Stay Away From Insider-Only Venture Capital Rounds
When you (a VC) see a round of new fundraising comprised only of existing investors, what do you think the reason is? (select all that apply)
The second most popular answer was “To keep a good deal to themselves.” The first most popular was “To overcome a short-term setback”. (Gompers et al., 2016)
Who’s right? Let’s review the literature:
Note: We define an ‘inside round’ as a round of new fundraising comprised only of existing investors.
Throwing Good Money after Bad? Political and Institutional Influences on Sequential Decision Making in the Venture Capital Industry — (Guler, 2007)
Guler extrapolated from VC data from 1989 to 2004 that VCs invested in follow-on rounds even though those follow on rounds had lower IRRs and lower frequencies of successful outcomes than the initial investments. He says, “In short, VC firms do not behave so as to maximize profits in sequential investment decisions.”
Guler also finds a positive relationship between the amount of capital a VC has invested in a company and that VCs liklihood to follow on in the next round. He says, “The amount invested by the VC significantly decreases the likelihood of termination, even though it does not significantly increase the likelihood of success. This is consistent with prior work on risk seeking in the domain of losses (Kahneman and Tver sky, 1979; Whyte, 1986). Other VC-specific factors, such as geographic proximity, a VCs prior experience in the venture's industry, or stage preference, do not significantly affect the hazard of success or termination.”
He then offers possible explanations: “First, intra-organizational politics may decrease the effectiveness of the investment process, especially in larger organizations, as large syndicates do not enjoy higher success rates (model 6a) but suffer difficulties in termination. Second, contractual pressures from co-investment partners limit the ability to terminate investments by penalizing VC firms that walk out. Third, investment norms in the industry discourage termination, and deviance from the norms is penalized through the syndication network. All but elite VC firms feel the pressure to comply with these norms in order to maintain their standing in the network. The political and institutional features of the VC investment process may create perverse incentives to continue investment, even as the likelihood of success declines.”
Do VCs Use Inside Rounds to Dilute Founders? Some Evidence from Silicon Valley — (Broughman and Fried, 2012)
The authors do not find evidence that VCs use inside rounds to dilute founders, but they find evidence that inside rounds underperform:
“First, we examine the incidence of inside rounds. Consistent with backstop financing, we find that inside rounds are more likely to occur in firms where VCs lose money. Firms whose exits generated profits for the VCs rarely used inside financing. We also find that inside rounds increase when market conditions (as proxied by NASDAQ and startup valuations) deteriorate.
Inside rounds tend to be preceded by deteriorating market conditions and declining firm values and followed by worse firm outcomes. On average, inside rounds have a lower IRR over almost the entire time period of the study.”
They propose possible rationales:
- Increased chance of being sued by the company if insiders don’t offer a mark up
- Improved signaling to “window dress” for other investors and fundraising purposes
- Down rounds have an extra cost in triggering anti-dilution provisions which often must be renegotiated
- Investor hubris
Posturing and Holdup in Innovation — (Khanna and Matthews. 2016)
The authors show the benefits of marketing higher a higher valuation for a company than it deserves.
“If potential competitors are eager to enter the firm’s market, or employees, customers, suppliers, or future investors are reluctant to deal with the firm, the venture capitalist can have a strong incentive to purchase at high prices in later financing rounds to create excitement and induce desired actions by third.”
Insider Financing and Venture Capital Returns — (Ewens, Rhodes-Kropf and Strebulaev, 2016)
The authors find that “inside financings lead to a higher likelihood of failure, lower probability of IPOs, and lower cash on cash multiples than rounds with new (outside) investors.”
They also find that inside round NPV for investors is negative, implying insiders would be better served not investing in their existing portfolio companies, even if it meant some of those companies failed as a result.
The paper posits an explanation for the phenomenon, the VC investment period. Typically, the first five years of a venture capital fund, the ‘investment period’, is when the venture capitalist may invest in any company. Once the investment period is over, the remaining capital (often a significant percentage of the original commitment) is set aside to invest in ‘their winners’. Post-investment period, a vc fund may only invest in future rounds of its existing portfolio companies, dramatically reducing the universe of potential investments from that of the investment period. This difference, the authors suggest, contributes most to the difference in returns.
That hypothesis is robust to a number of tests:
- VCs are more likely to participate in follow on rounds post-investment period than during the investment period
- Inside rounds underperform relatively across funds of the same venture capital firm
- Funds in the ‘post-investment period’ tend to make follow on investments longer than their ‘investment period’ coinvestors
Think otherwise? Let me know!