Startups and VCs Should Avoid "Pier" Funding

Posted on May 23, 2010 | 41 comments


Often when startups who have raised venture capital need another round of financing they will turn to their existing investors to give them money before raising from outsiders.
This happens when the company has been making steady progress but hasn’t built enough “proof” to raise its next round of financing from external investors.

The traditional way that this type of financing is offered is what is known as “convertible debt.”  This means that the investment does not have a valuation placed on it.  It starts as a debt instrument (e.g. a loan) that is later converted to equity at the time of the next financing.  If no financing happened then this “note” may not be converted and thus would be senior to the equity of the company in the case of a bankruptcy or asset sale.

If a round of funding does happen then this debt is converted into equity at the price that a new external investor pays with a “bonus” to the inside investor for having taken the risk of the loan.  This bonus is often in the form of either a discount (e.g. the loan converts at 15-20% discout to the new money coming in) or your investor will get “warrant coverage” which is similar to an employee stock option in that it gives the investor the right but not the obligation to invest in your company in the future at a defined priced.

There is a primary reason that inside investors give companies convertible debt rather than just giving you the money as equity.  VC’s money comes from mostly institutional investors called LPs (limited partners).  They trust the judgment of the VCs to source, finance, help manage and then create some sort of exit for the investments that they make.  They also trust VC’s to determine the right price to pay for the company securities that they buy.

But when a VC is already an investor in a company and when they can’t raise external money it would set off a potential “red flag” with LPs.  ”Why weren’t they able to raise external capital?”  Or more importantly, “How do I know you’re paying the right price to invest in the company?  Maybe the market views this as not worth the price you paid?  Or maybe you’re biased and just investing because you’ve ‘fallen in love’ with the company and lost your objectivity.”  Whatever the case, VC’s usually don’t want to be seen to be driving price on a deal in which they’ve already invested.

So by offering convertible debt you can avoid a price discussion in the same way that angel investors sometimes do in order to win competitive early-stage deals.  The industry jargon for convertible debt is a “bridge loan”  or “bridge financing.”  It’s called a bridge loan because it’s meant to provide enough capital to bridge you from your last round of funding until your next round of funding.  Basically it is supposed to give you enough runway to prove some milestones and make it easier for your to raise money from an outside source.

But I used to jokingly refer to bridge loans as “pier” loans.  You know, because they give you a bit of runway but somehow it never seems like enough money to get you to the other side of the river.  I understand the mentality of why investors do this.  They want to give you enough money so that they don’t have a bankruptcy on their hands but not so much that if you eventually struggle to raise money they have lost even more money.  Basically they get the chance to see how you perform “on a short leash” and if they feel you’re doing well they can just keep extending the length of the pier 1-2 months at a time.

For me Pier Loans fall under the category of “penny wise, pound foolish.”  What VCs who have never been entrepreneurs and have therefore never been on the receiving end of small bridge loans don’t realize is that they skew the behavior of startup management teams in ways that can be self destructive.  You can only really know this for sure if you’ve been in these shoes.  You get the bridge in place so you breathe a sigh of relief that you’re going to live to fight another day but suddenly you because overly cautious.  You don’t want to be staring at a payroll that you don’t know if you’ll make again.  You don’t want to have a perpetual tin cup in your hands begging for scraps to exist.

So startup CEO’s in this position make compromises that don’t necessarily benefit the long-term potential of the company.  They might not replace an engineer or two that quits.  They might put the kibosh on company travel and not attend some key meetings or conferences.  They might decide to delay new product features or upgrading technology infrastructure.  They likely are extending payments to debtors way beyond that expected payment terms and start damaging supplier relations.  And equally damning is that the culture inside the company drifts insidiously from confidence to cautiousness.  From pragmatic risk taking to risk aversion.  And startup CEO’s can often suppress the anxiety that goes along with the funding uncertainty – even to themselves.  But no doubt their bodies feel the stress.  And it adds up.

