Do VCs Use Inside Rounds to Dilute Founders?

The following post comes to us from Brian Broughman of the Maurer School of Law at Indiana University, Bloomington, and Jesse Fried, Professor of Law at Harvard Law School.

In our paper, Do VCs Use Inside Rounds to Dilute Founders? Some Evidence from Silicon Valley, recently made publicly available on SSRN, Brian Broughman and I examine the role of inside financing rounds in VC-backed firms.

VCs typically invest through several rounds of financing. Each round is separately negotiated and priced. A subsequent (“follow-on”) round of financing could be provided by either (a) the firm’s existing VC investors exclusively (an inside round) or (b) a group led by a VC fund that did not invest in the startup’s earlier rounds (an outside round). Historically, most follow-on financings were structured as outside rounds, in part to mitigate conflict between the entrepreneur and existing VCs over the value of the firm. In recent years, however, more than half of follow-on rounds have been structured as inside rounds.

A number of commentators have suggested that VCs with sufficient control over the startup may use inside rounds to sell themselves cheap stock. In fact, while litigation by founders against VCs is rare, many of the lawsuits that are filed allege that VCs used an inside round to dilute the firm’s founders. Alternatively, VCs may use inside rounds as a form of “backstop” financing: when outside VCs refuse to invest in the firm on acceptable terms (or at all), current VCs may be forced to resort to inside financing to keep the firm going. Unfortunately, there has been no empirical study on whether VCs frequently use inside financing rounds to dilute founders or for other purposes.

To shed light on the purpose and effect of inside rounds, we collected data on 90 follow-on financing rounds from 45 Silicon Valley firms that were sold in 2003 or 2004. Our data covers the lifespan of each firm and includes, for each round of financing, (1) the identity of the VC investors, the (2) terms of financing, and (3) the economic returns generated from the sale of the firm. We also collected qualitative assessments from the founders on the circumstances surrounding each of the 90 financing rounds.

We find that inside rounds are more likely to occur in firms where VCs lose money. Consistent with backstop financing, we also find that inside rounds increase when market conditions deteriorate. The picture that emerges is confirmed by the founders’ own accounts of their firms’ fundraising efforts. According to almost every founder in our sample, VCs consistently sought outside financing and resorted to inside rounds only when outside financing was not available.

Even if VCs do not conduct inside rounds by choice, they may still use inside rounds to dilute founders by setting the valuation too low. To address this possibility, we compare the valuations used in inside rounds to those used in outside rounds. For each firm, we determine the relative valuation of the last financing round by comparing the assigned valuation to the best available proxy of what the firm was actually worth at the time: its eventual sale price. If VCs use inside rounds to dilute founders, we would expect the relative valuations of inside rounds to be lower than the relative valuations of outside rounds. In fact, the relative valuations of inside rounds are higher than in outside rounds, and in various regression models the difference is both economically and statistically significant.  We perform various robustness checks on these results and reach the same results: inside rounds are overvalued relative to (and yield lower returns than) outside rounds. We also find evidence consistent with valuations being driven by litigation considerations.

All in all, we find little evidence of the use of inside rounds to engage in dilutive financing.  Instead, we find that inside rounds are generally used for backstop financing – to support marginal firms that cannot attract outside investors, and when VCs conduct inside rounds they tend to use relatively high valuations, perhaps to reduce litigation risk.

The full paper is available for download here.

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