How Many Investors Are Too Many?

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Editor’s Note: This is a guest post by Mark Suster, a 2x entrepreneur who has gone to the Dark Side of VC. He started his first company in 1999 and was headquartered in London, leaving in 2005 and selling to a publicly traded French services company. He founded his second company in Palo Alto in 2005 and sold this company to Salesforce.com, becoming VP of Product Management. He joined GRP Partners in 2007 as a General Partner focusing on early-stage technology companies. Read more about Suster at Bothsidesofthetable and on Twitter at @msuster.

Lately I have seen a number of deals announced on TechCrunch in which five or more different VCs were participating in the deal.

This always makes me chuckle because in my first company we had five investors in our first round and we picked up five more before we finally sold the company. In my second company I had only five investors.

While there is no right or wrong answer, having seen the extremes I’d like to offer you a framework for considering the right answer for yourselves.

The Perils of Many

I understand the appeal of having many VC firms on your cap table. You may feel as I did in 1999 that the more smart people around the table the more intros you’ll have, the more sage advice you’ll receive and the more impressive you’ll seem to outsiders. Plus, if you need more money it’s far less for each to dip into their respective pockets to fund you.

While all of this is true, it’s also true that nothing so perfect ever comes without a cost. Here’s the problem:

Let’s say you have five VCs (plus angels but let’s ignore that for now) and each one owns 5% so you took 25% dilution to get the round done. By definition each of those VCs (unless they are a micro VC – and one who doesn’t mind 5% ownership) will view you as a sort of “option” where they might get to fund the next round if you do well. Either that or there is something other than a financial motivator involved – NO VC is looking to build a business off of 5% ownership in startups. You simply can’t drive good returns that way.

So why else would they invest if not as an option to re-up in the next round? Maybe they wanted the branding associated with a hot company, maybe they wanted to work with the other investors around the table or maybe they thought it was a cheap way to get educated on your market – it’s always easier to learn an industry when you’re on the inside.

These are all dumb reason to invest – of course. But it happens.

So let’s consider a bad (but likely) scenario where either you don’t hit your targets, the market sours or competition is kicking your butt making it hard to fund raise. Most companies hit a bump in the road at some point. None of those five investors is sufficiently motivated to help you in tough times.

Firstly, they haven’t really signaled that it’s “their deal” in the way that leading a deal does. They can plausibly tell others, “yeah, we were a really small shareholder there – we had nothing really to do with the problems.”

Secondly, in tough times they’re also thinking about all of their other investments. Let’s say each of those five partners has at least seven other investments each. In tough times I promise you their time and energy will be allocated more heavily toward deals where they have more money invested and/or where they have a larger ownership position to protect.

Sure, if you become Zynga everyone of those five investors will be helping you. In fact, it will probably show up on their Twitter bio & on their website. But how many of you are likely to become the next Zynga (and without hitting a few bumps in the road first).

Now let’s consider the upside situation where you happen to be in a super hot space. Now you have five investors of which at least a few will be vying to take a larger stake in your next round. By definition you can’t have three investors each wanting to increase from 5% to 20% ownership or you’re fawked anyways. So it will be an internal fight over allocations. This is not to mention the fight you’ll see if you want to bring in a new investor to lead the next round to set an objective price.

“Many” has benefits but it also has drawbacks. If you plan to do it I highly recommend that most of the VCs be smaller funds and ones who are generally not looking to invest much more after your first round of capital. There are firms with this stated objective – seek them out if you want to load the VC roster on your deal.

Note that I am talking specifically about five VCs splitting one round. It might be that over a period of five years you’ve done three rounds of investment and ended up with four VCs. That’s a different story. Each VC came on with different information, at a different price and with a different risk appetite. Hopefully each lead or co-lead their round so there is more harmony in the configuration.

The Pitfall of One

It is very common for funding rounds to have just one VC doing the investment. This is largely true because most VCs have a 20% minimum threshold in order to invest so bringing in multiple VCs can be very expensive in terms of dilution. So obviously before agreeing to work with this VC you better make sure you know them really well. And I always encourage entrepreneurs to do reference checking. Here’s my guide to how to do that.

There is an obvious pitfall to working with just one VC – if you fall out of love you’re screwed. There are reasons why VCs sometimes don’t support deals once they’ve invested.

The most common case is that the partner who did the deal left the firm. You are then a “stranded” portfolio company. You know the drill – the new guy says he’ll support you, but it was never really his deal. If you have any hair on you he can always distance himself and deny any involvement.

You might have a VC who is at the end of their fund and doesn’t have deep enough pockets to fund you if you hit bumps in the road. The VC might have lost confidence in you. You might just have differences of opinion on the direction / strategy of the company or how to handle situations in difficult times.

I have personally seen some VCs who decide not to support certain industries they once had backed. I know that a lot of VCs had roadkill in the Internet Video 1.0 world and many pared back investments. Whatever the reason, when you’re stranded and you have one investor the only way out is to find new outside investors.