So my view is that VCs and entrepreneurs need to make tougher choices.  The sh** or get off the proverbial pot judgment calls and the answer isn’t always “let’s fund.”  I had a friend recently call me who had been offered a pier from his VC.  He had raised about $500,000 in seed funding that lasted a long time.  He got a good degree of user adoption but clearly hadn’t proven his model.  He talked to his investors about a $250,000 bridge loan (7-8 months of runway).  Initially they acquiesced but when it came time to funding they only offered him $100,000.  This is literally what I said to him (almost verbatim)

“Honestly, [name], I wouldn’t take the money.  You’ve been busting your arse on this opportunity for the past 18 months.  You’ve kept a really low burn rate and paid yourself  a very small salary.  That’s the risk you’ve accepted and the commitment you’ve made.  I’ve seen the progress you’ve made but you clearly haven’t knocked it out of the ball park.  If you think you can still get a good return for your investor you should respectfully request that the minimum amount you’ll take is $250,000.

Tell them that if they’re not confident enough to put the whole amount in you’d understand.  The business hasn’t been an unmitigated success.  But if they do put in the money you’ll work your butt off to do everything you can to make this company a winner.  If they don’t have the confidence that you can pull this off then you’d be happy to help either shut the company down in an orderly fashion, sell the assets to somebody on the cheap or help transition the company to somebody else to run it.

I told him that if they’re going to drip feed you (at $100k he’d have less than 3 months of cash) it wasn’t worth staying.  His scarcest resource was his youth and the energy he had to put into startup ventures when he has no kids, no mortgage and no major encumbrances.  He had already given things his best effort.”

Frankly, if investors weren’t willing to write the $250,000 check that they had promised it seemed clear to me that he had lost their support or that they weren’t convinced in the future.  These aren’t angel investors or family friends for whom $250k might be a big deal.  These are institutional VCs.  I couldn’t see any reason for him to continue to kill himself in that context.

So there you have it.  Sh** or get off the pot.  Have the conviction to back your companies enough to really give them a chance to prove themselves.  I’m not talking about endless amounts of money but at least funding 6 months gives them 3 months to show progress and 3 months to fund raise.  Better even still if there’s a way to fund 9 months.  It’s legitimate to ask for cost cutting if you think the bridge won’t last long enough at the current burn rate.

But if you’re tempted to offer a pier (or if you’re tempted as a startup to take it) I think you’re better off looking in the mirror and asking yourself the tough questions about why you lack the conviction.  You might have legitimate concerns that warrant not funding the ongoing operations.  But piers are often counter productive.

  • http://aditya.sublucid.com adityac

    Not completely related, but, I think you mentioned in a previous post that if you're raising (seed) money for the first time, you should raise $250k or so… how long of a run-way do you think that should give you?

    Joshua commented on a recent thread on Hacker News (http://news.ycombinator.com/item?id=1356345) that if you're raising less than 500k seed, you're making a mistake… curious what you think?

  • http://twitter.com/ac adityac

    Not completely related, but, I think you mentioned in a previous post that if you're raising (seed) money for the first time, you should raise $250k or so… how long of a run-way do you think that should give you?

    Joshua commented on a recent thread on Hacker News (http://news.ycombinator.com/item?id=1356345) that if you're raising less than 500k seed, you're making a mistake… curious what you think?

  • http://www.ryanborn.net ryanborn

    Well this one sure hits home with me, and I'm interested to hear what happens to this entrepreneur. I sure hope that you will update us all when / if his business sinks / swims and the $100k runs out.

    Your advice here is priceless and it takes pretty big cojones for an entrepreneur to follow what you have said. The obvious reason being that you risk losing it all when the business could continue with the bridge and give birth to new products or otherwise save itself from distinction. The entrepreneur also risks alienating the VC's if they take offense and hold grudges for such brazen behavior (this would be extremely petty of course but certainly possible). Hurt feelings of course are no excuse to make business decisions.

    I think I may actually know who you're talking about in this post. From what I hear, he's taken the $100k and actually put it towards a killer new product, to be announced this week – as early as tomorrow. I hope you can give us an update soon.

  • http://www.ryanborn.net ryanborn

    Well this one sure hits home with me, and I'm interested to hear what happens to this entrepreneur. I sure hope that you will update us all when / if his business sinks / swims and the $100k runs out.

    Your advice here is priceless and it takes pretty big cojones for an entrepreneur to follow what you have said. The obvious reason being that you risk losing it all when the business could continue with the bridge and give birth to new products or otherwise save itself from distinction. The entrepreneur also risks alienating the VC's if they take offense and hold grudges for such brazen behavior (this would be extremely petty of course but certainly possible). Hurt feelings of course are no excuse to make business decisions.

