Surprising Insights From HubSpot's $35M Mezzanine Round

The following is a post from my friend and co-founder/CEO of HubSpot, Brian Halligan.
HubSpot just closed its mezzanine round, so I thought I’d share some surprising things I learned during the process. I’m by no means an expert in this field, so these are just the observations of one entrepreneur.

A Surprising Number Of Potential Investors With Widely Varying Value Propositions

My impression is that times have changed in the growth equity game. It used to be that early stage venture folks just did early stage investing, late stage venture folks just did late stage investing, and public equity investors only invested in publicly traded stocks.  What surprised me is that now, it seems like everybody invests in late stage private companies.

This is certainly not the “official” way to look at it, but here’s the way I ended up bucketing types of investors in my own head.

1. Typical Early Stage VC Firms with Growth Equity Funds – These are folks like Sequoia, Accel, General Catalyst, Redpoint, DFJ, etc.,  that have typically started new funds with new teams focused only on investing in late stage companies.  They write checks from $15 million to $100 million as far as I can tell, and I think they’re pretty valuation sensitive as a group. They usually want to take a board seat and can add a lot of value in terms of knowledge, connections, and pedigree -- Sequoia led HubSpot’s last round and has been huge on those fronts. 
2. Late Stage VC Funds – Think Meritech, Adams Street, August, Norwest, Tenaya, Questmark, SAP, and DAG. These folks only do late stage equity and write checks from $10 million to $40 million as far as I can tell. I think they are less valuation sensitive than the traditionally early stage folks. They are typically a bit more arms length in their level of involvement which often translates into a board observer seat -- they seem to follow-on the top tier early stage folks and rely on them for their advice and connections.
3. Big Check Late Stage Funds – GA, TCV, NEA, etc. seem to only do late stage equity and write checks north of $40 million. I think they are relatively valuation sensitive, but keep in mind I only have a small sample size here. It seems they’ll want a board seat and to be very involved – and they can add a lot of value.
4. Private Equity Funds – TA, Summit, etc.  are the types of firms I know the least about, but my sense is that these folks do late stage investing and write “biggish” checks. They seem to be wired to buy out existing investors, put in some working capital, and raise debt. This can be a great approach for a company, but it’s probably hard to work for a firm that already has a lot of venture money in it. My sense is that they want to be involved and are value-add.
5. Public Funds – The last bucket is folks like Fidelity, T Rowe, Janus, Cross Creek/Wasatch, Altimeter, Tiger, and Morgan Stanley. They invest out of public equity funds, seem to write checks from $10 million on up, and tend to be slightly less valuation sensitive (we’ll talk about why below). They are financial investors and do not want to be overly involved, which means no board seats or observer seats for the most part.

That’s my sense of things based on insights from HubSpot’s mezzanine round of funding. If I’ve missed some funds, please do include them in the comments section so we can make this article as useful as possible. 

The Surprising Value Of Public Investors Investing In Your Private Company

We went with public funds -- #5 above -- not private funds for three main reasons that made a lot of sense for us, though they might not make sense for your company:

1. Public investors tend to buy more of your shares after you go public, while private investors will typically look to sell their shares after you go public.  The venture funds incentive system is set up such that they are supposed to sell the shares and distribute the profits to their investors after a reasonable time elapses following the IPO. My sense is that the period of time between when you go public and when they sell varies widely, and the better the firm’s footing the more likely it is they will hold. Having said that, I think it’s pretty rare that the traditional venture folks actually buy more in the public markets.  It’s important to note that this does not matter if your most likely outcome is a trade sale.
2. Public investors can “recycle” their capital while most venture funds can’t really do that easily. Huh? If Fidelity gets a 70% return on their investment in your company in a year and a half, they are pretty happy -- they can turn around and reinvest that money into other stocks. If Accel gets a 70% return on their investment in a year and a half, they are actually pretty unhappy -- they need to return that 70% to their investors and can’t really reinvest it. In order for venture funds to make their math work, they need to get a 3X return on their investment. So what? Well, this means that the late stage venture folks will likely give you lower valuations and more “structure” (i.e. participation) in their deals to try to reach higher return levels, while the public folks will likely be more flexible. 
3. We are generally very happy with our board and were not looking for new members or even new observers. 

Now, that’s HubSpot. Every company is different. Let’s just say, as an example, that you are a travel technology company that’s doing well, but you need some help on the board, some VC pedigree and connections to improve your team, domain expertise, and maybe some money to buy out existing investors and their board seats. In that case, you’d be nuts not to go with, for example, General Catalyst or Sequoia. 

The Surprisingly Common Use of “Structure”

In our A through D rounds, the concept of “structure” did not come up. In fact, when one of the potential Series E investors asked me, “Are you open to ‘structure’?” it caught me off guard, because I didn’t know what it was and didn’t want to seem like a complete rookie. So I said, “Let me check with my board and get back with you.”  That turned out to be a good answer, by the way.

Structure is a fancy word for preferential terms set up to increase the return of the new investor, or limit the downside of the new investor. As I mentioned earlier, private investors typically need to get a 3X return on a late stage deal, and they’re nervous that they will invest money into a company and six months later it will sell for 75% more than they invested. For someone who can reinvest that capital, that’s a great outcome; for a VC, it’s not. In order to protect themselves from that risk, they will ask for participating preferred stock that, for instance, will put a floor on their return of 2X. Given the VC’s incentives, it makes perfect sense, but that is a different type of equity that sits on top of everyone else’s equity that needs to be looked at extremely carefully. It comes in a lot of flavors and can work well to bridge a valuation gap, but can be confusing, so I recommend folks dig in and build the model on how it ripples through.

Another type of structure that VCs put in is a block on an IPO or trade sale of less than 2X (or something like that). This block makes perfect sense for the VC given their contract structures with their LPs, and it might make sense for you -- but you need to go into that with eyes wide open.

The Surprising Importance of Your Series A Terms on Your Mezzanine Round

It turns out that the terms from your Series A are most often cut and pasted into your later round deals. When you compromise on terms in the early stages, you will have to pay the price in the later stages. You generally don’t start from scratch and rehash the terms.

Surprisingly Rational Pricing

The initial pricing interest in our early stage rounds varied widely; but in our mezzanine round, the numbers came in much closer to each other. There are hard public numbers to look at with publicly traded companies and recent acquisitions by public companies. The pricing discussions just seemed much more “real” than the earlier stage deals. 

My advice here would be to get your arms around the public companies for your industry, and where those companies were when they were your size. We built a chart that showed every public SaaS company and what their revenues and growth trajectories were from their early days to where they are today. It was a useful tool in our discussions, particularly when we were getting compared to public companies that were growing at 25% and we were growing at 85%.

Surprising Value of Currency Valuation in M&A

Private companies buying private companies with stock is a tricky business. After our Series D, we acquired another privately traded company called Performable with a combination of cash and stock. The trickiest part of deals like this is figuring out what their stock is worth, and what your stock is worth. The nice part about just having finished a relatively late stage, clean round is that at least our side had a real number to negotiate from. If neither side has a recent number, those negotiations are really tough to sort out.

Those are some of the surprising things we learned in our recent mezzanine round. Am I missing any insights that you have on this topic? Feel free to leave a comment and let me know.