Deal Flow

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Justin Hibbard
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May 23, 2005

Inside Job

Justin Hibbard

Telecom equipment maker Caspian Networks said today that is has raised $55 million in follow-on financing from its existing VC investors: Oak Investment Partners, U.S. Venture Partners, Morgenthaler Ventures, New Enterprise Associates, Alloy Ventures and ABN-AMRO. Back in the bubble days, a so-called inside round--in which no new investors put money into a company--was often a mark of shame, indicating no investors were interested, and the company's valuation didn't increase. Like so much else since then, attitudes about inside rounds have changed.

The partners at VC firm Advanced Technology Ventures recently explained this change to me. ATV is an early-stage investor, which means it invests in startups as early as feasible to get the biggest possible run-up in the value of its stake from the time it invests to the time a company goes public or gets bought. Trouble is, those run-ups aren't as big as they used to be. Therefore, owning a large percentage of a company is more important than before.

Say you invest $10 million to own 15% of a startup, which gets bought five years later for $150 million--a typical outcome these days. That means you'd get back $22.5 million, or 2.25 times your investment. Not so hot for five years of work. Now, say you owned 30%. You'd get back 4.5 times your money--not bad.

VC firms sometimes get an opportunity to increase their ownership percentages in follow-on financing rounds--the fundraising that happens between the initial investment and a sale or IPO. When companies raise follow-on funding, they issue additional stock, which reduces the ownership percentages of earlier investors. During the bubble, VCs that invested in an initial round would often invest in follow-on rounds, too--but only enough to maintain their original ownership stake. That left a healthy percentage for a new VC investor, which would join in the follow-on round and agree to a new (and usually higher) valuation for the company. Thus the value of the earlier investors' stock would rise. Back then, with companies regularly going public at $1 billion valuations, it wasn't hard to get stellar returns from a modest ownership stake.

These days, some VCs are reluctant to bring new investors into follow-on rounds. With $150 million outcomes being the norm, they want as much ownership as they can get. And with many VC firms sitting on big hordes of capital, it's little trouble to put more money to work. "There's one major venture firm on the east coast that has basically said for all of their good deals, they're going to do inside rounds," says Wes Raffel, a general partner at ATV. "They want to make sure they maintain their ownership and put more money in rather than let a new person come in and live off the work that they've done."

I have no idea whether this dynamic played out among Caspian's investors. But inside rounds aren't the black eye they used to be. Did I explain this clearly? Do you disagree? Submit your comments!

02:58 PM

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You overlooked an important issue facing any inside round. Who set's the price? Current investors are obviously conflicted. Can the CEO refuse the money? Do the investing board members recuse themselves from this decision?

Most investments have pro rata rights to maintain their stake as new investors come on board. I think most VCs would still prefer to have an arms length valuation for their company.

Show me a firm that saves all the good deals for insiders, and I'll show you a firm that no one wants to work with.

My $0.02

Posted by: Chris at June 16, 2005 12:13 PM

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