Insider Financings – The Shell Game That Won’t End Well

Activity levels in the world of venture and growth equity appear to be quiet.  But lurking under the surface is a murky trend – a significant rise in insider financing rounds.  Whether this is good or bad is all a matter of perspective.

An insider round, whereby an incumbent venture fund (not new investors) leads, prices, and structures a subsequent financing round does offer some advantages, such as providing companies with much-needed growth capital as well as protecting existing investors from dilution.  Because existing investors desire to keep the best deals for themselves, these insider rounds are occasionally interpreted as a "vote of confidence" in a company's future prospects.  However, the other side to this coin, is that it allows these same venture funds to avoid marking down their portfolio companies to their true (i.e. in today’s market, lower) value.

Obviously, this is not the most efficient or equitable strategy in the long run, particularly for the limited partners (LPs) in these funds.

We have witnessed a significant market correction, particularly in the valuations of most companies (public and private) in the technology/software universe.  With market multiples lower and, not coincidentally, growth rates for most technology companies slowing down, it would be logical to assume that there should be a preponderance of ‘down’ rounds (i.e. subsequent financing rounds whereby the current valuation is lower than that of the previous financing round).  Not so in the world of insider financings.  In fact, it is hard to find many examples in Canada (anecdotal or otherwise) whereby VC funds have taken the hit and done insider financing as a down round.  The only exceptions seem to be deals where there is clear distress.  (For greater clarity, this mechanism is self-regulating and therefore not an issue with respect to public market financings because there is much less debate about what fair market value should be.)

The historical data on private insider rounds is very clear (e.g. this Columbia University whitepaper) – insider rounds typically underperform.  In my view, the only way to get a true assessment of fair market value is to seek out fresh outside capital to price and structure the financing.  If I were a Limited Partner, I would want to ensure that appropriate controls were in place to maximize visibility and transparency with respect to insider rounds.

There will always be a delicate balance between short-term cost-based protection and long-term sustainability. However, the shell game that is currently being played can only go on so long, as every VC fund, regardless of size, has capital constraints.  Continuing to kick the can down the road to protect their existing portfolios by mispricing new financings will simply not end well.