If you’re the founder or CEO of a bootstrapped start-up or expansion stage company with a lot of momentum and a very bright future, you’ve likely considered the myriad financial options that will help take the company to the next level.
One of those, of course, is a capital investment from an institutional venture capital firm. For a lot of organically built and capitally efficient expansion stage software companies, that’s the best route for continued growth. But as you consider potential suitors, the question of investment syndication may come up.
The question is, should you consider investment syndication?
It depends on the situation. Investment syndication occurs when a group of venture capitalists or VC firms join forces to contribute the pool of money a small business needs to continue its growth. In some circumstances, syndication allows venture capital firms to mitigate risk and diversify their portfolios. For the portfolio company, the benefit can be a wide array of expertise and experience.
On the flip side, it hasn’t exactly been a banner period for venture capital syndicates the last few years. On his blog, entrepreneur Eric Roach discusses a great Wall Street Journal report that addressed the implications of recent venture capital syndication collapses. Roach points to a few examples from the WSJ article in which members of syndicates abandoned their investments, leaving otherwise strong companies scrambling to adjust.
There are certainly negatives to the practice. When a VC firm encourages the potential portfolio company to consider venture capital syndication, the company needs to keep its eye on a few warning signs that might be cause for concern. In those circumstances, there are three primary drivers causing that firm to promote syndication:
Investor’s Fund is Too Small
When an investment is made, the investor’s fund needs to be able to support the capital needs of the company all the way to a future exit. There’s nothing worse in software venture capital than a company whose VC is not able to lead or participate in future rounds. The risk to the company is the VC blocking future rounds, which creates an ugly Catch-22. So make sure that your investor can support you through an exit. These are some things you should look for:
- Size of fund the investment is coming from
- Average deal size of the first investments in that fund
- Total amount the investor can put in to any one company
- How much of the fund has already been deployed
- How much is being held in reserve for follow-on rounds in the current portfolio companies
Investor’s Risk Profile is Limited
If an investor’s risk profile is limited, it may prefer syndication to reduce the amount of capital that it invests in any one company. The pro for you here is that you, in turn, can reduce the influence of your investors (two investors will keep each other honest). The con is that the more investors you have, the more complex managing potentially conflicting investor viewpoints and interests becomes. That will manifest itself in your board meetings, affecting subsequent follow-on rounds and exit opportunities.
If you do choose to syndicate:
- Make sure that the two investors’ investment models and return objectives are aligned. You don’t want a short-term IRR focused investor coupled with a long term, multiple-return focused investor.
- Make certain that the two investors’ funds are somewhat alike in their profiles. You don’t want one investor to invest from a fresh fund, while the other contributes from the latter years of its fund.
Investor Has No Clue What You Do
A lot of times, an investor doesn’t truly understand your market or what you do and needs another investor to do the hard work. Avoid those investors like you would avoid the plague. Nothing more needs to be said.
The decision to consider syndication depends on the stage of your company. If you’re in the start-up phase (below $2 million in revenue), it should not surprise you that an investor prefers to syndicate. Investing in start-ups is all about investing in a portfolio of ideas, knowing that most of them are going to fail or wither on the vine.
So, in the start-up phase, investors’ hands are somewhat forced. They have to spread the risk. But the more focused and knowledgeable an investor is, the less likely they will be to prefer syndication. And vice versa.
If you’re beyond the start-up phase, I encourage you to focus on fewer (preferably one) investors. Again, the more venture capital investors you have on your board and cap table, the more complicated your life will become. So, if that profile fits you, my closing advice would be to find an investor that is more interested in doing the deal alone. They’ll be more focused an invested in your company and its eventual success.