After the Term Sheet Is Signed: The Messy Seed Round Syndication Process Begins

After a seed term sheet is signed, there is still work for founders to do in closing the round. I previously wrote a post about the relationship risks associated with this “venture limbo” period between the lead VC and the entrepreneur that could make the process agreement fall apart: wrapping up any remaining diligence, drafting and negotiating legal definitive documents, and other unexpected issues that arise.

I’ve noticed an additional increasingly important factor to be worked out during this period that takes both time and energy — syndicating the seed round to additional investors.

Unless an entrepreneur follows a subscription process (i.e. sets out a set of terms, typically a convertible note, and just asks interested parties to subscribe to it), then usually a lead VC issues a term sheet that the entrepreneur signs. But often that firm is only going to comprise somewhere between 1/3 and 2/3s of the overall round’s capital, which leaves room for another firm (or sometimes two) along with strategic angels.

Sorting out the investor syndication allocations can be messy. Really messy.

Since typically fundraising goes slowly until it goes fast, with some investors relying on “social proof” of other committed investors before making their own decision, it’s often surprising how much demand there is to participate in a round that only a week or two ago a founder was clawing just to catalyze! Once a term sheet is signed with a firm making a definitive high-conviction commitment, inevitably both firms and individuals on the sidelines will have renewed interest in participating.

(Given this dynamic, it’s better to spend more time early on in the fundraising process looking for a lead rather than fill-in capital, which includes firms who say “we’re in… as long as you find a lead.”)

If you’re a founder, how should you navigate this messy scenario to quickly close the round? Here are a couple of things to keep in mind:

1) Constructing the syndicate is about bringing together complementary skillsets and value-add to the table.

Assembling different firms and individuals provides an opportunity to construct a set of investors who have accretive viewpoints and potential contributions. One investor might have specific domain expertise, while another a valuable geographic focus, and a third a unique perspective from a diverse background.

2) Understand demand is a function of seed firm size and strategy.

Seed funds over the past few years have raised larger and larger funds, which has directly informed their own strategies towards greater demands for initial check size in seed rounds. Some of these funds will even ask for more than they actually ideally want, knowing that inevitably they will get cut back in allocation.

3) Recognize the natural tendency for round sizes to creep up.

Because of this increased demand from participating parties and a typical bias towards entrepreneurs wanting to include more parties, the result is that the simplest way to satisfy everyone is to increase the round size.

In many cases that’s a sensible approach to a round that’s “oversubscribed,” especially because more capital earlier on will empower a startup accomplish more on this financing.

But successive incrementalism can ratchet up quickly — both in dilution for the entrepreneur becoming less desirable and too much capital too early actually hinders the ability for the startup to capital-efficiently find product-market fit.

4) The entrepreneur is in control.

Investors may apply hard pressure that make it not feel that way (such as threatening to leave the round if they don’t receive the allocation they’re seeking), but it’s extremely important to remember that ultimately, it’s the entrepreneur’s company.

The founder decides who is involved and to what degree. And that’s the way it should be.

Not everyone will be completely satisfied, including some of the new investors. It’s better to include fewer, happier investors in an oversubscribed round than more investors who aren’t really happy at all. “Party rounds” of years past not only aren’t prized anymore, but also the optics are perceived to be negative by both co-investors and future capital partners.

Determining the seed round syndicate and corresponding allocations are a founding CEO’s first test of leadership.

Take control of the situation.

Honor promises made along the way.

Tell people no — and actually tell them (as opposed to just going silent).

All of these sound like straightforward actions, but they’re sometimes hard to do — especially when you have many parties and competing demands. But when founders proactively and strategically manage the fill-in process, it yields both the best results and the least number of bruised relationships.