This blog post is taken from my book.
Most successful VC-backed companies raise an average of three to seven VC funding rounds. When a company is raising its second or third VC funding round, the CEO, founders, board, and all parties should be aware of the different forces at play. They must understand the different perspectives and effectively negotiate the best outcome for their individual interests, balanced by their fiduciary duties to the company. Understanding what the other party wants is key to being successful in any negotiation, more so in a complex negotiation with multiple parties at the table. I find it useful to consider an analog model to the Porter Five Forces Model, but populated with venture related forces.
Porter’s model puts the client company or the competitive industry rivalry in the center and considers the impact of five different forces. The classic Porter analysis is shown in Figure 3.1. When looking at a B or later financing round for a company, map out a diagram with the operating company raising the financing in the middle, and the various influencing forces surrounding that center.
Figure 3.1 Classic Porter Analysis
A hypothetical “Romans’ Five Forces Analysis” is shown in Figure 3.2. Each company is unique and each situation unique, hence the value in mapping this out and making sure the CEO is on the case.
Figure 3.2 Romans’ Five Forces Analysis
I’ve seen incumbent VCs push for an up round or a flat round when the new VC is pricing the deal as a down round. The new investor will want to secure a position in the deal with the lowest possible valuation where the existing investors and management will want a higher valuation. If no new investors can be found, the existing investors may push for a down or flat round. This is all about dilution.
Looking at the five forces model in Figure 1.2, you can clearly see that the new VC joining is likely to be pushing for the lowest valuation he or she can get while not losing the deal to a competing VC. The new VC wants to buy as much of the company as possible for the amount of cash committed to the deal. The incumbent VCs want to report to their LPs that assets under management (the value of the LP’s investment into the VC’s fund) are up and that their dilution is minimized.
Sometimes VCs also have target ownership percentages. This can be driven by the need for a minimum percentage to justify a board seat or support of the venture firm. The number of boards a single VC individual can join is limited; so if the VC can only get 2% of the cap table then it may not work. Typical minimum target ownerships are 25%, 15% and 10% often driven by the number of VCs syndicating to complete a financing. My fund Rubicon Venture Capital is more flexible on this, because of our large network of angels, corporates and institutional investors we can leverage to take an effective board seat representing Rubicon even at a lower percentage ownership and simply leveraging our network to add value. Keep in mind another motivation for VCs to focus on getting a minimum target ownership in a startup is that historically 90% of the returns to VC funds come from 10% of their investments; so in a winner take all environment, the VC needs a meaningful percentage for a bit blockbuster exit to pay back her fund. At Rubicon Venture Capital we view this as old school and we understand it, but we operate differently seeking to get into good deals and be flexible with target ownerships to make sure we don’t get left out of a deal we want to invest in. We often invest in- between classic funding rounds with a small amount of capital to secure a position as insiders and position to increase our ownership in the next financing round. Again, we are far less sensitive to the ownership percentage, but if you are raising capital understand most classic VCs on Sand Hill Road are very sensitive as outlined above.
Mapping out your own specific deal will show clear dynamics. What becomes abundantly clear with a complicated later-stage venture deal is that each party has a very different set of interests, often directly in conflict. Interests are not aligned! And each different player is going to try to talk the CEO and board into doing what is in that player’s interest. The best VCs will support the CEO once the CEO considers all interests and sets the course on a sensible path. The CEO must lead and not be pushed. Go into these situations with your eyes wide open.
The point of the Romans’ Five Forces Model is to get to the bottom of the case quickly, understand the different perspectives of each player, set the strategy, and effectively negotiate with the knowledge of the needs and interests of each party.
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