LPs Should Heed the Do’s and Don’ts of Syndication –

In the aftermath of the tech bubble inflating and then bursting, GPs and LPs alike are once again discussing syndication. At conferences, in annual meetings and in private conference rooms the topic of syndication is back with a vengeance. Without any reservation, and in syncopated rhythm, every GP can breathlessly repeat the syndication mantra: “Syndication is good, we love to syndicate.” One can easily picture “The Graduate,” with a young Dustin Hoffman, as Benjamin Braddock, getting his first lecture on venture capital.

Mr. McGuire: I just wanna say one word to you. Just one word.

Benjamin: Yes, sir.

Mr. McGuire: Are you listening?

Benjamin: Yes, I am.

Mr. McGuire: Syndication.

Benjamin: Exactly how do you mean?

Mr. McGuire: There’s a great future in syndication. Think about it. Will you think about it?

Benjamin: Yes, I will.

Mr. McGuire: Shh! Enough said. That’s a deal.

Syndication is back because investors once again appreciate its system of support, validation and checks and balances. While most GPs agree that syndication is good, different models for implementing it are emerging at different firms. Most firms offer syndication strategies, but not every syndication model serves to provide the system of checks and balances that the industry first created in the 1970s.

In the “good ol’ days,” syndication started on Day One. Venture firms would invite each other into a first meeting with an entrepreneur and use the friendly exchange as an opportunity to vet teams and concepts. Eventually, two or more of the firms would move forward with the project.

Syndication didn’t stop on Day One. Early-stage VCs would seek partners to share the risk and work of early-stage projects. As companies progressed, additional syndicate partners would join at later stages, bringing along a different set of skills and outlooks, which would further help the company and the board share the risk and pave the ground for the ultimate reward.

Typically three financial rounds would bring three different syndicate partners at each step: early-stage, later-stage, and mezzanine. At each of these steps, new investors would join the old and bring with them a new set of relationships and perspectives. An early-stage investor might excel at working with the entrepreneur to hone strategy, hire an important executive or bring in an important customer. A late-stage investor might be more financially focused, driving for revenue, earnings growth, expansion and reducing risk in addition to making introductions to buy-side analysts who would ultimately take the company public.

What Changed?

The new syndication ethic does not purport to alleviate any of the risks that made syndication desirable in the first place. The distinction between early- and late-stage syndicates has all but disappeared, as has the limited partner cognizance to the historically divergent skills required for early- vs. late-stage investors.

Instead, some GPs are calling for “fully funded syndicates” as a way of chanting the syndication mantra. A fully funded syndicate, according to those who proselytize it, is a syndicate of large firms who join together in backing an early-stage project by agreeing to fund every subsequent financing event “around the table.” In other words, assume a company in a Series A round seeks $6 million. The company might need up to $50 million of lifetime capital. In this example, three firms agree to syndicate and each writes a $2 million check for the Series A, then reserves $14 million for follow-on.

This strategy is positioned aggressively by many GPs as the panacea to the financing risk of emerging companies. By aligning all the deep pockets on Day One, agreeing to the total amount of capital that each pocket will reserve, and removing the massively time-consuming constraint that outside fund-raising poses for the company’s management every 12-18 months, the company is left to do what it does best: build product and create value.

For a VC, this strategy is said to mitigate at least some of the financing risk. For example, as an early investor in a company, you want to know who you are getting involved with for the next four to six years; ensure that your involvement is with like-minded people who have both the courage and stamina to stay with a project for as much and as long as it takes; and ensure that subsequent later-stage investors will not benefit from all your hard work by coming into a company after much of the risk has been removed. In many cases over the last several years later-stage investors who ended up owning the majority of the company recapped projects that burned through $100 million of “early-stage” money.

For all of these reasons and more, fully funded syndicates are finding their way into the PowerPoint presentations of many GPs.

