Insider Trading – Are VCs Dealing Themselves Inside Rounds?

October 4, 2011 at 2:44 pm Leave a comment

Brian Broughman and Jess Fried put forth a study recently on insider rounds in venture-backed companies: Do VCs Use Inside Rounds to Dilute Founders? Some Evidence from Silicon Valley.

As the name implies, inside rounds are rounds of investment by existing investors, versus outside rounds that are led by new investors.

In our valuation practice, we are often confronted with clients having gone through inside rounds, and we need to make a determination if the pricing of those investments provides an indication of value of the equity of a company (regardless of which class of shares; but usually invested as preferred equity). Each case is different, but often such an investment is not a good indicator of value as it lacks arm’s length characteristics.

Although Broughman and Fried only cover a very limited geography (Silicon Valley), a very limited time frame (companies that were sold in 2003 and 2004), and had very specific exit circumstances (M&A), it provides a welcome quantitative analysis of such inside rounds.

The study tries to answer two questions:

1. Are inside rounds (ab-)used by venture investors in order to dilute founders?

Broughman and Fried’s analysis suggests otherwise: inside rounds were mostly used when outside financing was not available. Inside rounds were often flat or down rounds, outside rounds were often up-rounds. Companies using inside financing were less likely to return a profit to their investors. In those cases, the valuation would really not have mattered to the founders, given that any proceeds were first and foremost used to satisfy the liquidation preferences embedded in venture investor’s preferred stock. This analysis seems to be confirmed by the founders’ assessment: in all cases, the inside round was used as a backstop when outside financing was not available.

2. Are inside rounds overpriced or underpriced?

The authors analyze the valuations used in the inside as well as outside financings in their sample and compare those with the ultimate sales price of the target company. Not a perfect measure by any means, but the results are striking: the last inside round valuation was up to six times higher than the ultimate sales price for companies receiving inside rounds, with a median of about two times. Companies with the last round being an outside round had pre-exit financing round valuations of up to two times higher than the ultimate sales price, with a median closer to one times. We’ve summarized this in the following table:



M&A Exit Value vs. Value of Last Round

Character of Financing Round












Inside Round



Outside Round



And why would inside rounds be overvalued?

The authors propose several reasons why inside rounds may be overvalued:

1. Litigation risk: VCs can avoid litigation from disgruntled and diluted founders by overvaluing their follow-on round

2. Signaling: An inside flat round looks much better to the limited partners of a VC than an outside cram-down round. And after additional development milestones are met, it is much easier for the company to fundraise, even if the last was from existing investors.

3. Reduce down-round cost: Staying with a flat inside round avoids triggering anti-dilution provisions, and may eliminate the need for topping off the management option pool, which would lead to additional dilution.

4. Over-optimism: VCs need to be optimists by nature in order to invest in fledgling start-ups. They might as well be optimistic when it comes to pricing their current investments and dismiss an outside investment that comes in “too low”, i.e., carries too much dilution for them.

The study has a number of limitations, foremost its small sample size. Yet it provides some genuine evidence that not all investment rounds are created equal, and that inside rounds may indeed come with a valuation bias of being overpriced.

Gunther Hofmann is a Vice President of The Brenner Group and has done extensive work in valuations, M&A, venture capital, and corporate finance with significant international experience in small firms as well as global corporations. Gunther earned a Master’s Degree in Electrical Engineering and Business Administration from Darmstadt University of Technology in Germany, and was a Visiting Scholar at UC Berkeley. He is a holder of the Chartered Financial Analyst designation, and a member of the National Association of Certified Valuation Analysts. Gunther is Chairman of the Software/IT Industry Group of the German American Business Association (GABA).

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Entry filed under: Financial Advisory, Interim Management, Restructurings, Shareholder Services, Valuations.

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