Rounds between rounds

There's no such thing as a free fundraise

It has become increasingly common for founders to raise funding between the traditional venture rounds. These rounds go by many names - bridges, extensions, second seeds, seed+, tweener, etc. The fact that these rounds have so many names is a strong indication that they’re actually complicated, opaque, and hard for founders to evaluate. In this essay, we’ll create a functional classification of these rounds, discuss the incentives of all the parties involved, and talk about some of the tactics to make them work better for founders.

There is a generally accepted - though increasingly confusing - nomenclature for venture financings. First comes the friends and family round. This used to be the same as a seed round, but now maybe it’s called a pre-seed. Then there’s a seed round, differentiated because there are professional “seed” funds and they couldn’t very well call themselves “friends and family” funds. After the seed, if your company is doing well, you get to your Series A, then Series B and so on up through letters until IPO.

But reality is more complicated and founders are now raising quite a lot of rounds “between” the conventionally accepted rounds. When I started my own startup I did this - we raised money at Demo Day out of YC, raised a seed round from Sequoia, and a bit later did a…bridge, or an extension, or something without a name led by Resolute Ventures. We did that round because we hadn’t quite figured out the story for our A but were growing quickly and needed money to prove that we were approaching escape velocity. We later discovered that we were not on that path, and the bridge was our last financing.

That path didn’t seem common when we did it, but in the years since the “round between the rounds” has become increasingly fashionable. What’s strange about these rounds to me is that, unlike a Series A or even a seed round, these rounds happen in something of a bimodal distribution around quality. That is - companies raise them when they’re doing very well and companies raise them when they are doing rather poorly.

No matter how the company is doing when the founders raise these rounds, one thing seems constant - founders don’t fully appreciate the downstream impact of these rounds. That’s problematic, because these rounds can cause significant issues for companies by dramatically changing investor expectations, complicating financing math, and creating unexpected dilution and even voting changes.

Let’s do this one round type at a time. While not perfect, I’m going to assign the term “Bridge” to the companies that are raising intermediate rounds from a position of strength and “Extension” for the companies that are raising money just to survive. I’m also going to frame these rounds as happening between Seed and Series A, because that’s the most common type in the market.

Bridges

I think of strong companies raising bridge rounds because bridges - actual physical bridges - allow for faster movement from point A to point B. Companies that raise these bridges are usually doing well enough that existing investors and new investors are eager to throw money at the company in order to get some ownership. There are a few different categories of these investors and their incentives, which I’ll break out below. I’ll also work through the tradeoff that founders need to work through before saying yes or no to an offer.

Existing seed investor

Seed investors have a tough business model. They have a high rate of loss in their portfolios and - at least in current markets - a bizarrely high risk adjusted entry price. This means that they’re paying a lot of money for comparatively little equity and losing most of it. There’s a few ways to deal with this problem. The first would be to place fewer bets that are higher ownership. This is certainly what some firms do, but it is increasingly uncommon. The other mode is to place lots of tiny bets, and then do your best to put more money into the winners.

Putting more money into the winners can be hard to do since winners tend to raise their next formal rounds quickly. That means that existing seed investors need to figure out who the winners are BEFORE the Series A firms do. Then, they need to convince the founders of those companies to take more money precisely when the founders don’t need it because they are doing so well. The investors also kinda need to do this without the founders realizing that they could probably just raise an A instead of doing an in between round.

New seed investors

These investors weren’t lucky enough to bet on a winner in the first place and know that if they wait until the good company is ready to raise an A, they won’t be able to compete. So, they try to convince the founders that their money is basically risk free/costless and that they will be able to dramatically improve the company’s trajectory.

This is a tough trick to pull off, and usually only works if you’re already an extremely well known investor.

Series A fund

Series A investors are largely focused on doing Series As. However, these investors know that the hottest companies will be able to run competitive processes. Nobody likes competing for a deal if they can avoid it, so Series A investors will try to invest ahead of a round while trying to convince the founder that there’s no need to run a process because it’s not really a “round” round and so therefore just take the money and that way we can get to know each other and prove that we should get the A and besides don’t worry it’s not that dilutive.

Founders/Pros/Cons

There are few better feelings - as a founder - than getting offered money when you don’t need it and weren’t looking for it. Investors know this, which is why they often make precisely that sort of offer to a founder in the hopes that the good vibes will get them all the way to closing a deal before the founder thinks too hard about trade offs.

Bridge rounds are a case study in this dynamic. When a company is doing extremely well, there is usually a point at which it needs to raise capital in order to keep doing extremely well - at least at the early phases before free cash flow is sufficient to fund growth. Usually, when this happens, the response is to go to the market to raise a round.

But raising a round can seem scary - process, negotiation, terms, lawyers, etc. It also seems like a distraction. Bridge rounds seem perfect here because the promise is money without a process and low dilution. The belief is usually that a bridge is easier to raise and will magically allow the founder to “skip” the next round of financing as if financing a startup is equivalent to chutes and ladders. This is appealing because fewer rounds should mean less dilution over time.

But the reality is generally more complex. Bridge rounds rarely happen at less than ~10% dilution, which is roughly half the dilution of a standard A and possibly more for particularly good companies. For this tradeoff to make sense, the bridge would need to dramatically reduce the dilution of the next round by doubling the post money of that round.(1) Now, that certainly is the case in some situations - I’ve been part of a few! But it is an incredibly high hurdle that is rarely discussed.