Checks Without Balances

Unfortunately, the fully funded syndicate delivers the precise opposite benefit to LPs. Instead of reducing the project risk, as it does for entrepreneurs and GPs, fully funded syndicates dramatically increase the risk to LPs. The reason is precisely why syndicates came to play in the first place. Their purpose was to provide a system of support, validation, and checks and balances across different firms and stages that can bring aggregate value to an investment project. A fully funded syndicate eliminates most, if not all, of the checks and balances in the system, to the great detriment of LPs.

By agreeing up-front to support a project during its lifetime and not seek outside capital, VCs fundamentally eliminate the intermediate milestones that make risk capital a profitable proposition to both investor and entrepreneur. Of course, a fully funded syndicate will profess to apply some level of determined discipline to milestones that would trigger follow-on financings. In other words, the entrepreneur is not to assume that dollars will continue to be wired, only that, should money continue to be wired, it would come from the original investors.

The reality is much different. For starters, as difficult as it may be to define realistic milestones in an early-stage venture, it is even more difficult to meet them. The result is that 12 to 18 months after initial funding, the syndicate faces a difficult decision: Should it continue to fund the company. Unfortunately and quite typically, the answer is not predicated by demonstrable results and in those few cases where it is, the answer is simply to fund.

The vast majority of deals, however, force their investors to make a subjective decision regarding ongoing funding. Regrettably for the company, the fully funded syndicate has not allowed it to build the “hygiene” needed to gain outside funding validation. For more than one year, the CEO was told, “If you need money, we’ll have it for you. You should not waste your time with other investors.” As a result, the decision to fund becomes entirely arbitrary without the danger of “competition” originating outside the company.

After the initial funding, the syndicate faces several more decisions. One of the firms may begin to see the early signs of a company that is simply not delivering on its promise, or a market not developing as rapidly as originally thought. It may have second thoughts about the internal round. This firm is likely to face pressure from the others, to the point of ostracism, should it not continue funding. For many, alas, funding of early-stage projects is as much an emotional decision as it is a rational one. The partner who wants to “take the hill” and continue funding almost against all evidence is commonplace. Rare is the fully funded syndicate partner who can coldly walk away from an investment, an action that could exclude him from the club.

LPs should learn to diagnose and monitor this kind of strategy, since it provides little upside to their investment. Portfolio reviews or evaluations become subjective dialogues removed entirely from the likelihood of a company’s success. A GP could easily rank a company as “safe” because an inside round has just extended its runway by 12 months. However, without the validation of a new, outside investor, LPs will never know how this company is really doing.

Furthermore, this process could continue several times over and build on itself. Once a company has violated the age-old rite of seeking outside backing in subsequent rounds, it becomes impossible to re-introduce it later. This helps explain why we see so many defunct companies having raised $50 million or more in insider money before seeking bankruptcy. At any point during that company’s life, an LP may have asked, “How is the company doing?” And a GP would have answered. “Great. So well that we don’t want to share the wealth’ with outside investors and we, the current investors, will continue to support it because it’s doing very well.” As most LPs now recognize, more often than not it often turned out that the company was not doing well. The problem was that insider-led financings never allowed them to see that.

Alternatives Models

Blueprint Ventures recently backed a company that turned away a fully funded syndicate. The entrepreneurs – experienced managers with a history of success – became concerned at the overhang of money that was “promised” to them by a single set of investors. Instead, they sought to find a classic syndicate, which brings together two or three early-stage investors with limited cash infusion in the Series A. Later, should the company be successful, management will seek additional outside capital at an upside valuation.

After we closed the first round and hired a very experienced CEO to take over the helm, we summarized his bonus milestone with a very simple objective: “Raise a minimum of $10 million in a qualified Series B financing from an outside lead, at an up round valuation from Series A.” Most CEO bonus structures include a complicated series of milestones that are difficult to state, monitor, and meet. This incentive structure was simple and to the point. Should the company fail in this objective, our LPs will know how to value the company. Should it succeed, we will have accomplished more than just raising money. We will have done our small part in restoring syndication to the way it should be.

Bart Schachter is a founder and Managing Partner of Blueprint Ventures and George Hoyem is a Partner with Blueprint, an early stage technology investor based in San Francisco.