Sometimes when raising funding start-ups feel like they’re the prettiest girl at the prom, swatting of suiters with a flirtatious flick of the hand. As get closer to closing the funding round, which may have felt like it took an eternity to pull together, another larger and later stage suitor (investor) enters the fray. They express an interest to participate in the current round and have no interest in waiting for a subsequent round that might be a similar size and stage that is more of a fit to the other companies in their portfolio.

We have had this happen to a couple of portfolio companies recently. While I’d like to think that the fundraising environment is slowing down as valuation have come off, it feels like there is still a significant amount of capital that has been raised by growth stage funds in Southeast Asia.

As a result, there’s a lot of capital that still needs to be deployed. There were only a limited amount of VC backable businesses that were started in the past decade or so, which means that there is only a limited amount of VC backable businesses that can be invested in by an increasing amount of larger growth funds. Based on various surveys, there was over USD10bn that was raised by venture capital funds in 2021.

As a result of this, the growth funds are willing to stretch their mandate and look at early-stage opportunities in the hopes of encouraging companies to grow into their mandate within their investment period. This causes several issues for founders to think about, such as, “What’s the typical size of their investment tickets?” and “What happens if they don’t follow on?” amongst other questions.

If a growth-stage fund typically writes USD5m tickets but they are willing to write a USD500k cheque to be able to participate in this round (because there’s not enough space etc.). Then there are two issues that could potentially occur:

The fund doesn’t follow-on

Most funds will claim that they are just dipping a toe in the water and will follow on in the next round, which will give external investors additional comfort. But what if they don’t follow-on in the next round? The potential negative signaling from an existing growth investor that doesn’t want to invest in your growth round could be enough to sink a subsequent round.

The fund writes off the investment at the slightest sign of trouble

If you’re raising a USD1-3m round and the growth-stage investors is coming in with a USD500k ticket, then this is going to represent a relatively small proportion of their fund. Unless they do follow-on, it will be hard for that investment to make a meaningful contribution to the performance of their fund both on the upside and the downside.

If they were to write-off that investment, it wouldn’t move the needle very much. If they are investing out of a USD100m fund, then USD500k is only going to represent 50 basis points, hardly enough to worry about and very easy to write-off when things don’t pan out as planned.

At smaller funds, the smaller tickets represent a larger amount of the total available capital and likely represent a meaningful amount of capital for the general partners. This means, they are going to do the work to try to help founders get to the next level and will be rolling up their sleeves when things get challenging.

There have been several occasions, where I have heard of later-stage funds writing-off their investment in “out of mandate” investments at the slightest sign of trouble. It makes sense if you think about it – it’s not going to meaningfully impact their incentive structures (read: carry), whereas the opportunity cost of spending time trying to resolve any issues in a small corner of their portfolio could mean larger prospective portfolio companies are missed.

There are two a couple of the key reasons why it may be a bad idea taking an investment from a later stage VC. I don’t feel like it’s worthwhile giving a list of reasons about why you should take their capital as these will be showered on any potential founders that find themselves being wooed. There are undoubtedly other reasons for accepting a cheque from a later stage VC than just the capital but those qualitative matters need to be weighed carefully. However, it is worthwhile discussing some of the ways that founders could potentially deal with additional interest from later stage funds.

How can you deal with this situation?

Unless you’re dealing with a priced round, which makes matters significantly more complicated, then you have the option of taking in capital on SAFEs with increasing valuations. While this isn’t often seen in Southeast Asia, it’s very common for start-ups in other developed markets. There are a number of companies that will raise money at ever increasing valuation caps on SAFEs with the valuation cap rising each week or fortnight.

While this option isn’t palatable for most investors, it also encourages them to act and take some thought leadership lest they be stuck with a higher valuation than the last investor or squeezed out of the round completely. We didn’t see of lot of this behavior in the last bull market in Southeast Asia, likely because it wasn’t culturally tolerated.

On the other hand, founders who have done the dance in the past will be quick to tell you that, “It’s never going to be easier to raise cash than it is at the seed-stage of a business.” This is true because at the inception of a business, investors are investing in the team and the idea. There isn’t the same level of financial information that investors are able to pout over to triangulate their investment decision. As a business accumulates more “investment collateral” there are more items on a due diligence checklist that need to be marked before closing a successful fundraising round.

Conclusion

There’s a tendency in Southeast Asia for investors to lack thought leadership when it comes to investing in early-stage companies (maybe this phenomenon is further spread but I can’t comment on other markets). As a result, there are typically a lot of investors that will want to participate in a round, when a “desired investor” has indicated their interest in participating in a round. This results in two issues for founders; firstly, there is a lack of interest until they can secure a lead. Secondly, when a lead is secured, there are a lot of investors that are interested in participating in the round. To reward those investors that are willing to take leadership in a round and discourage “followers”, founders could use SAFEs with rising valuations.