What’s the Lateral Capital Criteria for Follow-On Investments?
The LC model assumes that about half the companies we invest in initially will justify a follow-on investment (FOI) and that about half of those will receive a third round of investment. For Lateral Capital IV, each of these FOI rounds is modeled at $100,000; follow-on investment amounts are expected to increase in Lateral Capital V. The reasons to make a second or third investment in an Early Stage company are typically because the company:
- Needs additional capital to fund growth behind the current model. Generally, these are no-brainers: the company looks to raise more money because it has proven that the current product/market fit is well understood and that current customers want to buy more.
- Underestimated the amount of money they needed the first time. This is not ideal, as it often suggests that the company isn’t progressing at the rate promised, or that something has to be redone. But it’s not a signal that all is lost.
- The company needs to bridge to the next point of value inflection. This is often a subset of not raising enough money, but it could also be because research failure or something else unexpected. But if the company simply can’t raise more money at reasonable valuations before some new data is available, then we often (not always) step up.
- Is taking a down round. No one likes these situations, but they sometimes happen – even to companies that later become very successful. To protect our position, we often “join the group” of investors behind a strategic pivot.
- To make acquisitions. Merging/buying other companies is not always a great idea. It can distract the management on both sides of the transaction. But if it is the right kind of deal – to expand distribution channels or enter another country, for example – we are open to reinvesting.
In evaluating a follow-on opportunity, we look at the following:
- How much must we invest to offset the dilution caused by the new capital? Should we invest to hold our position? Or is this the time to expand our position?
- What new exit price is required to yield a 1.0X, 5.0X and 10.0X on our original and add-on investments? We look at these as separate decisions: the first investment requires a 5.0X potential return; should the second or third investment require only 3.0X? At what sales price?
- What happens to the company’s value position when the preference stack and option pool are considered? This includes the likely increases to “recharge” the options pool required to extend incentives to the management team.
- Are the strategic buyers we identified at the first investment still around? Is there still a commercial market for the company, or will the company now require Venture Capital to take us out?
- What’s the state of affairs for the books of the company? Records, IP filings, etc. Have they been good stewards of our money so far? Plus, the next-next investor is likely to be the buyer. Is the company ready internally for that line of inspection?
- What is the Board’s latest thought on selling the company? Is the minimum acceptable deal to the Board and CEO reasonable to us? Is it absurd? In other words, why would we invest more into a company which the controlling owners won’t sell at any reasonable price?
- If this really the “last money” the company needs before it sells? If not, how many tranches (really, really) are required before someone will buy it? Will the current investment take the company to Cash Flow Breakeven – so it can motor on for 2-3 years until buyers can be found?
Historically, we have not invested when:
- The lead investor negotiates terms which we are expected to match, but which make no sense for Lateral Capital. For example, we routinely pass on convertible notes which have valuation caps which are way out of the money or no caps at all. This is good for the company, perhaps, but this kind of note doesn’t compensate the investor for taking additional risk before a sale.
- The company is not on a path to cash flow breakeven (CFBE). We don’t insist that invested companies be at CFBE before we will invest again, but they have to be on a path to get there quickly and with confidence.
- The company loses key staff members before asking for more money. We invest because we believe the team in place can deliver the plan. But if the founders get into a fight or the CTO leaves for a competitor, we may not be willing to bet more again.
We would be remiss if we didn’t thank veteran investor John O. Huston for coming up with most of this. We particularly like his list of “Showstoppers” below.
- Any trust or honesty concerns.
- Outside directors not investing.
- Insufficient regular reporting on how the company is doing.
- New money goes to solve old problems – back taxes, payables, accrued salaries, etc.
- Very large round or valuation so the company has to deliver a $1Z (“a zillion dollars!”) valuation for us to get our money.
- The Board has “gone native,” to the point that the business plan has become delusional.
- The CEO can’t or won’t say what he or she has learned and what they will now do differently.