Social proof is the meanest mofo in the Valley. Second tier VCs want to be in the same rounds as first tier VCs and third tier VCs want to get in on the deals offered to 2nd tier VCs. It’s all very high school if you think about it on any sort of anthropological level.
What’s worse is that TechCrunch, Twitter and Angelist have made the “who’s in with who” more blatant nowadays, and thus our industry is seeing an influx of self-perpetuating celebrity seed rounds. It’s easy to name names (Exec, Socialcam, Pair) but harder to begrudge a startup for taking money from the cool kids. I mean, who’s going to say no to Andreessen as an investor?
These rounds are called “family-style,” or more pejoratively “Party Rounds,” denoting when a startup raises a seed or early stage round without any one investor leading but many participating. Usually these name-droppy rounds include large mix of angel investors and venture capital firms and, as Chris Dixon wrote earlier this week, can ultimately be detrimental for a startup.
Counterintuitively, Party Rounds are not much fun for founders. In fact, this type of structural round can be extremely detrimental. First of all, the risk that a company takes when structuring a deal this way is huge. As Paul Lee, partner at Lightbank, points out, startups need to consider the economics of these rounds for investors before joining the party.
Let’s say a few VC firms each put in $100,000 to $200,000; and angel investors each put in $25,000 to $100,000 in a $1 million seed round. For large VC firms who put significantly more into a Series A or B round for more ownership of a company, the risk is that these firms may not have the incentive to really take an active role in the company, and in putting money up for the next round. And with no lead investor, there’s no one angel investor or firm who has ownership and responsibility over a startup’s progress.
Dixon’s feelings on the type of deal are similar to Lee’s. He writes:
If there is a tough financing or acquisition, no lead investor is there to step up. Instead, certain smaller investors who are in the investing business for the long haul tend to carry the weight. But this is changing: most of those helpful investors are tired of carrying the weight for the – investors, and have stopped doing party rounds, which means party rounds will be even more problematic in the future.
Cloudflare CEO Matthew Prince describes the dilemma as such:
The Party Round is rarely the last point of time at which the company is going to need to raise money. When the next round comes up, the company goes to the current investors to see what they’re thinking. It’s difficult for any “insider” to set the price for the new round which means they all ask two questions: 1) who else is going to be involved; and 2) what are the other members of the party round things?
Since all the people who are likely to be involved are already in, it’s hard to answer the questions. Even if some new outside investor is interested they are hesitant to participate because they’re afraid that they’re just acting as a stalking horse for the insiders. The insiders know this too so, even if they are interested, they act rationally and wait for the last possible minute before writing a check which ends up driving down valuations.
So why are Party Rounds at all appealing?
“For entrepreneurs, early on your concern is that no one is going to take you seriously and you’ll have a hard time getting traction,” Prince explains, “That’s a reasonable concern. Every investor promises that they’ll bring more than money [and cache] to the table. Even though you suspect that’s largely puffery, you figure that if they’re all involved then it’s more likely to suss out who is actually able to help. Or, more likely, you assume that if everyone promises to help then, together, they’ll add up to more than any one of the investors on their own.”
“From the investors’ point of view,” Prince continues, “It’s very difficult to tell whether something at the seed/series A stage is going to get traction. A few hundred thousand is less than 1/100th of your capital and buys you an option on future rounds if it takes off. In this case, the upside is potentially infinite as you can throw your weight behind the winners and the downside is relatively limited. What’s more, because you’re involved, you can actually scare away other investors in the next round for the moderate successes ensuring you have, effectively, a last right of refusal.”
For founders fresh on the startup boat, it can be difficult to resist the temptation of taking funding from a group of all-star firms, celebrity entrepreneurs and angel investors. Having marquee names associated with your startup is sometimes an immediate win, and it’s hard to deny the clout that comes with listing Ashton Kutcher on your funding announcement. At least your mom is impressed.
And it isn’t always a wash.
As Lee tells us, each deal is different — And Lightbank has invested in Party Rounds in the past. Some have worked, and some haven’t he says. But in each case, the firms tries to convince the entrepreneur why would make sense to work with one large investor as the lead.
“The better solution for an entrepreneur faced with a lot of interest is to use it to dictate terms,” explains Prince, “Having ten big name investors is of limited additional benefit, both in terms of optics and in terms of the value they can deliver, than having one who is significantly more committed. In our experience, every one of the investors we said no to in our last round has continued to be interested and wanted to participate if we do a round in the future.”
And of course, like always, it comes back to dating/highschool:
“Saying yes to every guy or girl who asks you isn’t a great strategy and can get you labeled some unattractive things. On the other hand, if you say no to someone who asks you out to go out with someone else, but you’re polite and reasonable about it, chances are when the opportunity comes around again in the future they’ll be all the more eager and appreciate you even more. As I think about it, that may be a stretch in the dating world, but it’s very true in fundraising.”
There’s a saying in Greece, about dating or any sort of courtship really, “The more you spit on them, the more they stick,” So go ahead, say no to the alpha investor who comes on strong early on. Who knows, it might even motivate them to commit to your Series A, as a lead.
Article courtesy of TechCrunch
