Avoiding Pneumonia When An Investor Catches A Cold

There is an axiom in the venture industry that investor syndicates provide more stability for a young company, by avoiding a single point of failure. While this is true most of the time, it does not mean that from time to time, an investor within a syndicate may not develop a problem (catch a cold) that could create major challenges for an entrepreneurial company.

Today, these “colds” come in the form of sponsoring partner departures (no champion remaining in the partnership) to a shortage of capital reserves for follow-on investing and/or a combination of the two.

For the entrepreneur, a single investor failure in a syndicate can quickly become a financing crisis or “pneumonia.” In many cases, the remaining investors – facing their own reserve limitations – may not be able to cover the pro-rata capital expected from their under reserved compatriot. And if the sponsoring partner leaves, who will be at the table, when the tough decisions are being made to speak on the entrepreneur’s behalf? If the entrepreneur is not represented in this critical discussion, chances are he/she will end up at the bottom of the allocation priority list.

In today’s environment, it’s best for CEOs to take nothing for granted when it comes to their syndicates. While challenging, a broken syndicate can be successfully managed, if the entrepreneur plans ahead and makes the time to focus on it. How do you manage for this potential challenge?

  1. Try to build a broader base of support inside each of your investor partnerships – look for an opportunity to present to all of the Partners on a regular basis
  2. Always cultivate a small group of potential investors who like your story and might be interested in “stepping in” when there is an opportunity
  3. Don’t wait to the last minute to find out if you have a syndication problem.

How do you know you have a syndication problem? Force the discussion of potential financing as early as possible – a year in advance in today’s environment is reasonable. Finding one of your stronger investors to support you in this process will make it harder for a weak investor to try and kick the can down the road.

In many cases, an investor will not want to make the tough call until the last possible minute. Unfortunately, that will leave you without time to fix the problem, With 6 months notice and proper preparation, you can work through the broken syndicate challenge. Without enough runway, it’s very difficult to pull this off – particularly when new investment commitments are harder to come by in today’s environment.

While syndicate problems are not that common, they are more common in today’s environment than an entrepreneur would expect. Of course, the situation can be materially worse if you have a single investor and he/she catches a “cold”. That cold turns into pneumonia really fast.

Bob Ackerman is the founder and managing director of Allegis Capital (www.allegiscapital.com), a seed and early-stage venture firm headquartered in Palo Alto, California. Ackerman has worked with more than 50 corporate investment partners over the past 20 years as both a venture capitalist and a startup executive. Read his past peHUB posts here

10 Comments

  • Syndicates are financial downside protection of subprime VCs, and increase risk rather than diminish it. An investor who knows what massive social economic value they buy into and the back-planning that is associated with its trajectory will want to own every(!) piece of it. Syndication is for wimps.

    Syndication, rounds of funding are derivatives from the PE world and things we have gotten used to in SV, but are financial instruments that actually hurt the creation of upside. That’s not what Steve Jobs does when he funds innovation inside Apple.

    The financial system associated with Venture is broken (way beyond syndication) and thus discussing the details of its imperfections is moot. To the point of your article: not entrepreneurs need help in how to navigate through its incompatible financial system (that doesn’t perform in the first place), but VCs need help finding groundbreaking innovation that creates large social economic value and re-establishes public trust.

    So, I suggest you start writing articles for and to your peers as to how to replicate your success.

    Best,

    Georges

  • CEOs facing wobbly syndicates should also be aware of high-quality secondary investors that may be able to step in, and add value beyond merely writing a check. However, picking the right secondary investor is just as important as picking the right VC.

    If this is a final round, the investor should be able to invest larger amounts, and have good investment-banker links. If this is an earlier round, the secondary investor may be able to take a Board seat.

    Different secondary investors have different styles and approaches, and this is still a relatively opaque area. We get involved on behalf of VCs and companies, to help match-make with the right investor, and find that each situation is a bit different.