Then there’s the allocation math to consider. Usually, when bridges get raised, pro rata rights go along with them. That seems fine when you sign the docs, but when you get to your A and realize that the lead wants to take $13M of a $15M raise, that your seed investors have rights to $3M and your bridge investors have rights to another $1.5M you will suddenly find yourself with a mess. Again, manageable but important to know going in.

Bundled up in the dilution and price math is a fundamental issue - when you raise more money, expectations of what you’ve accomplished between fundraises generally go up. That’s fine if you can get enough done, but there are a lot of founders who raise bridges after they have a great 6 months only to slow down and then struggle to raise an A.

Extensions

On the other end of the distribution are companies that need money in order to survive and/or hit a critical path milestone to unlock their As. This story has many different forms. Sometimes the process of product market fit is slower than expected. Sometimes a customer delays closing. Sometimes there’s a global pandemic that throws all plans into a blender and spits them out.

Regardless of the cause, companies that need more money in order to make progress have significantly less leverage than companies being chased with offers. The first and most important difference is that these companies have to go and ask for money vs. having investors ask them if they want it. Founders need to understand the different investor types and their incentives in order to successfully make that ask.

Existing investors

Any founder who needs an extension needs to start that process with the investors that have already made a bet on the company. This is largely because any new investor that the founder pitches will immediately want to know what insiders are doing before making a decision. These new investors know that insiders have more information about the company, and are therefore a decent barometer of whether or not the company is a good distressed bet or a dumpster fire.

BUT new investors also know that existing investors are not objective observers. The sunk cost fallacy works in two lanes here. The first is emotional - Early stage investing is largely an emotional decision. Once an investor falls in love, the investor wants to stay in love despite more recent evidence. The second lane is financial (though also that’s emotional). Every investor wants to believe the story that the once favored company is just a minor pivot and a few million dollars away from glory. The fact that these narratives are sometimes actually quite true - see Slack - makes the entire process trickier.

So, existing investors have to evaluate whether or not there’s an opportunity to buy up more of a great company that just happens to be struggling OR if funding an extension is just a way to light money on fire.

New investors

New investors who get pitched by a founder that needs an extension get to play the classic role of distressed investor. This is one of the hardest and most rewarding games to play in all of investing. The risks are obvious - funding a struggling company. The rewards are potentially huge - getting a chunk of a company that is distressed but is legitimately about to turn the corner. The math may be simple, but the uncertainty is huge.

Founders/Pros/Cons/Tactics

The potential negative consequences of raising an extension mimic those of a bridge, and are largely outweighed by the fact that founders who need an extension simply don’t have a choice.

Tactically, there are a few ways to improve the chances of raising an extension.

The first thing, as noted above, is to start with the insiders vs. starting with outsiders. Again, every new investor will immediately ask what the insiders are planning to do. That’s the strongest signal in an extension. When convincing insiders, founders should strike a deal that looks like a good bargain to the existing investor. Often this means flat to the last financing. Sometimes that means a reduction in price (safe or otherwise). This is hard for founders to stomach since no one wants to raise a down round. However the trade between flat/down round vs. no round and company death should be fairly obvious.

That’s not to say that the messaging here is easy. Founders need to communicate strength and reasonableness at the same time. Hitting that balance the right way means that the insiders quickly agree to an extension, which makes getting everyone else in easier. Sometimes this can take months to get done with round after round of negotiating. That’s a particular conversation that isn’t easily dealt with in an essay.

Once insiders are convinced, founders can expand the circle of conversations, usually working off investor and founder intros. Again, sticking with reasonable asks is critical. Founders need to emphasize what’s gone well with humility about what went wrong and confidence in the future.

If founders manage to get through the insiders and the new investors and close the extension, they’ve given themselves the opportunity to take another swing at building a big company. They’ll deal with the complications of that in-between round when they get to the A.

Semi-philosophical digression

Venture capital isn’t a static system. As startups change, funding mechanisms evolve, funds grow and shift strategies. There’s a feedback loop in this cycle that we could spend thousands of words discussing.

However there’s one part of the system that doesn’t really change - founders wake up every day and make a trade: spend your life working on this startup or do something else. That question doesn’t get enough serious consideration in the decision process leading up to and through fundraising. While this calculation is easier when raising from a position of strength, it is still critical.

Each financing, every new dollar in, and every bump of valuation shifts the set of possible outcomes for a founder - making it harder to exit or downshift. At the same time, a large number of companies raising extensions should be thinking more carefully about whether or not to shut down - which I’ve written about before. The reality is that sometimes an extension is just a road to nowhere.

Conclusion

Bridges and extensions are often presented as simple, easy, and free. They’re anything but. Every fundraise involved complicated tradeoffs, discrete processes, and downstream effects. Always remember that there’s no such thing as a free fundraise.

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1. As an imperfect example, let’s say a company is likely to raise a $20M Series A. On the way to that round, the company takes a bridge of $5M at $50M post, for 10% dilution. In order to limit the combined dilution of the company’s fundraising activities between seed and B to be limited to 20% - a target that founders talk about quite a bit - the founders would need to raise $20M at $200M, for another 10%.

Disclosures

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