This is the second article in a series that discusses and demystifies some business concepts commonly encountered within a startups.
If you follow startup news, you've likely come across headlines such as "Startup X raises $10 million in a Series A round led by Venture Capital Firm Y." But what does it actually mean when a VC firm "leads" a funding round? Let's dig in to this aspect of startup financing and discuss how it can shape the trajectory of a growing company.
So, What is a Funding Round?
Before diving into what it means to "lead" a round, let's get some information on the table about what a funding round actually is.
Typically speaking, startups raise capital in distinct stages or "rounds," each designed to help the company reach its next significant milestone. These commonly include:
- Pre-seed/Seed: Early funding to develop initial product and validate ideas and demonstrate the need in a given market for the product being developed
- Series A: Financing to refine the business model and accelerate growth
- Series B, C, and beyond: Additional capital for scaling, expansion, and potentially preparing for an IPO or acquisition
Each round usually involves multiple investors contributing capital in exchange for equity (ownership) in the company.
What Does "Leading" a Round Mean?
When a venture capital firm leads a funding round, they're doing much more than just writing the biggest check (though that's often part of it). For the best investing opportunities VC firms often find leading the round to be desirable. However, leading a round also involves several key responsibilities:
1. Setting the Terms
The lead investor typically negotiates and sets the critical terms of the investment, including:
- Valuation: What the company is worth, which determines how much equity investors receive
- Price per share: The cost of each share being issued
- Investment instruments: Whether it's preferred stock, convertible notes, SAFE (Simple Agreement for Future Equity), etc.
- Investor rights: Board seats to have direct oversight and influence on company decisions, pro-rata rights to retain an ownership percentage thereby withstanding stock dilution, information rights to receive financial statements, business plans and accounting information.
- Protective provisions: Special rights that protect investor interests when doing things like appointing new board members, issuing more shares, taking on debt or changing the focus or product area of the business.
These terms then generally apply to all other investors participating in the round, which is why this role carries so much influence.
2. Due Diligence
The lead investor conducts comprehensive due diligence on the startup—examining everything from financial records and legal documents to market analysis and team capabilities. This thorough vetting serves two purposes:
- It protects the lead investor's own capital
- It provides assurance to other investors who may rely on the lead's due diligence
3. Filling the Round
Once terms are set, the lead investor often helps the startup "fill the round" by bringing in other investors from their network. This might include:
- Other VC firms for co-investment
- Strategic investors who bring industry expertise
- Angel investors who can contribute specialized knowledge
4. Post-Investment Support
After the investment closes, the lead investor typically takes a more active role in supporting the company compared to other investors. This might include:
- Board representation: Taking a seat on the board of directors
- Strategic guidance: Regular meetings with founders to provide advice and support
- Network access: Introductions to potential customers, partners, and future investors
- Recruitment assistance: Helping to attract top talent
- Operational support: Providing resources to help with growth challenges
Why Does Having a Lead Investor Matter?
For startups, securing a lead investor offers several advantages:
A Signal of Credibility
When a respected VC firm leads your round, it sends a powerful signal to the market. It's a bit like saying, "We've done extensive analysis on this company, it's business model, sales pipeline and it's founders and employees and we believe strongly enough to put our reputation behind it." This validation can help generate hype and attract customers, partners, employees, and future investors into the fold.
Efficiency in Fundraising
Having a lead who sets terms and helps bring in other investors streamlines the fundraising process. Instead of negotiating separately with dozens of potential investors, the startup can focus on reaching agreement with the lead, then use those terms with others to make up the round.
Expert Advice from the Partnership
Beyond the money, the lead investor often becomes a key partner in building the business. The best leads contribute strategic insights, open doors to opportunities, and provide support during difficult decisions and times of turmoil. The expertise and support offered by a good lead investor can be a critical component of a long lasting and successful partnership between founders and investors.
Alignment of Interests
A lead investor typically has enough skin in the game to be truly invested in the company's success. Unlike smaller investors who might have minimal involvement, the lead has strong incentives to help the company succeed, not least to protect their reputation and provide valuable returns to their funds.
How Much Does a Lead Investor Typically Invest?
While there's no fixed rule, lead investors may typically commit to investing at least 25-50% of the total round amount. In some cases, particularly in early stages like seed rounds, a lead might commit to an even larger percentage.
For example, in a $10 million Series A round, a lead investor might contribute $3-5 million, with the remainder coming from other participating investors who make up the round.
What Makes a Good Lead Investor?
Having given this a bit of thought, at least from a startup's perspective, a good lead investors always bring more than just capital. As an employee with skin in the game it's good to see:
- Relevant experience: Knowledge of your industry and business model
- A Strong network: Connections to customers, talent, and future investors
- Alignment with and understanding of the product vision: An understanding of where the product will be in 6 months, 1 year and beyond helps align expectations
- Founder-friendly approach: Supportive of founders, understanding that building businesses is hard but still providing honest feedback
- Value-add capabilities: Resources beyond money, such as recruiting, marketing, or operational expertise
The Lead Investor's Perspective
For VC firms, leading rounds is both an opportunity and a responsibility. Leading offers several benefits:
- Deal flow advantage: Successfully leading rounds enhances reputation and attracts future opportunities
- Investment control: The ability to negotiate favourable terms
- Influence: Greater say in company direction through board representation
- Ownership target: Ability to secure desired ownership percentage
However, it also requires more work, resources, and reputational risk than participating as a non-lead investor.
Final Thoughts
When a VC firm leads a funding round, they're doing much more than contributing capital—they're taking an active role in shaping a company's trajectory. For founders who find themselves with a variety of VC firms showing interest, finding the right lead investor can be transformative, providing not just financial resources but also guidance, networking connections, and much needed credibility and "hype" in the marketplace.
It's worth remembering that the best lead investor relationships aren't just financial transactions—they're strategic partnerships that can dramatically influence a company's chances of success. So if you've worked yourself into a position where you have options, it pays to choose carefully.