Friday, August 4, 2006

The VC Syndication Two-Step

Peter Rip from Leapfrog Ventures continues to impress me with his excellent commentary on the VC landscape. His recent post on VC Binds that Tie sparks a number of reactions in me. Peter tells of an entrepreneur who, after 6 months of searching for VC funding, has finally received a term sheet:

After six months he has finally connected with a VC who gave him a term sheet. He likes this guy a lot. But he has a problem. The lead VC is with a firm based out of the Valley and they are trying to build a syndicate. In the process, he was connected to another VC in Silicon Valley at so-called ‘top tier’ firm with whom the lead VC would like to work. While he likes VC #1, he doesn’t feel VC #2 really clicks with him, despite the overt feedback he is getting to the contrary. In particular, VC#2 is trying to suggest business models and go-to-market approaches that seem rather cookbook.

This is a tough one. As an entrepreneur, the most time I have ever spent building a syndicate for a two-handed Series A was 7 months (back in early 2001 when it was really difficult to raise early-stage money). It is certainly tough to keep the faith after dozens of VC rejections. What do they know that I don't? Is it timing, is it me, is it my business, do I smell bad, or is it all of the above? I certainly feel for this entrepreneur.

So, in this case, you like VC#1, but VC#1 is not "top-tier" and wants you to land VC#2, who is considered "top-tier". Heck, you even landed VC#2 - well done! But, you don't feel the right vibe with VC#2. Work it out now. If it is just that VC#2 is offering suggestions on business model or go-to-market strategies that you don't like, the answer is easy. Use the time now to talk to VC#1 and VC#2 about the suggestions - dig in, ask some tough questions and play out some possible scenarios. Be tough - the VC's don't want a pushover running the company! Figure out how the three of you can work together, before you agree to take their offer. The decision to take VC money is the biggest one that you will make for your business, and you need to choose your investment partners very carefully. If you have never worked with VC#1 or VC#2 before, spend as much time as possible now, before you agree to allow them into your company as investors, to get to know their styles and strength. Check their references - they are certainly checking on yours!


If the bad vibe continues, walk away from VC#2. No harm, no foul. It will be the best decision you will ever make.


The thing that entrepreneurs forget, especially after being on the hunt for funding for so long, is that they are in the driver's seat. It's their company. It's their idea. It's their vision. If it is a worthy one and the timing is right, they will find appropriate and matched investors. In this case, VC#2 may be exactly right about the business model and go-to-market strategies - impossible to know at this stage. However, it does give you the opportunity to discuss the differences with an open mind and you may find that VC#2 is a match after all. Open and frequent communication with the individuals that will be on your board of directors is critical - so get started on that now.


The easy advice (and the advice I gave him) was not to jump into this relationship. It is obvious that he will be tethered with VC#2 for a long time. So chemistry matters. More importantly, what is being signaled in the conversation is that VC#2 isn’t committed to the approach. Nor is it likely that VC#2 is committed to the entrepreneur as leader if the default approach doesn’t work. This is the larger red flag. So my advice to him was to (1) have a frank conversation with #1 and then #2 about his sense the #2 isn’t really committed to him, but rather the “opportunity,” and (2) work other connections from #1 to find an alternative #2.

Totally agree. If VC#1 truly believes in you and the business, and you have solid reasons for passing on VC#2, then you have an opportunity to learn more about working with VC#1 now. Does VC#1 "require" you to get a top-tier syndicate partner? That's a bad sign. Are you completely unable to continue to self-fund through this extended fund-raising process? Ask VC#1 to bridge you into another VC syndicate partner, one that is the right partner for BOTH of you. Having VC#1 put some skin in the game, say $125K-$250K as a note that returns interest, converts to Series A at the Series A price (or at a small discount), and offers some warrant coverage, allows you two to be aligned on the goal of moving the business forward and sharing some of the early risk. It is a win-win and solidifies the VC#1 commitment (from a VC partner that you think you like).
The real point here isn’t the lack of chemistry. It is the VC-to-VC dynamic that underlies the issue. Co-investments are unique points of VC intersection for an entrepreneur, but they are just points on a line for VCs. We may co-invest in several deals together. In fact, ‘showing another VC a deal’ is the currency of dating in the VC business. It is the method by which VCs socially level themselves or raise themselves in the economic-social strata of VC-dom. So VC#1 has not yet worked with VC#2, but wants to; hence the introduction. VC#1 is less sensitized to the ‘fit’ issues because this is the beginning of getting into VC#2’s deal flow.

Ah, there is an entire article hiding in that paragraph! Nicely said, Peter. I plan to write more about this particular topic, so I'll be brief for now.

It's good to understand the motivations of your VC investors. Nobody teaches the entrepreneur how the VC business model works and how the VC class system plays out. We entrepreneurs naively believe that the VC is naturally aligned with us and the company because they are putting money into the deal and we all want to win (and win big). The VC will operate solely with the best interest of the company in mind at all times. It's, unfortunately, a bit more complicated than that. Especially when VC#1 is on their first or second fund, has a so-so track record of exits (because it has been tough out there these past 6 years), and is looking to raise that next fund.


A couple complicating factors include:



  • When a VC is at the end of their fund investment cycle and it's time to raise the next fund, they feel that the Limited Partners will judge them by the company that they keep. Showing co-investments with "top-tier" / "name-brand" VC's show that the VC is able too play with the big dogs. As such, VC#1 would love for you to get VC#2 to join the party - it may do more for his firm than it does for your business (I don't necessarily believe this; taking top-tier money has some significant advantages to your business downstream that I will touch upon in a future article titled "All Money Is Green, Right?"). This is important because young funds may not have had time to build a track-record of exits for the LP's yet, but co-investing with the name-brand firms gives validation to the portfolio companies in their current fund.

  • When a VC is at the end of their fund investment cycle and it's time to raise the next fund and you are already in their portfolio (and valuations are on the rise), they will tend to want you to raise some outside money so they can bump up the Net Asset Value (NAV) of this particular portfolio company, which will bump up the on-paper value of their current fund (unrealized). Even in cases where it would make more sense from a business perspective (yours and theirs) to do an insider round (like, because, your company is kicking butt and the VC should want to double down), or not do a round at all (like, because you are cash-flow positive and don't need more money) they will still want you to get someone outside to price it. Someone top-tier, of course, but in a pinch they will accept anyone (if you are the star of their portfolio). As you can imagine, this gets complicated when you have multiple investors at different points in the fund raising cycle on your board.


The fact is that the top-tier Venture Capital firms do get to see the top-tier deals. As such, top-tier funds tend to stay top-tier funds. They have longevity and deep pockets, which is important to you. As an entrepreneur, it is valuable to you to have top-tier money in your company. No question. However, you should only accept a term sheet from investors that you want to work with over the long haul. Period. Better to save future headaches by saying "no, thanks" now if you don't feel good about a prospective investor.

Check out my Venture Capital FAQ Series for more random babbling from me.



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2 comments:

  1. [...] After my post on The VC Syndication Two-Step (in response to Peter Rip’s VC Binds that Tie article), I found this excellent article written by Jeff Bussgang of IDG Ventures. Jeff’s blog has a collection of very well-written topics. [...]

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  2. [...] Published August 9, 2006 Venture Capital Leave a Comment After my post on The VC Syndication Two-Step (in response to Peter Rip’s VC Binds that Tie article), I found this excellent article [...]

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