And this is doubly hard when your existing investor isn’t supportive. The standard line the new investor wants to hear from your previous VC is, “we’re behind this company 100%. We’re willing to do our full pro-rata & might even like to do a bit extra.” If your VC had stranded you, you won’t hear this – believe me.

Still, most deals involve one VC – just to be clear.

The Squeeze of the “Two Handed Deal”

The most tempting thing to do in a financing is to find two investors to split a deal. In my mind that’s the perfect scenario. You get all the benefits of the “many” deal without the drawbacks. If you can pull it off, I love the “two-handed” deal. If you’re doing well but need a little more gas to prove yourself, it’s so much easier for VCs to split an inside round. It’s both a smaller check and it’s external validation that somebody else was willing to fund.

The biggest problem in two is the “squeeze.” All VCs want to own between 25-33% of your company. That’s the number they feel comfortable owning in exchange for their time & resources over what will likely be a 7-10 year endeavor (if you’re successful). They internally almost all have their secret minimum threshold, which is 20%. There – the secret is out.

So in order to get a two-handed deal you need to dilute by 40% which is an awful lot at the start of your company. When you consider that they’ll also want a 15-20% option pool in the company you’re talking about founders owning as little as 40% after just one round. That wouldn’t be bad if you had just one founder, but if you have 4 you’re already at 10% each and you have 7-10 years more work left (not to mention 3 more funding rounds!).

There are a bunch of VCs out there who don’t cling to the old “20% or the highway” mentality on every single deal and I suggest you seek them out. They are the ones who will often partner better with other VCs. There are ones I’ve worked with like True Ventures, First Round Capital, Greycroft, Rincon Ventures …. just to name a few. And of course most of the micro VCs (fka super angels) also don’t hold to this minimum bar.

The easiest configurations to push for are either one lead VC who takes 20-25% and one smaller VC who takes 7.5-15% or two leads who take 15-17% each.

Rules of the Road

1. Always Have a Lead

No matter which option you choose always have a lead. If you want the “many” deal then give half the round to one VC and let the other 4 split the second 50%. No lead = no one on the hook in tough times = no one to corral other investors to take action = nobody with enough skin in the game to give a damn. Always, always have a lead. Not just to get through tough times, but for conflict resolution in general.

2. Make Sure You’re Stage Appropriate

If you select a lead VC make sure they’re stage appropriate. If you’re raising $2 million on an A round and it’s a $1 billion fund make sure they have a track record of backing and being active with early stage deals. If you’re raising a $10 million B round and a $100 million fund ponies up $8 million you better have a firm grasp of how much of their fund is allocated, how much they have reserved for you and how they plan to support you in tough times.

3. Make Sure They Have Enough Gas in the Tank

In any scenario it’s a good idea to understand where the VC is at in their fund. You can’t ask this kind of stuff on the first date, but ultimately you politely want to get out of them: when their fund was raised, how much capital did they raise, how much is allocated, when they’re raising their next fund and what their “reserve” strategy is. Best if you get much of this from due diligence of calling other portfolio companies and then use this information to confirm with the VC.

4. Make Sure They Play Nicely in the Sandbox

I often see VCs getting sharp elbows out at the time of a fund raising. They start muscling for ownership percentages and start angling to kick out certain investors or angels. I find this behavior strange but now a bit predictable.

I usually counsel entrepreneurs with the following advice, “if your VC can’t play nicely on the way in when they love you the most and are on their best behavior, imagine how they’re going to be in difficult times or when the final pie is getting split!”

Seriously, man. Assholes in good times are insufferable in bad times. If you experience this behavior run. Didn’t you get enough of this crap in high school to want to revisit it again?

5. Always Pitch Outsiders for Follow Ons

I have staked my strategy as a VC as being both stage agnostic and willing to follow great deals by leading another round and increasing my percentage ownership. So it seems strange advice for me to recommend that you pitch outside investors first for follow on investments.

Here’s why – even for a VC you really like and who you might like to lead your next round. You know the old saying, “great fences make great neighbors?” My corollary for VC is “pitch outsiders and you’ll have great insiders.” It just keeps us a bit honest. I think if your inside VC wants to lead a round and is giving you a “fair” price it’s reasonable to not “over shop” the deal and try to drive the highest price possible. Get a fair price from outsiders or at least market test the interest level.

6. Always Make Room for Value-Added Angels

Finally, I believe in making room for value-added angels on every round and in every deal. Yes, I include many micro VCs in this category. If there are 4-5 investors who each want to kick in $50-75k – why would I want to turn away smart people from working with the company? These aren’t people who are going to compete for increasing pro rata in the future. They aren’t people who are going to demand minimum ownership %’s.

They’re all dopeness, no wackness (presuming they are great angels and not PITAs).

If your new prospective VC is opposed to a great angel or a small investment from Founder Collective, Felicis Ventures, SV Angel or similar – please re-read number 4 above.

Image: Cassius Marcellus Coolidge

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