Sometimes there are many new investors who want to invest in a company, but none are willing to make the first offer. None are willing to lead the round. I’m using the word “lead” here to describe the investor making the first offer. This doesn’t mean that they also have to contribute the largest investment amount, although this can also be the case.
The reason for this investor paralysis is that leading a round is uncomfortable. It requires you to step out from the crowd and show conviction in the company. It also requires you to set the terms for the round. Although these terms may later change as the round’s other investors also chip in with their requests, they serve as an anchor for the rest of the discussions.
In times like this, we’ve found that an easy way to get the ball rolling is for an existing investor (or founder if the company doesn’t have investors yet or it does but existing investors refuse to lead) to lead the round. An existing investor has the greatest knowledge of the company’s past performance and likely future trajectory, so they’re best positioned to show conviction in the company. If they don’t believe in the company, it becomes more difficult for new investors to believe.
As for the terms, an existing investor may be biased in setting the terms. If their investment amount in the new round is such that they have more to gain by setting a high valuation which shows a strong mark-up for their existing investment than they have to lose from making their new investment at this high valuation, they may be tempted to inflate the valuation. This is shortsighted because such divergences between a business’ fundamentals and its valuation tend to converge over time. But it does happen. However, this high valuation defeats the original purpose of them leading the round because it makes it less likely for new investors to jump in. So existing investors are incentivized to set, even if somewhat aggressive, largely reasonable terms.
When an existing investor steps up to lead the round, this places time pressure on new investors to join. The train is no longer sitting at the terminal. It’s leaving. And if new investors fail to act, other investors may take the remaining allocation and there may be no room left. So this motivates them to act.
Also published on Medium.