Inside-Led Rounds: The Risks For Founders

Part I of this series explained what an inside-led round is, why many VCs favored them in the recent bull market and why it can be a “win-win” for investors and startups. But, it’s important for founders to also understand the downside risks of inside-led rounds.

How does a ‘win-win’ turn into a ‘lose-lose’?

If things go south, as in the macro environment dramatically changes or the company underperforms, what was once the goal—a high ownership percentage—suddenly becomes a potential problem. Said another way, if a company needs bridge funding, often investors will pony up a dollar amount that equates to their pro-rata ownership. If the ownership is high, the VC will feel pressure to fund the bulk of the capital. And if doubling down on potential winners is a common practice of the investor, they may find themselves with multiple companies in need of bridge funding and not enough capital to provide it.

A lesser-discussed contributor to this problem is that investors typically own preferred stock while company employees and advisors own common stock. When a company needs financing, they don’t go to the founders or employees: They go to the investors.

Said another way, if a VC owns 15% of the company (as in our example from Part 1), they likely own more as a percentage of the preferred stock; let’s assume 30%. Let’s compare that with a VC who owns 10% of the company; let’s assume they own 10% of the preferred shares.

Now, imagine that our struggling company needs a bridge round from its existing investors. The company has a high burn rate and needs $30 million. As a first step, the company likely goes to each investor and asks them to commit their pro-rata of the preferred ownership to the bridge financing. In our two scenarios, this is either $9 million or $3 million.

What are the knock-on implications for this?

If the VC in the lower ownership scenario does not have reserves of $3 million for the company, it is a small hole for the company to fill. On the other side, if the VC in the higher ownership scenario does not have any capital available, the $9 million hole is material.

Additionally, in our higher ownership scenario, it is likely that the company has fewer total investors around the table because the VC continued to support the company and therefore did not make as much room for new investors over time. All in, this scenario creates a larger funding gap with a fewer number of investors around the table to fill it.

If the same VC did this with a number of companies, they may not have large dollar amounts to support their companies and will need to prioritize. This may create tension between the company and its larger investors. The investors may be incentivized to pursue other options for the company (e.g., venture debt, M&A, etc.) because there simply isn’t enough cash to support the company through this fundraising environment.

So what can founders do to mitigate the risks of inside-led rounds?

If you have already taken an inside-led round or are contemplating one, here are a few ways you can reduce your risk and build options for the future:

1. Keep the financing round open longer. Negotiate to keep the investment round open for an additional 60-90 days and try to find others to join in the round. These could be strategic investors who bring a lot to the table but need someone else to be the financial lead. In both good times and bad, having such a strategic investor on board can pay dividends.

2. Ask your VC about reserves directly. It is appropriate to ask VCs directly and transparently about their reserve policies in general and more specifically if they will have reserves for you.

3. Build multiple relationships with your investor’s firm. The investor on your board is critical. This person is your champion and likely whom you will confide in and speak to frequently. But in the case that this person leaves the firm, you do not want to find yourself without another ally internally. That’s why you should cultivate relationships with multiple individuals from your investor’s firm.

4. Explore alternative financing options. There has been an influx of specialty players such as Capchase, which provides non-dilutive working capital to SaaS companies, and Armentum, which helps match startups with the best debt provider according to structure and cost. Get familiar with your options before you need them.

5. Extend your runway. If you have any doubt whatsoever about your growth in the near/medium term, you should think about cutting your costs immediately. “Flat is the new up” for now, but the tides are always changing. By giving yourself more time to grow into your target valuation, you, your employees and your investors can benefit.

6. Consider M&A. Sometimes, it really is the best option. There are steps you can take now to ensure that a favorable M&A option will at least be on the table if and when that day comes.

As a startup, it’s usually worth the effort for you to try to find outside investors, even if your existing investors are willing to back you in your current round. Remember, macro environments change, people leave firms and funds can close down. While each startup’s situation and options will differ, all else equal, having more allies around the table is likely beneficial.

That said, if you have no other options, or if the benefits of an inside-led round really seem worth it, your No. 1 job is to stay solvent, and capital is key for that.

A version of this article originally appeared on Forbes