Monday, December 27, 2010

Series B Psychology

Venture investors never like to lose money. But if we must, we prefer to lose it approximately 2-4 years after investing. Why? Losing money after more than 4 years is more painful and expensive because of the opportunity cost of our time and that of everyone else around the table. If a company fails after 4 years, it was either a sudden turn of events or a slow, agonizing death...but in either case, we wish we had recognized it earlier and moved on to the next exciting venture.

However, even worse than this is losing money, or recognizing that you are going to lose your money, within 12 months after making an investment. Yes, losing money in a short period of time frees up time to spend on the next opportunitybut in the venture world, there is little excuse for not anticipating such a reversal of fortune so soon after conducting due diligence and writing a check. When this happens, one feels blindsided, duped and foolishall emotions we tend to shy away from as money managers.

It is for this reason that venture investors are wary of investing in a company that promises imminent business success in the form of revenues, partnerships or customer wins but only after receiving additional investment. This awkward situation is most common in the proverbial ‘B round,’ or second institutional round. At this stage the company has a product in hand, but while initial customer traction may be evident, growth and execution is still far from conclusive.

For many years, companies at this intermediate stage could easily raise their Series B round due to an oversupply of capital. This led many VCs to refer to the second institutional financing as a “shiny” Series B (i.e. “it looks fantastic, but we have no idea what it's really worth?”). In recent years, companies have found that finding a new institutional investor to lead such a B round is quite difficult even when you are dressed up pretty.

My first bit of advice is don't over promise, when there is a good chance you may under deliver. When an entrepreneur expresses complete confidence in the company’s imminent success, we as investors first question why the company was unable to properly forecast its cash needs or hit its milestones with its available cash. Then we question why the existing investors don’t share the entrepreneur’s confidence and find it in their interest fund the company to this obvious and accretive milestone just around the corner. We know that confidence cannot pay the rent or salaries, but funding a venture in anticipation of near term results can be hair-raising for a VC. Sure, sometimes we hold our noses and take the plunge. But too often it looks like we are expected to invest on the assumption that the company will hit its milestone, while the company raises cash based on the fear it might not hit that same milestone. We never want to feel that the company is buying an insurance policy to cover the small risk of failure, and we are acting as the insurer.

My second piece of fundraising advice is expressed in the following maxim, which applies to all stages of financing: great entrepreneurs are never fundraising, and great investors never care to ask. Regardless of cash needs, start-ups should consider fundraising on the back of a significant accomplishment and barring that, to set the prospective investor’s sights on achievements at least 12 months out. For this reason, when you raise your Series A round, don’t let investors underfund your business to suit their fund limitations, and give yourself sufficient buffer to demonstrate business momentum, not just initial traction.

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