Can You Trust Your Co-investors?

How to assess syndicate partners

Scott Lenet
Jul 27, 2020 · 6 min read
Image: Shuttestock

As I’ve previously written, entrepreneurship and venture capital can be more challenging during a downturn, but startups that make it through can emerge in a position of strength. While investment capital typically becomes tighter during a recession, startups generally have less competition. As a result, more enduring companies may potentially be founded at times like these according to research from the Kauffman Foundation. It remains to be seen how the current recession will play out in the venture capital ecosystem.

While a recessionary period often brings stress between founders and investors, one of the most challenging aspects of managing through a downturn can be the relationships between venture capitalists and their fellow investors, known as “syndicate partners” in the industry.

To minimize the chance of friction between a startup’s backers, co-investors should communicate frequently and bluntly about whether they are likely to continue supporting a portfolio company financially, and why or why not. This helps each party forecast potential financial obligations more accurately and to help ensure the survival of the startup.

For example, in an outside round of $5 million where an investor owns 5% of the startup, that investor “owes” $250,000, because that fund’s pro-rata contribution is calculated as 5% x $5 million. But in an inside round where existing investors are the only participants, this same investor would owe more. If all investors combined own 25% of the startup, then the same 5% owner “owes” 20% of the round (5% divided by 25%), or $1 million.

What happens if that 25% is divided equally among five investors, but two of them cannot — or will not — invest? Now the same firm is on the hook for 33% of the round, or $1.7 million. The difference between $250,000 and $1.7 million is meaningful, and this is just for one portfolio company. What if five or more portfolio companies require capital in the same six month period, and multiple co-investors are unable to participate in these financings? Such a scenario could face many portfolio managers in the second half of 2020.

Investing with reliable syndicate partners is a best practice in any economy, but even more essential in a downturn. Here are a few ways to stay in sync with your existing or prospective co-investors, and to maximize the chances of being there for each other and your portfolio companies when needed:

  • Start with communication, by connecting with all your portfolio CEOs and co-investors, staying in coordination more frequently during a downturn — this is the time to over-communicate and be clear on where you stand

When you have these conversations, it’s important that your fellow investors don’t feel interrogated. It’s also fair play for your co-investors to ask these same questions of you, so you should proactively ask yourself and your partnership these same things to avoid fire drills and unnecessary drama. This is especially true for corporate investors, whose timelines and processes for deal approval may be less agile. There are less blunt ways to ask these same questions, so use your judgment based on the length and strength of your relationship with your co-investor. Here are some direct questions that can help you determine if your co-investors will be there when you need them:

  1. “Where does this company fall among your priorities?” The purpose of this question is to get an honest assessment of whether the person who is leading the deal actually cares — someone who cares will probably advocate more forcefully for a deal within his or her partnership.

Syndicate partners owe it to each other to be honest about where things stand and what each investor’s firm is likely to do. This is how trusting relationships are built, and trust is the fabric of the venture capital ecosystem. No one benefits from surprises when it comes to anticipated participation in follow on rounds, especially not the entrepreneur.

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Scott Lenet is President of Touchdown Ventures, a Registered Investment Adviser that provides “Venture Capital as a Service” to help corporations launch and manage their investment programs.

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