    I think I may actually know who you're talking about in this post. From what I hear, he's taken the $100k and actually put it towards a killer new product, to be announced this week – as early as tomorrow. I hope you can give us an update soon.

  • http://www.hypedsound.com jonathanjaeger

    Sounds to me like a go-for-broke scenario. Asking for $250K or nothing means he could potentially get nothing, a hard thing to stomach when you are so emotionally invested in the project (putting pure rationale and objectivity aside). I agree with your reasoning behind your key points, but also keep in mind the entrepreneur might not necessarily be able to jump into a new project that fast. You say there's no point wasting your youth by taking this uncommitted VC's $100K, but gaining traction for a new project can take way longer (let alone coming up with a solid new idea, team, and business plan). Also, since the bridge is so short, it seems like more of a risk for the productivity of the company rather than a waste of time that could be used on another project.

  • http://www.hypedsound.com jonathanjaeger

    Sounds to me like a go-for-broke scenario. Asking for $250K or nothing means he could potentially get nothing, a hard thing to stomach when you are so emotionally invested in the project (putting pure rationale and objectivity aside). I agree with your reasoning behind your key points, but also keep in mind the entrepreneur might not necessarily be able to jump into a new project that fast. You say there's no point wasting your youth by taking this uncommitted VC's $100K, but gaining traction for a new project can take way longer (let alone coming up with a solid new idea, team, and business plan). Also, since the bridge is so short, it seems like more of a risk for the productivity of the company rather than a waste of time that could be used on another project.

  • http://discourseandnotes.com/ Dan

    I wonder if this is essentially another way of saying that if insiders don't fund a small follow-on round, don't look to outsiders to do it.

  • http://discourseandnotes.com/ Dan

    I wonder if this is essentially another way of saying that if insiders don't fund a small follow-on round, don't look to outsiders to do it.

  • dv

    I agree with your premise, being drip fed is counter-productive and will almost always end up in not reaching the desired outcome of raising a larger round. However, going for a 6 month or 9 month round is also not productive in my opinion, you need at least a 12 month commitment to give you time to focus on building the business.

    Our worst decisions are usually made from points of desperation – there are ALWAYS other options out there that if you are thinking correctly will come your way. On the flip side if you're desperate it putts off people more and you will likely get into a lose-win (you lose, they win) situation. It's better to tell the employees what is going on and get them to share in the process of extending the runway than to get into a deal that you will regret which will ultimately hurt the company.

    Also, is the VC/investor offering any recommendations or improvements in offering less? This sounds like a red flag on the investor. Perhaps good to post this on http://www.TheFunded.com for others to know.

  • dv

    I agree with your premise, being drip fed is counter-productive and will almost always end up in not reaching the desired outcome of raising a larger round. However, going for a 6 month or 9 month round is also not productive in my opinion, you need at least a 12 month commitment to give you time to focus on building the business.

    Our worst decisions are usually made from points of desperation – there are ALWAYS other options out there that if you are thinking correctly will come your way. On the flip side if you're desperate it putts off people more and you will likely get into a lose-win (you lose, they win) situation. It's better to tell the employees what is going on and get them to share in the process of extending the runway than to get into a deal that you will regret which will ultimately hurt the company.

    Also, is the VC/investor offering any recommendations or improvements in offering less? This sounds like a red flag on the investor. Perhaps good to post this on http://www.TheFunded.com for others to know.

  • # marano

    .

    these are two [very] innovative projects seeking VC funds

    http://www.newspaceagency.com/

    http://www.olpcdesign.com/

    .

  • # marano

    .

    these are two [very] innovative projects seeking VC funds

    http://www.newspaceagency.com/

    http://www.olpcdesign.com/

    .

  • cthomaschase

    great topic, I can relate having raised a round and then needing a follow-on 12 months later. it's really tough for the entrepreneur to continue spending as the burn is, well, burning, which can be the case in a post-round “hit the gas” scenario. as you point out, instinct to start cutting back can kick in quick, not saying that's necessarily the right call. clearly the investors are in a tricky spot as well, because this is one of those times where they're looking at the event from potentially two perspectives, one of the existing shareholder and one of the potential new shareholder. also, if looking at going outside for funding, other investors want to know if the existing guys are going to buy-in again, somewhat of a vote of confidence for the company. definitely a tough dynamic situation where parties are weighing options that may seem to be driven from conflicting sides of the table.

