Email from Li in Silicon Valley just arrived!
Li writes: “My friend wants to know why a VC firm insists on having
other VCs join in the first round of financing of his startup. Do VCs do that?
Why don’t they do it all themselves? Does this cost more of the company? Is it
a good thing?”
Li’s friend has encountered a chunk of the soul of “deal
flow,” the lifeblood of venture capitalists. Deal flow is a river filled with
startup investment opportunities. Like Google. Like Cisco. They are traded like
hotels in Monopoly: “I’ll let you in on Cisco if you let me in on Google!” So
deals are agreed to by the boys with the bucks (and a few gals).
Two and three VC firm syndicates are formed. The deal terms are agreed to between members. Founders get to say “Yes” or “No.” Result: Each VC has reduced its risk (diversified) and has gotten in on a good sounding deal.
The VC that puts the syndicate together is the “lead VC.” A partner (not an associate or junior grade person in the VC firm) puts the deal together, negotiating terms with the startup founders, setting the price per share, cash to be invested and rights to do follow-on rounds. Li’s friend should focus on picking the lead VC partner. He’ll have to live with that person for at least half a decade.
Li’s friend is also advised to look for VCs with “deep pockets.” That is good advice to Li’s friend. Startups need cash, lots of it. Like a teenager needs carbohydrates. Or it dies. Four years of cash. That’s how long it takes to get most startups to bring in more cash than it uses. Cash flow positive it’s called. After the seed round is spent, more capital will be needed. As optimism turns to reality even more than planned will be required. Ergo, investors will need a deep pot to dip into for the big bucks needed soon.
VCs expect that. Veterans plan on disappointment. They reserve funds for follow-on funding beyond the startups’ plan. Bucks per company are measured and set aside so the portion of the VCs portfolio is kept below a maximum. Therefore VCs syndicate deals.
Li’s friend can get a better deal. But only if he gets two or three VC syndicates competing for his deal. Competition (for his deal) is the entrepreneur’s best friend. VCs are competitive. Very competitive. They form groups, cliques that get along, understand each other and invest together. They get first look at each others’ deal flow.
More details about the terms of real VC rounds can be found by reading the term sheet at www.nesheimgroup.com and Chapters 4 and 9 in High Tech Start Up.