Is an “inside round” a bad thing? Does it hurt a startup’s chances of future funding?

QUESTION:

My investors want to do an “inside round,” and I was wondering if an inside round is a bad thing? Does it hurt a startup’s chances of future funding? What should I look out for?

ANSWER:

Ethan Stone

Ethan Stone

by Ethan Stone, Stone Business Law

First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish a lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site. The information below is general in nature and should not be understood as a substitute for personal legal advice.

There are two possible problems with an inside round.

Possible Problems

Valuation

First, there’s the question of valuation. Without a new investor coming in, the existing investors have no incentive to fully price the round. If all stockholders (i.e. including the common) participated, that wouldn’t be a problem, since everyone would keep their relative positions. Generally speaking, however, only the investors will participate in the funding, so they will increase their percentage stakes in the company vis a vis the founders. Whether this dilutes the economic value of the founders’ shares or not depends on whether they pay full price for their new shares (a small slice of a big pie can be bigger than a big slice of a small pie). There is, unfortunately, no easy, objective way to value the shares of most VC-backed companies. That’s less true if you’re cash-flow positive or profitable. Easy or not, however, the founders should think about how comfortable they are with their ability to independently value the company’s shares.

Perceptions

Doing an inside round can create the perception that the company was close to running out of money and wasn’t attractive enough to get outside interest. As I’ll discuss below, there are other reasons for doing an inside round and VCs know that, so it certainly won’t bar you from future outside financing. But it does mean you’ll have something to explain. Of course, if the perception is true and you’re headed for the wall with no other obvious alternatives, dealing with perceptions when raising future rounds of capital is a high class problem.

Good Reasons for an Inside Round

As I noted above, one common reason for an inside round is that there are no good alternatives. Make sure you’ve thought hard about other alternatives before you reach this conclusion. It’s also worth taking a few seconds to make sure you can see the new capital producing a good outcome for you. In general, you will not be paying yourself much of a salary in these circumstances, so a good outcome for you basically means a scenario where (1) there’s enough money to justify paying yourself well, and (2) you’ll eventually get some kind of “payday” on your stock. Remember that the investors will usually have liquidation preferences before you get anything out of your share in the company. If you can’t see much likelihood that the company’s value will eventually clear those liquidation preferences, you won’t be getting paid. There are also emotional reasons for carrying on in the face of adversity. You may feel a sense of duty to the team and the investors. You may be personally committed to realizing your project. I’m not saying you should discount those. Just you go in with your eyes open.

In any case, if that’s your situation, just focus hard on closing the round fast (so you can put the money to work) and getting the best price and least draconian terms you can wrangle.

A more positive reason for an inside round is that the founders and the investors know you’re very close to achieving an important milestone (first commercial launch, significant new version, lab tests etc.) that will get lots of outside investors excited about investing at a much higher valuation. If you need a small slug of additional capital to “bridge” you over to the point where you can raise a monster round, it makes a lot of sense for the current investors to do it: They’re already invested and they’re closely involved with the business. So you don’t need to spend a lot of time explaining the situation to them and convincing them to invest.

You still need to think about valuation in this scenario. In fact, the proximity of an event that the founders and investors expect will justify a much higher future valuation complicates the current valuation. Convertible debt is often a good way to go in this situation, since it can be done quickly and it can defer a precise valuation to the next round. For a discussion of convertible debt, take a look at my post here: http://www.foundersspace.com/fund-raising/what-are-the-advantages-of-convertible-debt/.

I hope that helps. Good luck with the round and using the capital.

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