by Aaron Harris9/19/2019
Recently, while discussing a preemptive funding offer with a company, we noticed that the offer was more dilutive than expected. Wondering if this was an outlier, we looked at 120 US Series A rounds from our portfolio over the past 18 months to see whether or not preemptive offers were generally more or less dilutive than process driven rounds.1
We were somewhat surprised to discover that, on average, founders taking preemptive offers are taking ~1.4% more dilution for less money.
There’s a clear logic here, but it runs counter to what we expected. Our initial assumption was that investors need to offer founders better than market terms to convince them not to test the market with a process. This should almost certainly be true given that the companies that are preempted have obvious leverage – the investor is telegraphing a belief that the company is hot and would do well if exposed to other investors.
The reality is slightly more complicated. Investors that make preemptive offers are capitalizing on two different founder incentives. The first is a Risk Premium as expressed by a founder’s preference toward taking a sure thing – the offer in hand – vs. risking being told “no” by the market.
Founders who use this as the primary driver for taking a deal are making a mistake. In nearly all cases, an investor willing to preempt a deal is willing to make a formal offer in the course of an actual process. Once an investor makes up her mind to do a deal, she is emotionally bought in and will fight to get it in a process. Good investors are also highly competitive, and enjoy beating rival partners.2
The second incentive could be called the “Work Premium.”3 This is the price that a founder is willing to pay to avoid the considerable work of fundraising via a process. A full fundraise can take 6 months or more, and is hugely distracting. For a business that is doing well and scaling, this distraction can hurt growth and the company. This is a tough premium to value, though you could think of it as the value of the amount of burn you’d take while raising + the delta between the growth of your KPI when focused with extra capital vs. the growth while distracted by fundraising over the time of the fundraise, multiplied by some factor to account for the improved price you’d get as a result of that growth.
However this works out, it is unlikely that the numbers will be significant except in cases where a company unexpectedly inflects into a rapid adoption curve with extremely limited capital and time.
Importantly, pre-emption looked different in each scenario. In certain cases, founders had to build out a full deck and pitch to the full partnership; for others the partnership meeting was a formality; and for the final group, one or more investors approached them with a term sheet already in hand.
One of the crucial differences we noticed was the number of investors which companies talked to. Some only talked to a single investor, while others used their first pre-emptive term sheet to run an accelerated process with a few investors that were already in the loop. When we split these two groups and analyzed the data, we found that companies that talked to multiple investors took ~2% less dilution and raised ~$900k more than companies that only talked to a single investor. In other words, most of the difference in dilution between pre-emptive vs process-driven rounds is likely due to founders in pre-emptive rounds that only talked to one investor. However, founders that used their pre-emptive TS to run an accelerated process were able to minimize the “cost” of the pre-emptive offer.
That suggests that to get the best of both worlds – to minimize the Work Premium as well as the work of running a full fundraise – founders should use pre-emptive offers to run an accelerated, abbreviated process with a handful of select investors. The way to do this is for founders to make sure they are cultivating relationships with a subset of investors they think would be good partners for their company far in advance of their actual raise. This allows them to ensure that in the case of pre-emption, they have other partners who could keep up with an accelerated process.
A preemptive offer is neither good nor bad in a vacuum. As discussed in A Guide to Preemptive Funding Offers, each offer needs to be considered on its own merits and in the context of the business, founder, and specific investor. The Risk and Work Premiums – combined with knowledge about market norms – are helpful frameworks for founders to use when evaluating whether or not to actually take the offer in front of them. However, founders can also minimize these premiums by leveraging pre-emptive offers to run an accelerated process.
1. Because each market has different average dilution levels, we limited our analyses to the US. This provided a more comparable set, and is also more relevant to most of the rounds we see. We don’t yet have a large enough data set in any other market to do a similar analysis.↩
2. This could go badly if the founder runs a botched process. Founders who know that they are bad at pitching investors should value this Risk Premium more highly than those who are good at it.↩
3. Jared Friedman’s term for it, with echoes of the Liquidity Premium.↩
Aaron was a Group Partner at YC and a cofounder of Tutorspree, which was funded by YC in 2011. Before Tutorspree he worked at Bridgewater Associates, where he managed product and operations.