Another Financing Risk

This post is designed mainly for companies raising their first seed or VC round of $500K-1 M and have multiple entities who want to fund them.

In the past year, we’ve tried to help many companies with acquisitions – specifically when they are running low on cash and are unable to raise more. For a few, we wonder if they would have had a different outcome if they had different investors.

I’ll describe by illustration. A startup (NewCo) raises $1 mm from a bunch of individuals and a large VC – the proverbial “party round.” This gives them 12 months of cash. Around month 9, NewCo is doing well but not an “A” level. The company argues – and the investors agree – that if “X” happens or “Y” is hired, then NewCo has a very good chance to turn the “B+” into an “A”, i.e., attract VC financing. NewCo needs about 6 months of cash (i.e., $600K) to make X or Y happen.

NewCo is in a bind. The investors don’t have either the motivation and/or ability to invest more. In the individual’s case, they more often than not don’t have the money (ie, ability). In the large VC case, they don’t have the motivation – it was a small bet and they don’t have the incentive to finance a “B+” investment (this doesn’t make them evil; this is just their business model). It takes a few months or longer for new investors to come on board because you have to convince them that “X” or “Y” is really possible and value-creating. By that time, you’ve lost a lot leverage. For the record we at SV angel rarely if ever invest in this scenario.

This is the financing risk. Even though everyone involved thinks this is a promising company, it’s in no man’s land. They have no investor who has the motivation or ability to “protect” their investment. This is a subtle but very different motivation from “wanting to invest more.” In the latter case, they think that it’s a good investment from a risk/reward standpoint. In the former case, it’s about survival – maybe NewCo is one of only ten companies in their portfolio. And NewCo’s demise would have a material impact on their portfolio. They may not even think that it’s a great investment. But they have an incentive to “defend” this investment.

We’ve seen this come up mainly in the B2B context. These companies have no cash, needed a bit more to “turn another card” and no one gave it to them per above. Thus they were acquired or went out-of-business. No matter how good the founders, their fate is tied in some entity’s hands – mainly, the sales cycle. (Although that this seems to be less of a risk as startups can ‘sell’ directly to developers.) It’s not like an iPhone app where a startup can largely determine their initial fate (i.e., is the app good?). In this case, I’d argue that the financing risk described above isn’t as important.

Like all investment advice, it’s not useful to generalize. In many cases, investors overstate their value-add. Being hands-off can be the most useful way to help. But in some cases, investors who have the ability and motivation to “protect” or “defend” their investment is a valuable resource. And potentially worth the lower valuation (i.e., higher ownership) that these investors will demand.