Based on my experiences, it becomes clear whether a startup has the potential to scale its activities within a year after receiving its seed investment. Assuming that you invested based on proper research into the startup’s founding team and their target market, you can reasonably expect half of the companies you back to show the progress necessary to raise follow-on funding. At this time, it’s important for you to be able to participate in the new round. If you do not do so you will have sacrificed your hard-earned opportunity to share in the future upside of a startup which you supported when very few other investors were comfortable with its associated risks. In addition, not participating in the new round is likely to lead to the significant dilution of your stake. When an exit occurs, many seed investors who didn’t make follow-on investments are disappointed to discover that their final share has become too small to compensate them for the original risk that they took.
In order to participate in the follow-on round, you need two things. The first is to have the right to participate at the same terms as the other investors in the round. You can prepare for this situation by including a right of first refusal clause in your original seed investment. In addition to having the right to participate without offering better terms than a competing investor, you also need to have the capital to do so. This is why it’s important for seed stage funds to structure their fund so as to allocate sufficient capital for follow-on investments. Since the better performing half of your startups will raise follow-on funding in a round which will likely be two to three times as large as the seed round, it’s good practice to reserve between a half to two thirds of your fund for follow-on investments.
In addition to the clear benefits which follow-on investments have for seed stage investors, they are also advantageous for entrepreneurs. Earlier investors have an important informational advantage over later entrants in terms of their knowledge of the startup’s past activities. This makes them better able to evaluate the startup’s future potential. As a result, a follow-on investment by an existing investor sends new investors a strong positive signal about the startup’s prospects. This makes it easier for the entrepreneurs to raise new funding. By spending less time on fundraising, entrepreneurs are able to focus their efforts on where it matters most: improving the performance of their business and scaling.