VC signaling

We’re talking about VC signaling in early-stage these days, and I’ve been reading to understand more about how founders should relate to this. Figured I’d share a condensed version of what I’ve found out so far.

First: VC signaling is what happens when you take money from a VC, and they choose not to follow up their investment in later rounds. If they have inside information and choose not to invest more, why should someone on the outside take a bet on you?

If you’re a founder who just raised capital, you’ll be in one of three categories next time you raise money (more in Mark Suster’s brilliant post on this):

  1. Everything sucks. You have failed with your plan, missed all targets. Nobody will invest more in your business, including you. You gave it a shot and it didn’t work out. Nothing matters (including VC signaling).
  2. You’re like Facebook. You’re crushing all milestones; everyone wants to work for you, buy your product, buy your stock. You might have concerns, but not regarding VC signaling.
  3. You’re almost there. You’re doing okay, but not great. With more resources, you’re convinced you will pull it off. This is where most companies are, and where you potentially should be concerned about VC signaling.

Since you should hope for the best but plan for the worst, you should consider VC signaling before deciding who to pitch.

First, consider what the investor’s preferred entry point is? (discussed more by Brad Feld). Some investors do the thorough assessment right away, as they view the seed investment as either the only or the first round of several. If this is the only investment they do (like us), ensure they are consistent with this approach. One exception and every other portfolio company get a bad signal. 

If this is the first of several financing rounds they plan to do, explore whether they need an outside lead in the next round, or if they will take it? If they plan to lead, what milestones do you need to reach in order for this to happen? If they need an outside lead, how do they decide whether or not to follow/take pro-rata?  

Other investors consider seed deals to be options; a foot in the door to get more information – and postpone the real assessment until next time the company fundraises. You should be especially alert when approaching this group, as the risk of signaling is higher. Chris Dixon elaborates

“_when you take any money at all from a big VC in a seed round, you are effectively giving them an option on the next round, even though that option isn’t contractual…Even in the good scenario when the VC does wants to follow on, you are likely to get a lower valuation than you would have had you taken money from other sources of funding_“.

This is because new investors expect existing investors to follow. Jason Lemkin explains; ”_The bigger the brand of the fund, the more important it will be [that they follow]_”. By already being shareholders, brand name VCs have leverage in the following round. You could say that the more tempting is to bring an investor onboard early, the more harmful if said investor doesn’t follow. Which is somewhat counter-intuitive, but true. There’s examples of VCs offering to sell back shares if they don’t follow, but my impression is that’s not the norm.

To mitigate this risk, make sure you discuss potential investors’ seed strategy before taking their money. But further, don’t overthink it too much. Signals exist everywhere, regardless of how you go about fundraising. Going back to Mark Suster’s post, that has a few examples of other signals:

You’re on your second company. A prominent VC funded your first company but isn’t currently investing in this company. Think that’s not a signal? Think again.

Or you’ve never done a startup but your last boss from Google, Facebook or Yahoo! is now a VC. Many are. They didn’t invest in your company? Signal, signal, signal.

OK, so your boss didn’t become a VC. You were a VP at a startup company that sold for $100–200 million making the founder very wealthy. You’re startup raised angel money and is now looking for VC. That founder wasn’t one of your angels. Think that the VCs looking at your deal won’t wonder why? Think they won’t call him? Signal.

In conclusion, signals exist and you should be wary of them when you fundraise. Discuss this with potential investors, and you know what to expect. Then go back to focusing on what you can control, which is the performance our your own company. Do everything you can to become a type 2 company, and you don’t have to worry about signaling whatsoever 🙂