  • cthomaschase

    great topic, I can relate having raised a round and then needing a follow-on 12 months later. it's really tough for the entrepreneur to continue spending as the burn is, well, burning, which can be the case in a post-round “hit the gas” scenario. as you point out, instinct to start cutting back can kick in quick, not saying that's necessarily the right call. clearly the investors are in a tricky spot as well, because this is one of those times where they're looking at the event from potentially two perspectives, one of the existing shareholder and one of the potential new shareholder. also, if looking at going outside for funding, other investors want to know if the existing guys are going to buy-in again, somewhat of a vote of confidence for the company. definitely a tough dynamic situation where parties are weighing options that may seem to be driven from conflicting sides of the table.

  • http://twitter.com/JoshGrot Josh Grotstein

    Very good article, and good perspective on the perils of bridges from VC's.

    I'd probably extend this to include tranched financing rounds, as they often result in similarly unintended consequences…i.e., CEO's afraid to grow business, hand-cuffed in re: bringing on new staff, etc….as most milestones associated with these tranches are often difficult to size and time appropriately in advance (particularly for earlier stage companies), and therefore are seldom made; and this usually leads to the hand-wringing meeting between Management and Investors in which both sides excoriate one another, more concessions may be given (usually in the form of salary cut-backs), and the investors continue to fund the next tranhce and Management remains equally stuck in their ability to move the business forward.

  • http://twitter.com/JoshGrot Josh Grotstein

    Very good article, and good perspective on the perils of bridges from VC's.

    I'd probably extend this to include tranched financing rounds, as they often result in similarly unintended consequences…i.e., CEO's afraid to grow business, hand-cuffed in re: bringing on new staff, etc….as most milestones associated with these tranches are often difficult to size and time appropriately in advance (particularly for earlier stage companies), and therefore are seldom made; and this usually leads to the hand-wringing meeting between Management and Investors in which both sides excoriate one another, more concessions may be given (usually in the form of salary cut-backs), and the investors continue to fund the next tranhce and Management remains equally stuck in their ability to move the business forward.

  • http://twitter.com/JoshGrot Josh Grotstein

    Very good article, and good perspective on the perils of bridges from VC's.

    I'd probably extend this to include tranched financing rounds, as they often result in similarly unintended consequences…i.e., CEO's afraid to grow business, hand-cuffed in re: bringing on new staff, etc….as most milestones associated with these tranches are often difficult to size and time appropriately in advance (particularly for earlier stage companies), and therefore are seldom made; and this usually leads to the hand-wringing meeting between Management and Investors in which both sides excoriate one another, more concessions may be given (usually in the form of salary cut-backs), and the investors continue to fund the next tranhce and Management remains equally stuck in their ability to move the business forward.

  • http://startupcfo.ca startupcfo

    There are two very legit use cases for bridge or pier funding:

    1.) When you have or are about to get a term sheet and need some runway to close; and

    2.) to bridge the gap in terms of milestones needed to move from seed to Series A. I find that there is a big gap in what series A VCs need to see vs. what can be accomplished with the typical seed round. This usually requires some form of seed top up

  • http://startupcfo.ca startupcfo

    There are two very legit use cases for bridge or pier funding:

    1.) When you have or are about to get a term sheet and need some runway to close; and

    2.) to bridge the gap in terms of milestones needed to move from seed to Series A. I find that there is a big gap in what series A VCs need to see vs. what can be accomplished with the typical seed round. This usually requires some form of seed top up

  • http://twitter.com/JoshGrot Josh Grotstein

    3.) term sheet (in hand) from prospective investors in next round OR prospective buyer of company…

  • http://twitter.com/JoshGrot Josh Grotstein

    3.) term sheet (in hand) from prospective investors in next round OR prospective buyer of company…

  • http://www.victusspiritus.com/ Mark Essel

    Thanks. Totally agree with the rationale and consequences of pier funding. I think the philosophy behind your post lends itself to many facets of our professional and personal lives.

    Commit or quit.

