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Earlier this year, I ran some numbers and showed that there hadn't been a lot of outsider-led growth stage venture financing in the sector. Anecdotally, I get the sense that this is changing, but it does raise the question: What if anything do all the "insider-led" rounds tell us about the underlying health and progress of the companies receiving them?
A quick refresher on VC: in the venture capital world, the preference is typically to have a new outside lead investor for every new series of preferred shares. Why? Because it adds another source of fresh capital around the table (in case further investments will be needed), and importantly, it also provides market validation for the new price per share (good for both legal reasons and just to keep investor-entrepreneur relationships happy).
So ostensibly, the fact that so much of the financing right now is essentially insider-led isn't a good signal of the sector's health. By traditional implication, it means a lot of those companies couldn't attract a new investor and thus must not be interesting, right?
Not necessarily.
There are three basic types of insider-led rounds. And unfortunately, it can be hard to discern from press releases, etc., which type of round has been completed.
The first type of inside round is basically a "kick the can down the road" round of financing. It's essentially intended to be bridge financing to some other event, like a new round that hasn't fully come together yet, an anticipated exit, or just a big company announcement that is expected to change the story and unlock more investor interest. Often, this is structured as a convertible note round. But not always -- sometimes it's a re-opening of the last round of financing.
If it's a bridge to a near-term new financing, the latter is rare. The company doesn't want to signal to new investors that existing investors think the old price per share is still valid. And either way, it'll usually be a relatively small amount of financing, at least as compared to earlier rounds that the company had raised.
To be clear, many an investor has ended up putting in a "kick the can down the road" financing only to later discover that they were engaging in wishful thinking and the company still can't raise new capital. A "bridge to nowhere," as it were. But when you see a smallish insider financing, especially in the form of a convertible note, it doesn't tell you much about how the company is doing. It could be in trouble, or it could be gearing up for a big up-round.
The second type of inside round is the reboot, often a "recap," where the company has gone sideways -- or worse, it can't attract new outside investment, and some of the existing investors can't or won't continue to back the company. So only a subset of the investors put more money into the company, and often (but not always) do so in terms that are punitive to other investors who aren't participating in the inside round. The argument is that if those investors are going to continue to keep the company afloat when no one else will, they deserve more ownership and control.
Now, there can be other reasons why some of the insiders couldn't participate in the new financing. They might be tapped out of capital to invest even in companies that they like. Certainly, many companies that have gone through some kind of recap have ended up being successful winners -- that's the whole purpose of the new round, after all. But generally, this type of round isn't a great sign of a company that's growing like crazy.
Unfortunately, from the outside, it's tough to tell the difference between a "kick the can down the road" financing and a reboot financing, since they'll both typically be smallish and the press releases will look the same. But watching to see whether or not major known existing investors are mentioned in the press release can sometimes offer a clue. Of course, companies know this, so sometimes they won't list the investors at all. So good luck figuring it out.
The third type of inside round is the "double-down" round, where insiders with deep pockets just decide they'd rather not over-capitalize a good company and want to just put in more money themselves. For reasons described above, this often is not a first recourse. But sometimes a startup will go out and talk to outside investors, get a good sense of what their market value is, and then end up just doing the same basic deal with their existing investors.
Neither VCs nor entrepreneurs want to gain reputations for using outside investors as "stalking horses" in this way, but it does happen. Often when it does happen, it wasn't the original plan. It's more that the signals from the market were positive, but not as positive as had been hoped for. Or maybe, as Sequoia has done a couple of times lately, the VCs just really like the story, and the company never engaged in conversations with outside investors at all. These rounds will tend to be relatively large (in comparison to the first two types), and are more likely to be a new series (Series B versus previous Series A, for example), but they are otherwise pretty hard to distinguish from the first two types.
In short, inside rounds can be a signal that a company is doing great, doing OK, or is close to collapse. In my career, I've personally been a part of all three types. They all happen with some regularity. So what are we left with?
There were a lot of inside rounds in the sector in the first half of the year. But was that a bad thing? In my opinion, that trend reflected the VC herd's whims more than the underlying performance of companies in the sector. I've seen a few companies in this sector that without the "cleantech" label should have been really popular among outside investors -- strong growth, nearing break-even, big market opportunities ahead -- and yet still had a really hard time getting generalist VCs to put in a term sheet.
What's telling to me is how many of the inside-led deals done in the first half of the year included a new strategic investor as well. Strategic investors often don't like to set terms on a new round of financing. Some do, and more are learning how to do so out of necessity. But it's not surprising that a large corporate investor would be interested in a well-performing company, and it would require an inside financial investor to set the terms, simply because generalist investors weren't interested in the entire category and category-specialist investors weren't able to make any new investments at all.
We're probably at a part of the capital cycle where insider rounds are more likely than ever to be a sign of a company doing well, not a company in trouble. And the good news is, eventually the results of healthy company performance will inevitably draw capital back in. However, they need to relabel things in order to justify it.
In fact, I think we're already starting to see it happen in Q3.