Can You Trust Your Co-investors?
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
- If you don’t know what you are going to do, be honest— setting unrealistic expectations that you will fund may create intense backlash if you ultimately fail to support your portfolio company financially
- Ensure frequent financial reporting from your startups: know the cash position and “fume date” for each company so you don’t experience the unwanted surprise of a CEO calling for cash on short notice
- Institute scenario planning that includes inputs from actual customer behavior, including cash flow dynamics like delayed payments, and then model expense adjustments to tune for desired cash balances
- Accelerate the regular evaluation of reserves against your initial investment, which should usually be done quarterly, and decide proactively which companies you would support if they need more cash
- In light of the fact that some investors may be unable to participate for various reasons, consider increasing your reserves per deal and potentially decreasing the number of new investments
- Work together with your co-investors and portfolio company management teams to assess your startup’s business model, cash efficiency and help guide any adjustments or pivots if needed
- Close the loop and find out from your syndicate partners what each is likely to do in the event of an inside round, so that you can forecast accurately what your fund’s obligations might potentially be
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:
- “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.
- “What does your partnership think about the deal?” While the individual responsible for the deal might care, the firm might not. This is delicate ground because you may be wading into the power dynamics of your counterpart’s partnership, but it is still your job to understand whether the individual has the political capital to get a deal done in the current climate.
- “Are you holding reserves for this company?” Most venture capital firms calculate reserves for follow-on investments in portfolio companies. If your co-investor no longer holds reserves for your shared portfolio company, that’s a powerful signal that a new infusion of capital from that firm is unlikely. Asking this acid-test question could spark an open discussion of how the partnership truly views the investment.
- “When did you raise your most recent fund?” While the individual investor and partnership may view your co-investment favorably, the firm may nevertheless be unable to provide ongoing funding. For traditional institutional VC firms, they may simply be out of fresh capital. Most VC firms raise new funds every 3–6 years, and if the most recent fund is 10 years old, for example, the firm may be out of “dry powder” to fund follow-on financings. Again, this can be a sensitive topic, so tread lightly if your relationship is new. Some of this information may also be publicly available, even on the VC firm’s web site.
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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