  • The same can be said for angel syndicates. My company is raising its second angel round right now. We had 3 angel groups invest in the previous round. With this current round 1 of the groups is making serious noise that they are “tapped out” with some of their other portfolio companies also requiring investment. I’m potentially looking at a big hole to fill in this round.

  • George –
    Thanks for your comment but I have to disagree. If I go back 25+ years to my first venture backed company – we had a syndicate, led by Sequoia, hardly a subprime VC. Syndicates come about for a variety of legitimate reasons – desire for investor expertise, overall capital requirements exceeding the risk or an investment profile of a single firm, etc. Some times there is a legitimate argument against syndication – raw startup with minimal capital and not enough opportunity for multiple firms. At the same time, the dot com bust showed in spades what can happen when funds get very large, greed sets in, and the investors (even large, well funded, branded ones) get ahead of themselves – a lot of very bad news.

    My guidance is really directed at entrepreneurs -investors’ need to figure out what works for them based upon fund size, sector capital requirements, desire for diversification and anticipated holding periods. For the entrepreneur – my advice stands with the additional caveat to select your investors carefully – money spends the same but all investors are not equal. You may also want to keep in mind another bit of folksy wisdom – when you have one investor – you are en employee. When you have a syndicate, you are more likely to have partners.
    Bob

  • Hi Bob,

    Yes, I expected you to disagree as you have been practicing syndication like many others. It just does not make any sense that if a successful company that produces large Social Economic Value cost at least $25M to build to have syndicates fragment the money from LPs to mitigate risk.

    Instead, fragmentation of dollars from LPs is one of the most glaring evidence of subprime behavior. But fragmentation of dollars, by syndication, tranching, non-competes etc (10 levels deep) is necessary if the company you invest in has only micro-economic value and thus fragmentation is the only way to protect downside.

    Really VC today has got the world upside down, Venture is meant to be high risk and can then establish who is the investor with the right merit to engage in that endeavor. Sequoia is another bowl of wax together, are they a Venture firm or are they doing PIPEs, and I have seen them doing many micro-PE or subprime deals too. See my reference in 2010: The State of Venture Capital to Khosla’s definition of what Venture is (or should be).

    And no, you are not an employee if you have a company that shoots for high Social Economic Value and can find the appropriate investor, because that investor will not have a majority stake in the company. And, Bob it is a very well know fact that the more investors you add to the mix, the harder it will become to succeed, especially with most investors scrambling and nervous to make their ailing funds work (including some you would refer to as non subprime).

    Exactly for all those reasons have I designed a new venture model (and I am discussing with some big LPs) that re-introduces risk to the Venture equation, but this time we’ll deploy by virtue of a new economic model more intelligently.

    Best,

    Georges

  • Hey George –

    The key to syndication is getting it “right”. I have been in syndicates that increased risk – to your point. That said, I have also been in more syndicates that made the difference – either in terms of experience or when the time to develop a company is somewhat protracted and requires more capital/runway. “Most start-ups don’t fail – they run out of money”. Syndication is an art and it’s a challenging one. But based upon my investment experience and operating experience – I still prefer syndication to the lack thereof.

    As for risk – you bet. The earlier you go the greater the potential risk and the more – in my opinion – we are in domain of ex-operating execs as investors. Money does not cure risk – expertise can help.

    I know we are going to be comparing notes one of these days. After all, I started a venture firm 15 years ago because I too saw the need for changes – from a start-up execs point of view… Still see need for further change – or perhaps, a step back to the past.

    As for Sequoia – 30 years ago they were a venture firm – plain and simple…Today… well that is another discussion.

    Bob

  • Hi Bob,

    Yes, I look forward to getting together when I am in town next. Till then, let’s focus our energy and blogs on how to create and discover more disruptive innovation (I started The Venture Company Network for that reason) instead of helping entrepreneurs navigate venture fabrications that are flawed to begin with and simply have proven not to work well.

    I’ll be making suggestions for a new venture compass soon.

    Best,
    -Georges

  • You might have made my day with this post. Thank you so a lot.

  • Thanks for post \o/

  • Super post it is really. My teacher has been waiting for this info.

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