Building bridges

The importance of setting clear targets for a financing round.‍

In Venture Capital discipline is one of the habits that you are taught from day one. If a company does not perform, does not achieve its product market fit, or is not able to scale, it is recommended and appreciated by LPs to stop investing and possibly acknowledge the write-off.

So much for the theory.

I am writing this article to increase transparency about the rationale behind follow-on financing and to explain why some follow-on funding rounds are (statistically) more promising than others.

When I started my analysis, I came-up with the thought that an investor, would rarely do follow-on investments in companies that perform below average, but would invest as much as possible in the strongest performers in his portfolio. In other words, there should be a positive correlation between the total investment amount and the exit performance of a company.

Looking at real data however yielded that investors allocate as much as 25% more in unprofitable investments than in profitable ones. So, there is indeed a correlation between investment amount and exit performance, but it is surprisingly strong and negative, completely contradicting my initial thought.

This got me thinking: “How come investors teach and preach discipline and then invest more in less performing assets?” And just as important: “What does that mean for founders?”

To increase my understanding, I had a look at the structure of follow-on financing rounds. Generally, there are three different routes a round of financing can take — it can be value increasing (higher share price than before), value neutral (same share price) or value diminishing (lower share price).

Investors put the smallest share of their total follow-on money in financing rounds with value diminishing share prices (30% of total follow-on funding). Almost on a similar level, but slightly higher is the allocation in value neutral financing rounds (31%). Financing rounds with an uptake however, receive 31% more of the total funding than the other two (39% of total funding). In other words, investors seem to have most interest to invest in companies that bring increasing value — an intuitive finding. When I looked at the average investment per round, the picture turned completely, as the average investment in value diminishing financing rounds is 16% higher than an investment in a value increasing financing round.

So even though investors put more money in total in value increasing financing rounds, they tend to sign larger tickets in value diminishing financing rounds. Why is that and what is the rationale?

The answer is somewhat related to the difference between internal and external financing rounds. Internal financing rounds have the tendency to be value diminishing or neutral to investors (median is 0, while the average is negative), while external financing rounds are strongly positive (both median and average). Unfortunately, in this regard, investors tend to invest 2.3 times more in total in internal financing rounds than in external financing rounds and also the average investment is 40% larger in internal financing rounds. This is caused by the usual financing round dynamics in the respective round. In external, value increasing financing rounds, it is often difficult to fully maintain a pro rata investment because a new investor often has a minimum allocation and thus tickets for existing investors are reduced. In internal rounds however, an interest to minimize individual participation can be observed. So in the end investors often end up with at least their pro rata share.

The final question is “Why are internal rounds done at all if they deliver negative fair values?”

The cause for this is the bridge kind of nature of a lot of internal financing rounds. The most promising internal rounds are the ones, that are followed by an external round or an exit within no more than twelve months. If this can be achieved, a significant value uptake is often observed. If on the other side, an internal financing round is followed by another internal financing round, the valuation is likely to go down and the equity story is, in most cases, negatively affected.

So, in summary, investors willingly tend to take more risky investments with statistically negative expectations because they are expecting an external, value increasing financing round or an exit to follow. The probability of achieving this target however is at only 44%, which means that more than half of the internal rounds are ultimately loss making for an investor. The primary cause for internal rounds that are not leading to external financing rounds or exits is very often the absence of a clear target setting.

Ultimately, I would like to transfer this analysis to the fundraising life of start-up founders and want to give two clear recommendations.

1. Build properly sized financing rounds.

Internal financing rounds are statistically speaking a bad way to go. The cause for internal financing rounds is either the lack of customer traction for an external round (~50% of the cases) or insufficient internal development (~40%). The residual 10% are either very strong development — a pre-emption of an external financing round — or a turnaround. This means that more than 90% of the internal financing rounds are done because the company was not able to reach enough with the previous financing. Thus, my recommendation is to identify a clear target for a round, consider how much time is required to achieve it and finally implement a buffer of at least six months to account for operational delays and give enough time for fundraising to diminish the necessity for an internal financing round already in the early days.

2. If you need an internal financing round, make sure to build a bridge to somewhere!

… because a bridge with only one end is no bridge. Even if you have implemented a substantial safety cushion in your funding, things often go different and you will require some internal funding from existing investors. If you look at statistics, internal rounds are mostly profitable when they are followed by an exit or an external financing round. If internal round is followed by internal round, this is a costly path. Thus, I recommend to again make sure that it is clear what must be reached with a bridge and respectively build and structure the bridge accordingly.

Statistically speaking again, the appreciation of these aspects is increasing the probability to be successful — and then what in life is purely based on statistics?

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I have primarily used percentage figures in this article. The reason is that I have had a variety of funds for my analysis with very different fund volumes (EUR 40m to EUR 300m) and that absolute numbers were thus very different, and averages would have had less relevance for larger funds and exaggerated relevance for smaller funds. As the relations between numbers held true independent of fund size however and correlations were all with sufficient significance to bring relative numbers forward in this article I have opted to use this way of presentation.