Venture backed companies run out of money.
It happens all the time.
Most of the time its expected and planned for.
But sometimes it comes as a sudden and unexpected result. That's bad, really bad.
In any case, there are generally two ways that more money is raised.
The first is to do a real fundraising effort. That's time consuming and can be distracting. But it is often the best approach and generally results in the best valuation.
The other approach is to Pass the Hat. That means doing an "insider round". I've always liked that cliche.
I grew up going to church with my mom. At some point during the service, they'd pass the "hat" around. Everyone put some money in. That's how they funded the cost of running the church.
The same concept works in a venture deal. If the company can't go out and do a real fundraise, the exisitng investors all reach into their funds and come up with more money. There are a bunch of reasons why a company might need to do a Pass the Hat financing.
- Not enough value has been created since the last financing to support a higher price. If the price is going to be lower or the same as the last round, its better, faster, and more attractive to everyone involved to just Pass the Hat.
- The company needs money fast. This is, as I said, a really bad scenario. It will cause a lot of pain all around the table. But if the investors and entrepreneur want to keep going, then everyone is going to have to Pass the Hat.
- Something important is going to happen within a short period of time, after which a real financing can be done. This is the "bridge" scenario. A "bridge" financing generally is done to provide enough financing to get the company to an important milestone (ie a bridge to something). Almost all bridges are done as Pass the Hat financings.
There are certainly a bunch of other scenarios where a company would do a Pass the Hat financing and if you know of them, feel free to add them in the comments section.
Passing the Hat has some important rules. First, everyone must "Pony Up". That's another great VC cliche. You are getting two for the price of one today!
If one or more of the investors refuses to Pony Up when you Pass the Hat, then really bad things start happening. The terms of the financing get really punitive for everyone involved and its very damaging to the company, the founders, and the relationships around the table.
Second, the terms must be attractive enough to incent everyone to Pony Up, but not so attractive that they would be deemed to be unfair to the company and the existing investors. In a Pass the Hat financing, there aren't any new investors to provide "market" terms so the burden to behave responsibly rests squarely on the shoulders of the existing investors. Unfortunately responsible behavior in Pass the Hat financings don't always go hand in hand.
Third, Pass the Hat financings need to happen fast and be done inexpensively. If they can't, then its better to go outside for money.
I think we'll see more Pass the Hat financings going forward in the venture business for another reason. There is so much money out there that most venture firms are going to want to put more money into their good deals and not broadly syndicate them.
That will put an even larger burden on the VCs to behave responsibly in pricing and structuring these Pass the Hat financings. My advice to entrepreneurs in these situations is:
- Always plan for the next financing. Know when you are going to need money and start planning the fundraising process 4-6 months before you need money.
- Always know what the market price for your company is. This is hard without actually going out and doing a financing, but you can monitor what other similar companies are getting their deals done at (both sale tranactions and financings)
- Be open to a Pass the Hat financing if you like the VCs you are working with and if you can structure a deal with them that is fair to the company and you.
Negative cash flow businesses require financing to survive. Those around the table are often the sources of that money. Passing the hat works well when its done right. And its a very important cultural element of the venture business. If you aren't willing to pony up, you won't last long in the venture business.