LEGAL AND FINANCE Syndication—value in numbers Killu Tougu Sanborn explains why venture capitalists prefer to invest as part of a syndicate, and what benefits this offers startups.

tarting a company is an inherently If a VC fund invests $1 million in a $5 mil- risky business, but starting a lion round of financing, then it loses just biotechnology company is particu- $1 million if the deal fails rather than the full Slarly risky because of the speculative $5 million if it had funded the entire round. nature of the technology and the long and Sharing also limits the potential rewards, costly process of bringing it to market. because the VC only receives one-fifth of the High-risk, capital-intensive businesses are growth of the investment should the compa- limited in their funding options: most con- ny succeed. Because many more companies ventional funding sources such as banks and fail than those that succeed, however, the odds angel investors will not are against investors, and it makes sense for a take on such a gamble. VC to limit the downside even at the expense This is where the venture of losing some upside. capitalist (VC) enters, Bringing the best investor team to the table looking exclusively for also serves the interests of each VC fund. The high-growth and high- more heads and hands around the table, the return business opportu- better the investment, although this means © http://biotech.nature.com Group 2002 Nature Publishing nities. VCs are willing to some loss of control for each VC fund. If a accept the risks that go single VC company provides the entire hand in hand with the $5 million round of funding, then a single VC great rewards of innovative would take a seat at the board of the startup, technologies. Moreover, and the quality of venture investors’ partici- venture funds usually have pation would be limited to the quality of that deep pockets, are under individual. The ideal VC would bring a long

© Market Corbis Stock pressure to make invest- list of attributes to the company (see ments reasonably fast, and, “Attributes of the ideal venture capitalist”), as a result, are comfortable with writing mul- but it is rare for any one person to possess all timillion-dollar checks to startups. of these qualities (and still be willing to work Typically,VCs do not like to invest alone, for a living!); most good VCs have some, but and commonly several venture funds interest- not all, of the desirable attributes. ed in investing in a particular startup will form a VC syndicate. The term “syndication” Leaders and followers may sound sinister—conjuring up images of a Another important aspect of VC syndication tough Mafia underworld—but in VC vernac- is the notion of lead and follow-on investors. ular the term is rather more benign, referring In a financing round with several VCs, it is to the formation of an investor group whose common that one or more must step up as goal is to guide the company as it grows, even- the lead investor. Leading the round means tually providing it with a high return on that the VC can set the price of the round by investment. Because most biotechnology VC offering to buy the company shares at a cer- Killu Tougu Sanborn is a principal at funding is done through syndication, this arti- tain valuation. If the company accepts the IngleWood Ventures, San Diego, CA, which cle offers some insights into the rationale terms set by the lead investor, it can attract invests in early-stage biotechnology and behind, and operation of, syndicates. follow-on investors using the same terms, medical technology companies, primarily in without having to renegotiate the terms with Southern California. Areas of funding include Understanding syndication each separately. Often lead investors are will- biopharmaceuticals, drug discovery tools, Although there are several reasons why VCs ing to share with follow-on investors the due medical devices and diagnostics, and prefer to invest in “packs,”the two main rea- diligence materials (including research pre- healthcare information technology sons are sharing risk and creating the best pared on the company’s technology, validity ([email protected]). investor team. of its intellectual property, predicted market

