A venture fund maintaining some allocation for follow-on investments is not unheard of. But should VCs do this?
Follow-on investments won’t ever be the deciding factor in which funds win or lose, but they will continue to distinguish the top decile from the top quartile.
After all, if a company achieves wild success — the goal of any venture investment — then the initial investment will always do better than any follow investment.
So, as investors, why don’t we put everything into that first check to maximize the return? The answer to this requires an exploration of venture mechanics.
Follow-on investments increase the chances of follow-on investment
Follow-on investments are strategic and can often be the difference between a successful next financing round and your portfolio company going bust. They tell new investors that you have skin in the game and believe in your portfolio company, so they should too.
Imagine you’re a lead investor talking to downstream investors about the “best” company in your portfolio. You want them to lead the next round and suggest they do so, but when they ask if you’re joining the round, you tell them no.
Even if your reasoning is that you don’t reserve any capital for follow-on investments, you’re not sending a positive signal.
And what they do next . . . well, what do you think you would do in that position?
There is too much variability to be precise with the runway
Beyond optics, we find many idiosyncratic risks of venture capital. Besides a once-in-a-lifetime pandemic, you cannot always accurately predict things like FDA approval timelines or supply chain constraints, which means your portfolio company’s runway will likely be shorter than what is necessary to get to its next milestone.
Ultimately, there’s too much variability in how far a funding round will take a company, and even the best efforts to estimate runway are often wrong.
What’s more, even if a company reaches its milestone, a small coffin leaves little room to negotiate a good valuation, leaving earlier investors more diluted than they should be.
Allocating for a follow-on investment provides a bridge to get your companies to the next financing round and position them for a strong negotiation. If the investment is not a “bridge to nowhere,” the fund will likely have a higher survival rate and be poised for a higher return.
Success from piggybacking on other investors is incredibly rare
Asking if it’s possible to piggyback off other investors is a fair question. If you’re a small investor, can’t you let the bigger guy worry about the bridge and send a positive signal? If you’re only following on for $100,000 in a $10 million Series A, it wouldn’t be material anyway.
The answer to this really depends on how you make money.
One strategy we’ve seen is for a fund to spray investments into as many as 200 companies — sometimes more — on a hope and a prayer that at least a few of them are unicorns. This “method” is only as successful as your hit ratio ends up being. If you’re able to have a high hit ratio relative to your losses, then sure, this would yield a better result.
But in order for this spray-and-pray strategy to work, you must have a great deal flow, be a great company picker, and be able to convince the best startups out there to take your super-small check even though you’re likely never going to be useful to them given how many companies you invest in.
If you can somehow achieve all of these, then yes, you probably fit into a rare category of a fund that does not need a follow-on investment. Doing any one of these three is already hard. Doing all three of these is damn near impossible.
Know the role of your follow-on investment
Your follow-on investment is part of your fund’s overarching strategy on how you make money. It is important, therefore, to understand exactly where your return is coming from.
Some funds make their money primarily on follow-on investments. Others use follow-on investments to exert influences throughout their portfolio company’s life cycle or to send positive signals to downstream investors. Still, others need a high hit ratio and might use it to prevent catastrophic outcomes for any one company.
Venture funding has gone up 10x over the last 15 years. We don’t live in a world where it’s prudent or responsible to put all funds toward our initial investments. VC fund managers must be strategic and tactical with a clear understanding of how various investment stages may contribute to their overall return.
Follow-on investments won’t ever be the deciding factor in which funds win or lose, but they will continue to distinguish the top decile from the top quartile.