Historically, inside-led venture financing rounds were seen as a sign of weakness and generally indicative that a company could not attract outside capital—at least not at the preferred valuation. This narrative turned on its head in recent years as venture capital firms sought to double down on their winners to maintain or increase their ownership rather than giving other VCs a piece of the pie.
In fact, inside-led venture capital funding exceeded $50 billion in 2022, accounting for almost one-quarter of all VC investments, according to PitchBook. This constitutes a more than 100% increase in the share of inside-led rounds when compared to 2012.
So, what propelled this shift from 2012 to 2022? To put it simply, a strong investing environment with many VCs raising larger and larger funds, as well as additional pools of capital such as growth funds.
But all good things must come to an end. The changing economic environment is making VCs more hesitant to put capital to work and more restrained on valuations. Suddenly, many companies look overvalued and are tapping their existing investors for financing rather than taking a down round from an outside investor. Said differently, we are back to seeing more “defensive” inside-led rounds versus the “offensive” inside-led rounds seen in recent boom times.
This begs a number of questions: Why did companies take inside-led rounds to start with? What were investor motivations for doing them? Are companies that took inside-led rounds positioned differently in this environment than their peers who did not?
Let’s tackle all of these questions with an eye toward learning: Should startups avoid inside-led rounds going forward?
What is an inside-led round?
Before we get into the details, let’s distinguish “leading” a financing round from “participating” in one.
It is commonplace (and even expected) for earlier-stage VCs to “participate” in later investment rounds as a sign of confidence and support. “Participation” might mean that a seed or Series A investor writes a $500,000 or $1 million check into a later stage of financing (e.g., the Series B or C). It’s really more of a show of good faith for new investors than a material amount of capital.
“Leading” a round, however, usually means investing the majority of the capital. This entitles the lead investor to set the terms of the financing round, including the company’s valuation and often which other investors may join the round.
What drove the rise of inside-led rounds?
Before the recent economic boom cycle, when a previous investor led a subsequent round, it was usually an indicator that the company was doing poorly and could not attract a new lead investor. Existing investors were left with little choice but to put in additional capital, often at the same or lower valuation.
But this narrative began to change in the strong macroeconomic environment we saw from 2012 to 2022. VCs, flush with capital, saw that the math implored them to double down on potential winners. Said another way, VCs began investing in subsequent financing rounds of their hopeful winners to avoid dilution in their ownership percentage. At exit, this means they received a larger share of the proceeds than if they had only invested in one financing round.
As a simplified example, let’s use two scenarios. In scenario one, a VC only invests in the seed round and then gets diluted in each subsequent financing round. What was once a 15% ownership in a company becomes a 5% ownership. In scenario two, the VC invests in subsequent rounds to preserve the 15% ownership. If the company exits for $1 billion, in scenario one the VC receives $50 million of proceeds whereas in scenario two they receive $150 million. Depending on the size of the fund, a $150 million exit is a real needle mover for performance. This math creates an incentive to double down on expected winners, limiting dilution and maximizing the ultimate proceeds.
Of course, there’s also a possible scenario three where the VC not only maintains ownership but also increases its ownership stake in subsequent rounds. There are many real-life examples of this we can point to. One of the most famous ones is Sequoia’s capital investments in WhatsApp. Sequoia was the only VC invested in WhatsApp when it was acquired by Facebook for $22 billion. Sequoia’s $60 million investment across multiple rounds turned into $3 billion in proceeds.
In these scenarios, VCs are making offensive, not defensive investments. Although these startups could find other investors, the existing backers preferred to lead the round, secure their desired ownership and keep other investors at bay. It is important to note that the benefits of inside-led rounds are not exclusive to investors, though.
How can inside-led rounds benefit startups?
Taking capital from existing investors eliminates the need to spend time and energy doing “price discovery.” No CEO enjoys spending time fundraising versus running their company. It can be an enormous distraction for management to put together pitch materials, build a list of investors to reach out to, set up dozens of meetings, etc.
Another perk of inside-led rounds is that founders can sometimes demand a higher valuation than they may have otherwise earned. This may sound counterintuitive, but if an existing investor is eager and wants to double down, the power dynamic shifts and the company can be compensated with a higher valuation to justify not taking the opportunity to market.
Finally, if you have a good relationship with your existing investors, it can reduce the risks you might face with “the devil you don’t know.” In many ways, inside-led rounds can be a “win-win.”
In my next article, I will show you the other side of the coin and discuss how a “win-win” can turn into a “lose-lose.” It will also explain what founders can do to plan ahead to mitigate the risks of inside-led rounds, as well as what to do if you have already taken an inside-led round.
A version of this article originally appeared on Forbes