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size, and business strategy) assembled when breadth of business experience. Often, experi- gives the venture fund not only a percent- investigating the startup as a suitable invest- enced venture investors have been involved in age of its equity but also some control of ment. Although individual investors will do setting up successful companies themselves, the company in the form of a seat on its their own due diligence investigations, follow- sometimes in operating roles (such as CEO, board of directors. on investors may spend fewer resources on chief financial or operating officer, general In a typical deal with several VC investors, their investigations and may choose to trust at manager, head of sales, or head of marketing), the most active investor generally receives a least some of the lead investors’ materials. and are able to contribute priceless wisdom board seat, whereas less active investors are In general, it is the job of the CEO to attract gained through years of experience. often given the nonvoting rights of a board venture funds to the company, although most With the exception of a brief negotiation observer. (A board observer may attend board high-quality,“value-added” lead VCs will help period, when startup and investor negotiate meetings, but does not have a right to vote, in this role. In rare cases, such as that of a very the best terms for each, the interests of the and generally does not attend executive ses- “hot” startup, there may be several lead startup company and its venture investors sions.) Some investors might be satisfied with investor candidates. This poses an interesting are closely aligned: the success of the compa- no board representation at all. VCs with no problem for the CEO, as the choice of lead ny is expected to translate into good finan- role on the board have less control, but they investor will determine the nature of the VC cial returns for the investor once the compa- are also less likely to support the company as syndicate, its operating style, and the resulting ny has gone through an initial public offer- it grows and encounters challenges along the board dynamics. ing (IPO) or an acquisition. Therefore, way. On the other hand, VCs serving on the Some venture funds are interested in building a strong VC syndicate that offers a company’s board of directors also face poten- investing only if they can lead, whereas others are interested only in following. Some funds like to lead startup investments in their own geographical regions, but might only be fol- Although there are several reasons why VCs prefer to invest in low-on investors in deals farther away, as is “packs,” the two main reasons are sharing risk and creating the best often the case with global and national investors. Still other funds will have different investor team. reasons for preferring not to lead investments, such as their strategic focus, in the case of pharmaceutical or other corporate venture broader base of experience than could be tial legal liabilities that derive from their fidu- funds, or their small size, which might pro- found in a single VC fund, and that can more ciary duties (their legal responsibility to man- hibit them from putting in the time needed to surely guide the company to success, is in the age the company and its assets in the best carry out the necessary due diligence. best interests of not only the bioentrepre- interests of the company’s shareholders). In © http://biotech.nature.com Group 2002 Nature Publishing neur but also the VCs, and its importance general, the process of choosing who will take Benefits for the startup should not be underestimated. a board seat follows from negotiation with The formation of a VC syndicate also offers Having a strong VC syndicate is of utmost each VC, and the company’s directors are several advantages for the startup. First, a syn- importance for startups for another critical under the onus of making the best choice for dicate comprises a broader and more knowl- reason: financial backup. If the company the company. edgeable group of investors, including board should, for whatever reason, fall out of favor Sometimes, venture funds that did not members, who can help guide the startup with one VC, there would still be others invest the largest sum will still get board seats. through the tricky early stages of startup and around to bail the company out; if the start- This is often the case when a VC from such a growth. Second, VC syndicates provide up had just one investor, options for bridge fund has something particularly valuable to greater financial security than does a single or follow-on financing would become bring to the board table, such as industry investor, whose departure would be highly severely limited. experience, strong business and/or operating detrimental to the company. background, good knowledge of the local The combined experience of the VCs Round the table industry, or simply the willingness to play an involved in the syndicate serves the interests Additional help provided by a VC syndicate active role in the company. The latter is often of the startup company by providing more materializes through the startup’s board of the case with early-stage regional (local) knowledge, judgment, contacts, cash, and directors. In exchange for cash, the startup funds that are able to serve as the board’s and company’s eyes, ears, and feet on the ground, in contrast to other investors who might be Attributes of the ideal venture capitalist from geographically less desirable locations, Integrity: The venture capitalist (VC) must be honest, fair, trustworthy, and respected by peers, or have less time to spare. have a good reputation among his or her portfolio of investment companies, be patient but Why not give board seats to all VC focused, and be willing to work towards winÐwin solutions. investors? Experience has shown that the Deep pockets: The VC must be able to bail out the startup should the market dry up. most effective boards tend to have no more Industry expertise: Ideally, the VC should have knowledge of the startup’s industry, good judg- than five to seven members, and so a compa- ment, contacts, and be savvy about the technology in the startup’s area of expertise. ny will need to choose and negotiate the Business experience: A VC must bring operating and investment experience from building and managing successful high-growth companies. board roles and decide how they will be dis- Personable: Good chemistry with the CEO, senior management, and other board members is tributed among investors. essential. A typical startup might hold board meet- Hands-on: A VC should be willing and able to actively help the company through its early stages. ings every three months, but in a fast-growing Able to syndicate deals: A VC ideally should have a history of investing with strong VC syndi- company, the board may meet monthly, alter- cate partners. KTS nating between face-to-face meetings and

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conference calls. The frequent and critical to accept money when and where he or she severe blow, because other VCs might ques- interaction between a startup and its investors can find it, regardless of the quality of the tion the value of the company and the CEO’s makes it imperative that the VC syndicate source. On the other hand, a connection with business judgment if they learn that the previ- form a board that works effectively together. a venture fund that is perceived as inadequate ous valuation round was too high, and that This is one reason why many venture funds or worse can be a liability when the CEO tries the company was only able to attract a single, will often invest with “preferred partners”: to attract other venture funds, which would low-quality investor. VCs like to know who they are working with, rather co-invest with more reputable funds. Taking into account the factors outlined how those partners react to pressure, and The situation could worsen should the above, the key question that a fundraising whether operating styles are compatible CEO not only choose a single investor of CEO must answer is: “If I hold out longer to under many different conditions. questionable quality, but also receive an artifi- allow more time for more VCs to complete cially high valuation for the company. For their review of my company, will my chances To syndicate or not example, if the private equity market sets a of attracting a high-quality VC syndicate Not all venture funds syndicate all their pre-money (pre-investment) valuation for outweigh the cost of burning cash and investments. Each venture investor must the company of $5 million, and the investor spending time on fundraising rather than on decide whether to form a VC syndicate or to offers to buy shares at $10 million, the deci- operating the company?”Although syndica- invest alone, because the implications of that sion to accept this sum could return to haunt tion is preferred, should the company be choice can significantly affect the success of the startup: the next financing round could be close to running out of funds, a CEO would the venture fund, how it operates, and its rep- a flat or, worse, a “down round,”at or below be advised to lower the company’s valuation utation among its peers. previous round’s valuation. to try to attract investors. Similarly, whether to accept an investment In the short term, a high valuation may It is important to recognize that a VC from a single VC, or to hold out until a strong seem good for the startup, because it means syndicate is an evolving entity—as new VC syndicate is in place, is a critical decision that the investor bought fewer shares and paid financing rounds bring in new VC funds, so for a startup. On the one hand, startups are more for them than if the (lower) market val- the syndicate grows and changes, and the constantly strapped for cash and are in danger uation had been honored. However, in the board evolves. Which investor to accept and of running out of money should new invest- long term, this decision may cost the startup which to reject becomes a board decision ments not materialize in a timely fashion. The dearly. Both the company’s reputation and its once the company no longer holds the CEO of a startup is therefore under pressure ability to raise future funds could suffer a majority of shares. © http://biotech.nature.com Group 2002 Nature Publishing

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