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Most people involved in the start-up scene know all about seed
rounds and Series A or B financings. But, unless you've run into the
situation yourself, very little is said about a variant on follow-on
rounds called a "pull-through." While these tend to happen more often
in challenging times than in good times, a pull-through just might get
you and your company out the other side of a problem period to see happy
days again.
Imagine one of these situations - or a blend:
- You have raised venture capital from a couple of firms, perhaps
over a round or two. Your company has hit a few bumps in the road and
now you have some investors willing to write the next check, with others
not or not so sure.
- You have raised venture capital from a couple of firms. You are
doing a follow-on round, with a new outside lead investor to price it,
but one of your existing investors has run out of cash, or their fund
has gotten so old they can't / won't invest.
- You have raised venture capital and hit a few bumps along the
way. Your investors are still hanging in there for the next round, but a
couple of early employees / founders have departed. They own a
material amount of the Common stock, but are no longer adding any value.
This is inhibiting your ability to offer meaningful shares to
new people ready to do the heavy lifting.
The challenge becomes to attract the new money in a way that
provides incentive investors to play and punishes those who don't, while
rewarding employees who are pulling their weight yet punishing those
who aren't. If you are not careful, you can end up chasing your tail
with a simultaneous equation problem with more unknowns than equations.
But, there are some simple ways to approach this that savvy investors
know, that entrepreneurs should know.
However, before I get into the approach below, it may be useful to review a few key terms of the art:
- Pre-money value: The value of your company BEFORE new cash is
invested. For example, if you have two million shares of stock
outstanding, and I am ready to offer to invest in you at $1 per share,
you have a $2 million pre-money value. (2 million shares times $1 per
share)
- Post-money value: The value of your company AFTER the new
cash has been invested. In the example above, if I now invest $1
million at $1/share, that buys 1 million new shares. You now have three
million shares outstanding, at a value of $1/share, for a post money
value of $3 million. Simply put: post-money = pre-money plus new cash.
As you will see below, the post-money value from the most recent
round (hopefully) is a floor for the pre-money for the next round, or
otherwise that next round would be at less than the $1/share in our
example, and the risk and time taken by the investor would not have been
rewarded.
So, onward to the story...
Recently, I was crafting one of these pull-throughs (mostly the
first situation above, with a little of the third thrown in). The firm
has three VCs and a strategic investor. The strategic had reset its
attitude towards venture investing, and was probably not going to
participate. One of the other two VCs had a partner change on the deal,
and so pride of authorship was gone. The bumps the company was
experiencing were giving that new individual serious second thoughts.
Finally, a founder had departed with a large block of vested stock.
The lack of performance to plan was scaring off new investors, at least
for now. The only way to finance the company was with an inside round.
In addition, we had to make it clear that without new money, the
company would have to be shut down, and all investors would lose
everything. The goal was to get as many to play as possible.
What I did was put together an inside "Series B" financing that did the following:
- The pre-money value was set to market, which was (sadly) below
the last round post-money due to the problems in execution the firm had
experienced. In this case we calculated the new pre-money by looking at
what the new implied post-money would be (again: pre-money plus new
cash going in), then imagining the company made its plan for the next 16
months, and then guessing what the pre-money value of the next
round would likely be off of the company's 2011 performance. The
post-money from this round could not exceed the pre-money for the next
round, unless we were going to be foolish enough to set ourselves up for
yet another down round. We were not. This was a carrot to the
investor syndicate.
- The previous round was offered to be pulled though into the new
lower-priced Series B for those who participated in the new round, but
only 33 cents on the dollar. This incented the original investors to
play, without crushing the existing employees. Another investor carrot,
albeit a partial one.
- For those not participating, their original Preferred was
converted to Common, and reverse split 10:1. That's a wipe out. In the
end, the Series A would cease to exist. As opposed to the carrot, this
was the stick - a BIG stick.
- We did the math and for a few key employees we needed to refresh
their Common options somewhat, and so we had to build up the option
pool. We didn't bring them all the way back to where they were (everyone
in this scenario shares some pain) - but we did to appropriate levels
for their roles, after a typical Series B.
- The departed founder was diluted by all this, of course,
although they still held a share of the company that could be of
material value if the new team finally delivered on the original vision.
This is one of those classic cases where the "right answer" is for
everyone to end up equally uncomfortable, but for the company to get the
cash it needs to continue on. If the firm can now "pull through" on
its operating challenges, the pull through financing will have helped
make that happen.
While a pull-through financing isn't an option in every situation
where you have a syndicate with differing appetites or ability to
invest, it's another tool in the VC tool kit that can help entrepreneurs
and their backers get through the proverbial knot hole.
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