A enterprise fund sustaining some allocation for follow-on investments shouldn’t be unprecedented. But ought to VCs do that?
Follow-on investments gained’t ever be the deciding issue through which funds win or lose, however they are going to proceed to distinguish the highest decile from the highest quartile.
After all, if a firm achieves wild success — the purpose of any enterprise funding — then the preliminary funding will at all times do higher than any comply with funding.
So, as traders, why don’t we put the whole lot into that first verify to maximize the return? The reply to this requires an exploration of enterprise mechanics.
Follow-on investments improve the probabilities of follow-on funding
Follow-on investments are strategic and might typically be the distinction between a profitable subsequent financing spherical and your portfolio firm going bust. They inform new traders that you’ve got pores and skin within the recreation and imagine in your portfolio firm, so they need to too.
Imagine you’re a lead investor speaking to downstream traders concerning the “best” firm in your portfolio. You need them to lead the subsequent spherical and recommend they accomplish that, however after they ask if you happen to’re becoming a member of the spherical, you inform them no.
Even in case your reasoning is that you simply don’t reserve any capital for follow-on investments, you’re not sending a optimistic sign.
And what they do subsequent . . . nicely, what do you suppose you’d do in that place?
There is an excessive amount of variability to be exact with the runway
Beyond optics, we discover many idiosyncratic dangers of enterprise capital. Besides a once-in-a-lifetime pandemic, you can not at all times precisely predict issues like FDA approval timelines or provide chain constraints, which implies your portfolio firm’s runway will doubtless be shorter than what is critical to get to its subsequent milestone.
Ultimately, there’s an excessive amount of variability in how far a funding spherical will take a firm, and even the perfect efforts to estimate runway are sometimes improper.
What’s extra, even when a firm reaches its milestone, a small coffin leaves little room to negotiate a good valuation, leaving earlier traders extra diluted than they need to be.