Matching funds and burning out the risk in a round

One of the more interesting approaches to investment is the "matching fund" approach. Matching funds are essentially funds that follow other investors who have put in the time and effort to make investment decisions. They are betting on the vetting of the prior investors. Some / most I know of - do some minor additional vetting and review the due diligence reports of the prior investors, and all I am aware of discriminate base don the prior investor pools, but other than that, their goal is to ride the wave of others by investing later in the same round, when the risks have been baked out, at the same valuation as the earlier investors.

This is a good thing!

This benefits both the earlier investors and the matching funds, at least for companies that made it through the initial period before the matching funds enter. The companies that fail fast - too fast to get to the matching fund - are of course losses for the earlier investors. But for cases where the companies are not about to fail, the extra cash is like a tank filled with gas. The earlier investors are more likely to succeed with more resources behind the company, and the company is more likely to succeed with more time to live.

But it punishes the earlier risk takers a bit

The early investors who took the earlier risks are punished by those who tag along later in the round, assuming the process waits till the end of the round for the co-investments. At a recent angel meeting, one of the participants identified the shortest time till failure of a business he invested in was 89 days. Obviously, in a round that typically lasts 9-12 months, if he got in 3 months into the round, he lost and those who waited won by not investing. But if we all wait, the round will never get started and the company will almost certainly fail.

A twist and the sequenced discounting method

There is a path out of this. One company I advised was getting to where they might not need all the cash in a round, and they asked about different approaches. I identified two alternatives; (1) end the round early and open a new one if you need more cash later; (2) give a discount to the early participants in the round.

Ending the round early turned out to be the case for this client, who was already in the round and couldn't change the terms at that point. But the other approach I have seen used is a discount for early investors. The first $250K of a $750K round, as an example, is given a 10% discount over the rest of the round, so getting in early gives you an advantage. I have also seen time limited discounts where, before a deadline, you get a discount (more shares for the same amount).

The sequenced matching fund

For matching funds, there is another interesting option. Instead of placing the investment at the end of the round, the match starts with some threshold of prior investment and goes incrementally matching other investments that come in. Of course care must be taken here as well. Matching other external accredited investors who are not board members or employees and are investing in cash is the typical approach, but even here, there are some interesting exceptions. For example, a used piece of equipment worth $1M necessary for the company to move forward is often a good thing to match cash with because the cash may be required to operate the equipment, and the equipment might be at a very good discount.

In summary

Creative investment strategies offer a wide range of approaches to getting more money in over a shorter period of time. By balancing the risks and rewards for investors and doing a good job of rewarding the earlier risk takers you can often speed up funding and generate more in less time.

But be careful. Complex deal terms can lead to lots of strife in the investor community. At the end of the day, it's a negotiation, and those with the gold make the rules. But on the other hand, taking money only from the right investors is very much to your advantage. The way they treat you, and the way you treat them, is likely to accrue over time. Being good to each other is good for all of us.

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