Syndication is an integral part of the private equity business. It’s the process whereby several firms come together to share in the investment required to finance a business. Syndication occurs within financing rounds (e.g., two firms invest $2 million each for a $4 million Series A round) and in subsequent rounds (e.g., a new firm invests $5 million in the same company’s $10 million Series B round, with the two original Series A firms investing $2.5 million each).
VCs almost always syndicate their investments, yet despite the frequency and importance of syndication, it is often practiced with little thought to strategy, implications and execution. In this article we will explore some of the pitfalls and best practices of syndication.
Why do firms syndicate their investments? Simply put, to spread risk and involve new, value-added investors. This is a practice as old as the profession itself. Alas, firms are sometimes tempted to keep follow-on rounds of their “hot deals” without bringing in new syndicate partners.
Some VCs have designated follow-on funds that select their good deals for follow-on rounds, syndicating only their “other” deals. Besides the conflict this may create, many of these hot deals eventually hit upon tough times at some point. Syndication reduces future financing risk by bringing more investors to the table. If the company struggles to raise outside financing in the future, it can rely on the insiders to provide additional capital.
Non-syndicated deals reduce the chances that entrepreneurs can “pass the hat around” the board room table and expect significant support. Syndication in follow-on financing rounds also creates good deal hygiene. A new outside syndicate partner sets an objective valuation and validates to existing investors that a portfolio company is worth continuing to support.
Another key benefit of syndication is the Rolodex and strategic insight a new investor brings to the company. New value-added investors can open doors to flagship customers, business development partnerships, or potential acquirers. For example, a corporate partner could be an excellent syndicate option for a startup with several VCs on its board and in need of a strategic partner to guide its product development or channels strategy.
Value-added syndicate partners are far preferable to “dumb money” investors, who provide financing but offer little ongoing help to the company. These unsophisticated investors can actually be disruptive and destroy value if the company hits hard times and needs a bridge financing or pursues a workout strategy.
Form and function
Despite the frequency and importance of syndication, it is often practiced with little thought to strategy, implications and execution.”
George Hoyem and Bart Schachter, Blueprint Ventures
Many VCs are naturally attracted to high-profile syndicate co-investors in new financing rounds and the “highest valuation” in follow-on financing rounds. This approach, while completely understandable, can be quite shortsighted. A more important consideration is to fit a new investor with the needs of the company. It is critical that the new investors, existing investors and company management are firmly aligned on their view of the company’s strategy, burn rate, capital needs, exit valuation and timing.
Consider the situation where a new syndicate member is motivated to put large amounts of money to work in a start-up where the existing investors are focused on capital efficiency. If the company receives an acquisition offer for $100 million, the existing investors will vote to accept it while the new syndicate partner will vote to hold out for a $500 million-plus exit.
A misalignment of investor goals can not only cause heartache in the board room but can also mean the difference between a successful exit and a dysfunctional failure.
To ensure alignment among syndicate members and management, the board should carefully decide on the proper syndicate targets appropriate to the company’s capital needs. For example, a billion dollar VC fund is unlikely to be interested in writing a $3 million check. Conversely, a $100 million early stage fund cannot write a $10 million check.
Understanding the investment strategy, sector and stage targets for a syndicate partner is critical to saving time and nailing the right partner. Another important exercise is to map the company’s needs against the skills, background and interest of specific general partners at potential syndicate firms. A semiconductor-focused general partner is not a good target for a software company, even if the venture firm fits from a stage and size perspective.
A GP’s capacity to take on a new investment also must be carefully considered. A company looking for significant hands-on assistance from its investors may be disappointed if a GP serving on 10-plus boards is unable the commit time and resources to assist the company sufficiently.
Investors and management are best served by customizing a syndicate to fit the company’s needs and goals. For example, does the company need help building the management team, securing additional customers, building its distribution channels, dealing with governance issues, or coaching the CEO? These are all important considerations in targeting the proper syndicate partners.
A quick case study: We recently raised a Series B round for one of our portfolio companies, SpectraSensors. It’s a Corporate IP Spinout from Jet Propulsion Labs that develops laser-based industrial sensors for the cleantech and energy markets. We introduced SpectraSensors to a potential syndicate partner, Nth Power, a cleantech focused fund with deep relationships in the energy sector. This new syndicate partner participated in the Series B financing and helped deliver a significant relationship with a key industry partner shortly thereafter, demonstrating its value-add of sector relationships to the company.
Method to the madness
We recommend that the board and management team use a collaboration website like Microsoft’s Sharepoint to manage the syndicate tracking process. The company can create and maintain a spreadsheet with all the investor targets, current status and next steps.”
George Hoyem and Bart Schachter, Blueprint Ventures
Syndicating a follow-on investment takes time, sometimes up to six months from initial contact to the closing of the deal. It requires structure and attention just like any other part of the investment process. At Blueprint, we encourage our portfolio companies to follow a fund-raising and syndication process that involves materials preparation, message and presentation tuning, syndication targeting, warm introductions and periodic follow up.
The process begins with the management team preparing the funding presentation and associated operating plan. The presentation should have less than 20 slides and be completed in 45 minutes to appeal to Ritalin-craving VCs like ourselves. We encourage the team to perform dry runs with the existing investors to tune the message and content prior to hitting the road for fund raising.
Next, the board and management team select and contact the syndicate targets. The company should start with a few “lower probability” targets to work out any remaining kinks in the presentation and story.
All VC targets MUST have a warm introduction from someone with an existing relationship with the target firm. Without a warm intro, the odds the VC will meet with the company drop by an order of magnitude and the odds of the VC actually investing are virtually zero.
We recommend that the board and management team use a collaboration website like Microsoft’s Sharepoint to manage the syndicate tracking process. The company can create and maintain a spreadsheet with all the investor targets, current status and next steps. Also, the latest revisions of the company presentation and executive summary can be posted to this site.
Web collaboration allows all company executives, investors and board members to have immediate access to the up-to-date fund-raising materials and the status of each syndicate target. This process creates less wear and tear on the management team and eliminates the need to constantly update the board.
Bring it on home
So what is the best way to hook a new syndicate partner? A company must create a sense of urgency and competition. Most successful financings have multiple term sheets, where favorable terms can be modestly negotiated and the best syndicate partner can be selected. VCs that are able to construct the ideal syndicate do so through careful planning and execution. In the company-building business, fund-raising and syndication are just as important as a great product, customers and management team.
Before syndicating your next investment, take the extra time to map out your syndication strategy. Your portfolio company and your limited partners will be glad you did.
Bart Schachter and George Hoyem are managing directors with Blueprint Ventures, an investment firm that focuses on capital efficient technology start-ups and Corporate IP Spinouts. They may be reached at firstname.lastname@example.org and email@example.com.