Do VCs Use Inside Financing to Dilute Founders?

Abstract

Founders of startups sometimes sue their firm’s venture capital investors (VCs) for forcing the firm to accept follow-on financing from these same VCs at artificially low valuations, diluting the founders. However, there is no evidence on whether VCs systematically use such “inside” rounds – rounds negotiated and financed by the firm’s existing VCs rather than by a new “outside” VC – to dilute founders. Using a hand-collected dataset of 90 follow-on rounds in 45 VC-backed firms, we find very little evidence that VCs use inside rounds to dilute founders. Indeed, the contractual terms and economic returns of inside rounds are typically less favorable to VCs than in outside rounds. Our findings suggest that VCs generally prefer follow-on rounds to be led by outside VCs, and only resort to inside rounds when they are unable to persuade outside VCs to invest in the firm.