alternatives that the company has down the road, with regard to strategy, financing and acquisition. Buying out your investors is the ultimate vote of confidence, requiring the CEO or management team personally putting money into the company.
3) A buying opportunity: One top-tier VC said that they view this “negative signal” as a potential buying opportunity. Today, there are a large number of angel and Series A funded companies that are out looking for more capital, with a small number of VC’s in a position to follow-on aggressively in these companies. This VC actually has purchased shares directly from other investors in the company at a reduced price (called a secondary purchase). These secondary share purchases have worked out as great investments. Of course, the new investor needs to be aggressive and forward thinking, but they also need to do their homework prior to even engaging in such a discussion.
4) Work harder, sell harder: This scenario just requires more tenacity from the entrepreneur. Just because the existing investors are not participating or have lost faith in an investment, that doesn’t mean that other investors will not see the merits in the business or the management team. Every VC spoken with believes that the market for capital is very efficient and good deals tend to get funded regardless of the challenges. A good example is one of the top Silicon Valley VC’s Andreessen Horowitz not making a further investment in Instagram in 2011, after being early-stage investors in 2010. Instagram changed its business model to be competitive with another Andreessen Horowitz company, forcing the firm to choose between the two companies. In the end, Instagram was able to raise significant additional capital due to the core metric and growth of its photo-based social network and was sold to Facebook for $1 billion. (Of course, Instagram did not require a down round or re-capitalization of the company, unlike other companies).
Successfully managing situations like this differentiate the top-tier CEOs and entrepreneurs from the rest.
Unfortunately, more often than not, VC’s and entrepreneurs do not have the hard conversations upfront and cannot find the ‘win-win’ scenario, which ends up being bad for the company, employees, and investors alike.
Nikesh (Niki) Parekh is the CEO of ActiveRain — a professional blogging platform and social network in real estate — and EVP of Product at Market Leader — an online marketing solutions firm for real estate professionals. You can follow his ActiveRain blog here, or follow him on Twitter at @nparekh00.
Image Credits: Rock & a Hard Place: Copyright Andy Dean, Fotolia; Red Flag: RVW, Flickr, Creative Commons; Mountain Climber: Peter Gene, Flickr, Creative Commons