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.
Read the full article here
