How to evaluate late-stage funding sources

As a later-stage company, you will have a broader set of investors to choose from than you did in the early days. If you are a high-growth company choosing from a strong crop of investors, consider the following factors when selecting a later-stage funder:

Follow-on capital. Some late-stage funds can deploy hundreds of millions or billions of dollars. Is the fund able to follow on as you raise larger rounds?

Public market impact. Some public market investors, such as T. Rowe Price and Fidelity, send a strong positive market signal, as they are known as long-term holders of public equities. As you go public, they may hold your stock over the longer run, and this may impact your post-IPO perception and performance.

Note: At least one public market investor recently began publicly listing month-by-month changes in value in their private market portfolio (which makes no sense—can you really change a public company’s valuation on a monthly basis?). This has caused issues for these companies in follow-on fundraises, secondaries, and employee morale.

Strategic value. Late-stage investors may have specific industry knowledge, partnership/introduction potential, or country-specific knowledge. For example, when entering the Chinese market, Uber originally set up a stand-alone subsidiary through which money was raised from Chinese funders who can help with government relations and other aspects of entering China. An investment from a strategic investor can also solidify a key partnership. For example, when Google signed the deal to power Yahoo! Search (at the time a company-making move), Google took an investment round from Yahoo!

Simple terms. Some late stage private equity firms or hedge funds ask for complex structures or extra liquidation preferences when doing investments. Terms may include additional issuance of shares under an IPO price, extra clawback of value during a sale under a certain price, and the like. If you are able to keep terms simple that is often worth the trade-off of also getting a lower valuation.

Board seats. A number of late-stage investors are willing to invest without taking a board seat—something DST pioneered. Avoiding a bloated board may become challenging as the number of rounds a company completes grows.

Ability to buy secondary stock or drive tenders. Some companies will couple a primary financing event (buying preferred stock) with a secondary sale or tender (allowing employees, founders, or early investors to sell part of their stake). Depending on the fund they may or may not have the appetite or the SEC registrations

How DST revolutionized late-stage investing

The three biggest innovations in venture investing in the last 10 years include (in no particular order) (1) Y Combinator and the early-stage revolution, (2) AngelList Syndicates and distributed angel networks, and (3) DST and late-stage investing.

Yuri Milner and DST revolutionized late-stage investing by taking large stakes in a number of companies, starting with Facebook in 2009, with the following characteristics:

  • Investments could be primary, common stock secondary, or a mix of the two.
  • Investments were entrepreneur-friendly, with no board seat taken.
  • Investments were typically large in nature and could total $1 billion or more over the lifetime of the company. A company could effectively do a private IPO.

While this style of investing is now more commonplace, at the time DST entered the market with its Facebook investment its approach was quite radical. In those days, later-stage investors typically asked for complicated preferences, board seats, or other ways to control the company. A number of funds have since copied DST, but the firm seems to always be a step ahead of the rest with its global diversification and ability to cherry-pick some of the best companies and investments.

Key Terms

Late-stage financings are not that different from earlier-stage rounds for the key terms to consider. However, at the later stages the two most important items you’ll weigh tend to collapse down to preference and board membership.

Preference. While top-tier early-stage investors tend to have a clean preference structure (i.e., non-participating preferred 1), private equity firms and family offices may ask for unusual preference structures that effectively convert an equity round into a debt round. For example, if the company and investor cannot agree on valuation, the private equity fund may ask for a 2X or 3X preference, as well as a ratchet on the next round. Similarly, later-stage investors may put in special provisions around IPOs (e.g., if the IPO prices under a certain valuation, or takes longer than six to nine months, the investor gets extra stock), future fundraises, or other aspects of the company’s life cycle. In general, you should avoid these special terms if you can, although you may not have the chance to do so, especially if your valuation starts to exceed your core business metrics or capital is scarce.

Board membership. As with all financings, a key element to think through is whether or not to add a board member as part of the round. In general, larger boards are harder to manage. However, late-stage investors may bring a perspective to the board that has been lacking up to this point—around financial discipline, for example, or the state of the public market. This perspective can be helpful or destructive, depending on the board member and broader company context. On average, later-stage investors will be more numbers/revenue/margin driven, and this can drive a company down either a very good or a very bad path.

Additionally, later-stage investors may not be as used to dealing with the many “oh shit” moments that a startup typically faces in a rapidly evolving market, with a shifting product road map, and a changing org structure. Some late-stage investors are notoriously hands-off/founder-friendly (e.g., Yuri Milner and DST). However, many are used to “safer” late-stage investments and can cause trouble for a high-growth startup that’s still rapidly evolving.

Choose your board members carefully! And consider avoiding new additions altogether, unless your late-stage investors can help in unique ways. Depending on the dynamics around your fundraise, you may not have a choice—e.g., if the investor requires a board seat and you do not have a good alternative option.

Before adding anyone as a board member, make sure to (1) do due diligence on her past investments and board seats; (2) have frank conversations about company direction and expectations; and (3) decide if there are other ways to give late-stage investors meaningful impact and access to company information—without adding a board seat. Alternatively, a late-stage investor may be able to add enormous value to your board and even help to clean out poorly performing early-stage investors. See the section on Removing Board Members for more information on this. 2

One word of caution

One downside of dealing with private equity investors is their tendency to throw around their weight or act in ways not aligned with the traditional Silicon Valley venture capital ethos. One PE group in particular is known for signing a term sheet, then three weeks later trying to renegotiate those terms (after the company has told other investors it has selected a lead and lost leverage on negotiation). This firm got kicked out of at least one “unicorn” round recently and is known as a bad choice. However, their shenanigans are not fully public, so tread carefully when dealing with PE firms. There are some perfectly good actors in the private equity world (e.g., KKR) but also a small number of bad actors when it comes to venture.

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