Role of Lead Investors
Lead investors play a crucial role in structuring venture rounds. Typically, the lead investor serves the following functions:1
Provides Capital Security
If an investor invests $100K in a given Company, and the Company is unable to raise a venture round, then that investment would fail due to the lack of capital required for the Company to succeed. Venture investors, therefore, are often wary to invest a small amount in a Company in the absence of other investors providing the required capital.A lead investor provides capital security by writing a large check that takes up 25-50% of the total round. This creates a capital security for all other investors by eliminating or minimising the risk of the Company not being able to raise the required capital.
2
Sets the Valuation
Many investors do not have the experience and/or desire to set the valuation for a given round. By virtue of their experience and investing history, lead investors are equipped to set the valuation for the round.
3
Signalling Effect
The presence of a lead investor creates positive signalling effects, indicating to other investors the presence of others who deem the investment to be a favorable prospect.
Dynamics that Enable Party Rounds
A party round refers to a venture financing consisting of a large number of small investors writing small or medium-sized checks (without a lead investor). The below visual explains common scenarios in which party rounds typically take place:1
Presence of Brand Name Investor
In the event that the Company has a strong brand name investor on the cap table, party rounds become a viable option. With a strong brand investor as an investor, companies are typically able to convince many small(er) investors to write follow-on checks.As an example, YC companies are best known to raise sizeable party rounds (often without having a clear lead investor). Once YC invests in a Company, other investors begin to view that as a “signal” that the Company is a strong bet. This enables YC founders to put together party rounds driven by a large number of follow-on investors.
2
Incredible Growth & Financing Momentum
If/when a Company is doing well, and has shown significant momentum on growth and capital financing, then it often becomes possible to put together party rounds. The momentum on growth creates a strong pull for investors. And the momentum on capital financing indicates that the Company will be able to put together the capital structure it needs to succeed.
3
Exited or Pedigree Founders
Founders that have prior exits and/or background that makes them incredibly well-suited to build the Company that they are working on are often able to pull together party rounds (without requiring a lead investor). For such founders, the ability to attract the capital that they need is not perceived as a risk factor.