    Chock this post up to another professional experience share that helped avoid a bad situation I never knew existed. Good stuff Mark.

  • http://www.victusspiritus.com/ Mark Essel

    Thanks. Totally agree with the rationale and consequences of pier funding. I think the philosophy behind your post lends itself to many facets of our professional and personal lives.

    Commit or quit.

    Chock this post up to another professional experience share that helped avoid a bad situation I never knew existed. Good stuff Mark.

  • http://www.knyshov.com Leonid S. Knyshov

    Distractions are quite brutal. I am working on my startup and even a phone call can throw me off the track for a few hours.

    Raising funds every 90 days is hardly a low-stress solution. Perhaps the question to be asked is “What concerns do you have that prevent you from funding us with 250K today?” Apply standard sales questions and get to the root cause of lack of optimism.

    By the way, this site is currently reported as an attack site in Firefox. I have no doubt that is not your fault, but please resolve it. Let me know if you need help with that.

  • http://www.knyshov.com Leonid S. Knyshov

    Distractions are quite brutal. I am working on my startup and even a phone call can throw me off the track for a few hours.

    Raising funds every 90 days is hardly a low-stress solution. Perhaps the question to be asked is “What concerns do you have that prevent you from funding us with 250K today?” Apply standard sales questions and get to the root cause of lack of optimism.

    By the way, this site is currently reported as an attack site in Firefox. I have no doubt that is not your fault, but please resolve it. Let me know if you need help with that.

  • http://www.rogerlapin.co.uk Hampshire Magician

    I agree – distractions can put you of the trail for hours – it was reported that any distraction can put you off track for 12 mintues – 3 of them and you have lost half an hour.

    Roger
    Magicians in Hampshire

  • http://www.rogerlapin.co.uk Hampshire Magician

    I agree – distractions can put you of the trail for hours – it was reported that any distraction can put you off track for 12 mintues – 3 of them and you have lost half an hour.

    Roger
    Magicians in Hampshire

  • raduprisacaru

    Great post can you recommend any forums to join?

  • raduprisacaru

    Great post can you recommend any forums to join?

  • http://www.justinherrick.com Justin Herrick

    Great article mark, dont really have much to add because I really did not know anything about this aspect of funding until now. Very very informative and great to know, Thanks.

  • http://www.justinherrick.com Justin Herrick

    Great article mark, dont really have much to add because I really did not know anything about this aspect of funding until now. Very very informative and great to know, Thanks.

  • Marc Jacobs

    Good post. I would just like to add that there are other options out there.

    My company got in touch with eSolve Capital and they have a division handling high tech startups (you can find under http://esolvenano.com/about ) which has access to a wide range of funding offers providing excellent conditions.

  • Marc Jacobs

    Good post. I would just like to add that there are other options out there.

    My company got in touch with eSolve Capital and they have a division handling high tech startups (you can find under http://esolvenano.com/about ) which has access to a wide range of funding offers providing excellent conditions.

  • Marc Jacobs

    Good post. I would just like to add that there are other options out there.

    My company got in touch with eSolve Capital and they have a division handling high tech startups (you can find under http://esolvenano.com/about ) which has access to a wide range of funding offers providing excellent conditions.

  • Marc Jacobs

    Good post. I would just like to add that there are other options out there.

    My company got in touch with eSolve Capital and they have a division handling high tech startups (you can find under http://esolvenano.com/about ) which has access to a wide range of funding offers providing excellent conditions.

  • Matt

    Interesting. But can they deliver?

  • Matt

    Interesting. But can they deliver?

  • Marc

    Well sure, there was no problem.If you want to be sure, go to top level directly – Esolve Capital under http://esocap.com. There you can talk to a guy called Sewing

  • Marc

    Well sure, there was no problem.If you want to be sure, go to top level directly – Esolve Capital under http://esocap.com. There you can talk to a guy called Sewing

  • http://squallco.tumblr.com/ Kevin

    This is a great post and it speaks to the title of your blog really, really well. There are two sides to the table, and drip feeding companies isn't right or respectful of people's time or energy or ability.

  • http://www.cosential.com Dan Cornish

    A bridge loan is a loaded gun pointed at the founder's head. It becomes very easy for investors to use the leverage a loan provides to push out management. An investor can say, we will call the loan and bankrupt the company unless you step aside.