I would say that most venture backed startups require additional capital after the seed or Series A round. That isn’t a bad thing and typically part of the plan. And everyone knows that going in from the founders, to the early employees as well as the earliest investors.
At some point the company then needs to raise additional capital. (I’ve already written about how to focus your efforts with that early capital so i wont discuss that topic in this post.)
It is very common to seek out a new lead investor for the new round of capital. Why?
-sometimes the early investors don’t have the ability to “fully fund” the company to profitability on their own. Consider Facebook, their earliest investors didn’t have the ability to fully fund the company (company has raised hundreds of millions of dollars to date). That was part of the plan and obviously worked out for everyone.
-sometimes the early investors and the company want a new investor to price the stock. The theory goes that the market will set the price and the insiders shouldn’t do that to avoid any potential conflict of interest.
-sometimes founders and VCs seek out new investors based on the value add that the new firm/partner brings to the table.
The Inside Round: good or bad?
There are times where a follow on financing does not include a new VC firm. The new round is financed by the current investors. This is known as an “inside round”.
It used to be the case that an inside round often meant something was wrong. It meant the company was unable to raise money with a new outside lead investor due poor operating performance, team, market, whatever.
And sometimes that is a correct read on the situation.
But I believe that is no longer universally true.
In fact, an inside round could mean the company is stronger than ever. The company could be profitable, it could be capital efficient, or it could be crushing it. As a result the current investors may feel very comfortable offering the company a higher valuation for the stock which is compelling to the founders.
And that shouldn’t be a surprise if you think about it. After all, the early investors should know more about the company, team, performance and opportunites than most new investors. Further, if the offer is compelling to the founders, then the inside round will also save the company significant time and energy since fund raising is a big effort.
I’ve seen a number of inside rounds over the past few years in some great companies. And I’m thinking we are going to see this increase in the future – especially with startups that are capital efficient.
I’m sure a number of outsiders will see those inside rounds and see weakness. But it may very well be the other way around.