Signals Venture Capitalists Look for in Startup Funding Rounds
They play a bigger part in VC investment decisions than you might think and we may like to admit.
As a venture capitalist and an insider of the broader tech and investing industry in Silicon Valley for the better part of the last decade, I have seen some “stuff” to say the least.
Some of that “stuff” pertains to how we (VCs) make investment decisions about startups, particularly at the early stage funding rounds with which I’m most familiar with. You might think we all have a rigorous due diligence process rooted in a proprietary model of quantitative and qualitative factors. I would too. Every fund markets itself as being singular and most funds are, with lots of amazing investors representing them. Lead investors in funding rounds have, in fact, done a lot of homework on the startup’s business to back their decision to lead a startup’s financing.
However, for smaller investors in the financing round who are investing less capital than the lead investor, less diligence is typically done and not because those smaller investors are shirking duties. Rather, they are acting quickly. Especially for the hottest funding rounds into the most promising startups, investment decisions have to be made quickly to nab fast-filling allocations. For hot startups, founders aim to close quickly so that they can spend less time fundraising and more time actually building their businesses. If investors are too slow in due diligence to make a decision, other investors will take up the allocation, which was already hard enough and competitive to secure in the first place.
Additionally, the startup might not actually share much information to smaller, prospective investors for a variety of reasons, including not needing more money due to overwhelming demand from other investors and protecting proprietary company information from leaking.
In these instances, smaller investors may assess the dynamics of the funding round to complement any startup and management team specific diligence to facilitate a quicker investment decision. Below are some signals we’ll look for:
Is the lead investor in the financing round legit?
If a perceived “top tier” investor is leading the round, it is very likely that the funding round will be oversubscribed. This is herd mentality, a FOMO mindset. If a top tier venture capital fund with its previous startup investing successes is excited about the company, then shouldn’t I be too?
Premiere investors in this instance are not just the typical, recognizable mega funds like Kleiner Perkins, Sequoia, and a16z. They also include funds that insiders know are great in certain sectors, e.g. Paradigm, an amazing fund in the crypto space; or new funds started by star VCs from established funds, e.g. Lee Fixel leaving Tiger Global to start Addition.
Having a strong lead investor in the financing round generally is a bullish signal on the startup. It basically validates the startup’s future prospects because a top fund is now backing it and reduces the risk that the startup will fail. “Reduce” is the key word here, because a hot startup can definitely still fail even with top investors backing it, e.g. WeWork. Startup investing is inherently risky as most fail, so any signal that helps an investor reduce the investment risk in a startup is positive.
Is the lead investor from previous funding rounds participating in the follow-on round?
If a startup is raising follow-on financing, another signal to look for is if the lead investor or significant co-investors in previous rounds are participating. Prior significant investors from past financings of the company will typically have pro-rata rights for future financing rounds. If these investors are doing pro-rata in the new round, that signals they still believe in the company’s potential and wish to maintain ownership. An even stronger bullish signal is if this cohort of investors double down and exercise super pro-rata.
Conversely, if significant past investors aren’t participating and doing pro-rata, that’s cause for some concern and potentially a warning signal. These investors have information rights and the inside scoop. If the company is still on the right track, these investors would want to continue investing and not risk dilution.
There are caveats to this, however. Sometimes previous investors do not participate in new funding rounds because the company no longer fits the fund’s mandate. For example, an early-stage fund may not participate in a portfolio company’s late-stage financing rounds (i.e. Series B or later) because the startup’s valuation has grown too high, meaning the return from the later rounds will not be high enough to justify investing again. Early stage funds want to underwrite and forecast at least 10x upside on investments. If a portfolio company is already at $1B valuation at the B round, it may be tough to justify seeing another 10x upside from the Series B. You are better off deploying your precious capital to a Seed stage company where valuation should be much lower and there’s a higher probability of that 10x or even 100x upside from your cost basis.
Is the financing round a priced equity round?
Not all startup financing rounds are equal, generally speaking. A company that’s able to get a term sheet from a lead investor for a new equity round at a higher valuation usually signals that the company has tracked well enough and hit critical milestones to earn that markup.
If the company is raising a bridge financing in the form of a convertible note or SAFE, then the company likely did not perform well enough to get a priced round term sheet from a lead investor. These types of instruments will help extend the company’s runway and provide it with more cash to operate so that they can meet performance hurdles in the future and avoid possibly shutting down. Insiders, or investors who previously invested in the company, should step up here to provide the company some more jet fuel in order to not risk seeing the startup shut down and their investments get marked down. If the company has raised a bunch of these instruments since their last priced equity round, then this could be a bearish signal.
Beware reading bridge financings always as a bear signal. For example, sometimes a founder from a hot startup might open a SAFE financing round (e.g. with terms at a discount to the next round) for investors ahead of a highly anticipated, newly priced round at a higher valuation from the last priced equity round. If an investor has an opportunity to invest here, they should do it (provided that they are confident a newly priced round is around the corner). This is effectively an instant markup on the investment given the discount mechanics of the SAFE note. Investing in this bridge financing might also be your only chance at getting your money into the hot company since the newly priced equity round will likely be oversubscribed by whales.
Is the financing round from a new lead investor?
Investors like to see new lead investors join the party in subsequent financing rounds. It validates the company’s health, which merits new cheerleaders. This is key because investors from earlier funding rounds, a.k.a. insiders, are incentivized to see their past investments into the company do well. Alternatively, when the company can not source funding from a new lead investor, insiders may then give the startup what is known as an “insider-led term sheet.” This means that significant prior investors will get together and offer a term sheet to the startup so that the company can have more cash to operate at usually a higher valuation from the last round, assuming the company did ok since its last financing. While this signal does not necessarily mean the company has performed poorly, the company evidently has not done hot enough to attract new, outside lead investors.
Is the financing round oversubscribed?
This one’s pretty self explanatory. If there is more investor interest than the company is actually trying to raise in a financing round, then this bullish signal means the round is a hot deal. The company is doing something right and so is the investor who is able to get allocation from the company to invest in the round. The more oversubscribed the round is, the more belief there is from investors that the company will do well.
Is the financing round at a flat or down valuation?
Another straightforward signal here. If the company is raising a down round at a lower valuation from a previous round, that is generally a bearish signal that the company may be desperate. It might be able to turn itself around, but likely exhausted all fundraising options; this down round is a last resort to keep the company operational. Down rounds may also come with investor-defined punitive terms such as pay-to-play and the exercise of anti-dilution provisions, essentially measures meant to protect previous investor interests in the company. However, this means lots of dilution for the company’s founders and employees, a tough pill to swallow. Bottom line, if a company could have avoided raising on a down round, it would have.
Flat rounds are generally stronger signals than down rounds. They lack the stigma of a down round and associated punitive terms. Perhaps the company struggled a bit but is now at an inflection point from correcting its business strategy, for example. Investing in this round with the same terms as the last round’s investors could be considered advantageous, since you are entering (hopefully) with some tailwinds.
The above are some key signals VCs use to evaluate fundraising round dynamics of a startup. All have caveats (whether bullish, neutral, or bearish) that depend on each startup. Nonetheless, signals, such as those highlighting investing round dynamics, are a bigger part of VC decision making than you might expect. Hopefully these signals are informative to founders as you raise your next round of funding and consider what sort of signal you might be intentionally or unintentionally sending to investors.
Any other signals around round dynamics that I missed? Want me to discuss more signals that VCs look out for? Comment below!
