Fundraising · Venture capital

How to work with investors who can no longer lead your rounds?

Frank Cohen CTO and Founder at Appvance

February 21st, 2016

Has anyone experimented with investment terms or bylaws that reduce an lead investors terms - like converting them to common - when they can no longer lead?

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Dan Rua Founder, CEO, Chairman, Angel, and VC with combined company exits >$1B+. Rated #4 Most Loved & #17 Most Respected VC.

February 22nd, 2016

Peter's answer is solid for typical investors, whether lead or not.  

I would ask whether you purposely referenced "LEAD investor" and "no longer LEAD your rounds".  If you gave unique terms to a lead investor with some assurances they would lead in the future (not typical), then you could have baked in some "pay to play"/other requirements so they only retained their unique "lead" terms if they continued to participate in the future.

The typical venture track has a new lead with each new round, so it would be somewhat unusual to expect your prior lead investor to lead your next round.  That said, unless expectations were set otherwise, it's not unusual to expect a prior investor to participate for their pro rata in future rounds.  If they refuse you should get to the heart of why so you have solid answers for potential new investors.

If a prior investor cannot follow-on because they are structured with a smaller fund and specific investment caps over time, then you can sometimes explain away their non-participation so it doesn't torpedo future rounds (that is also a scenario where it may not be appropriate to bake-in penalties; consider "minor investor" versus "major investor" follow-on expectations/penalties).  If, however, they are not following on because they have lost confidence in the company, that can be deadly.  If that's the case, you should gather follow-on commitments from their co-investors in the prior round and spend extra cycles convincing them to remain supportive for due diligence and participate at some nominal amount assuming other, new investors will lead and take the bulk of the new round.  If they won't do that, then you'll need to prepare solid answers to the questions they will raise (e.g. why they lost confidence) for new investors -- and encourage those new investors to decide based upon their own excitement for a deal rather than letting another, prior investor's unique circumstances cost them an exciting opportunity.

Lastly, if you do get new investors interested and they really want a prior investor to participate, the new terms could be so onerous that the prior investor decides it's better to invest alongside those terms than sustain a highly dilutive round with zero participation.

This can definitely be a thorny topic, but one I've seen/helped multiple entrepreneurs and syndicates navigate successfully -- good luck Frank!

Irwin Stein Very experienced (40 years) corporate,securities and real estate attorney.

February 21st, 2016

They say that everything is negotiable, Frank, but the question you face is "how badly do you want our money?"  You can often get the terms that you want but you need to understand that the people who are providing the funding have their own requirements also. If have represented small companies that spent a long time looking for funding and then balked when they did not like the terms of the deal that they were finally offered. The best deals get funded more easily  and on the best terms. If you are really searching for capital and are having difficultly, the market is telling you something.

Peter Weiss President at American Outlook, Inc.

February 21st, 2016

"Pay to Play" provisions which reduce preferred to common are fairly standard in VC rounds.  They were created to ensure that if a round was syndicated among several VCs with the understanding they would all fund future rounds that no one could choose to become a free rider when the future arrived.

The issue these provisions creates is that you need to be able to ride to the end if your deal includes them.  For a VC this is usually a manageable risk; for an angel it can mean expensive common.  For an angel investing in a convertible note which ends up in preferred with a "pay to play" clause this can mean an indirect path to expensive common.  

As an angel a provision imposing a penalty on me for not participating going forward is a dealkiller; for a VC it is usually something expected from their peers, not the company.  

In most cases your investors have no obligation to continue funding you but they may have to deal with the consequences of a recapitalization and potential cram down if you need funds they cannot or choose not to provide.  I'd let the market handle the issue when it arises rather than trying to bake it into the current deal.  

If you're currently in the situation where you need capital and the current investors can't or wont lead or participate you need to refer to your existing agreements and figure out how to get the approvals you'll need to move forward.  
Good luck.

Peter Weiss President at American Outlook, Inc.

February 21st, 2016

Thanks. P Peter H. Weiss President, American Outlook, Inc. Providing Financial Consulting and CFO Services P.O. Box 1682 Mercer Island, WA 98040 206-890-4792 Fax 206-493-2800 pweiss78@alumni.princeton.edu

Diane Bernard Chief Digital Marketing & Growth Officer For Hire, CEO, Virtual CMO for Technology, Healthcare, Pharmaceutical, Consumer

February 21st, 2016

Great Information Peter. Diane