Follow-on decisions are as important as the original investment

In my earlier post entitled “Why VC’s need to retain their reputation in company referrals to other investors” I wrote about the importance of referring well performing companies to other investors during follow-on rounds. Of course, a complement or alternative to performing a follow-on round with a new investor is to provide the follow-on yourself.

While there is a cap to our ability to follow-on due to our available capital, it is critical that we increase our exposure to our best performing companies (as long as valuations remain reasonable) in order to have a successful portfolio. In fact, our follow-on decisions are as important for the success of our portfolio as the original investments we make.

As a simple example, let’s consider a scenario where we’re a $10M fund investing $1M per company at a $5M post-money valuation in each of 10 companies. We will therefore have a 20% share in each company and have not set aside any capital for follow-ons. Let’s further assume that 8 of these 10 startups fail and 2 of them succeed to achieve $50M exits after a single follow-on round of funding in which 20% further dilution takes place.

Since we don’t participate in the follow-on rounds, the value of our investment in each successful company at exit is 20% ownership * (1 – 20% dilution) * $50M exit value = $8M. The total value across the two companies is $16M, representing a profit of $6M on our original $10M.

Now let’s consider an alternative scenario where we allocate 50% of our $10M fund value to initial investments and the remaining 50% to follow-on rounds. In this case our $5M of original investments is allocated as $500K per company, once again at a $5M post-money valuation, in each of 10 companies. This gives us a 10% initial stake in each startup.

However, unlike the first example, we now follow-on in the best performing 3 companies. For the sake of simplicity, let’s assume that we allocate our remaining $5M equally across these 3 companies, so $1.67M per company. If we’re the only investors in the new round which takes place at a $10M post-money valuation ($8.33M pre-money), our ownership in each of the better performing companies grows to ($500K original investment * ($8.33M pre-money in new round / $5M post-money in original round) + $1.67M new round investment) / ($10M post-money in new round) = 25%.

In the event that 2 of these better performing companies achieve a $50M exit, our total return is 2 * 25% ownership * $50M exit value = $25M. This represents a profit of $15M on our original $10M. In other words, the incremental return from allocating capital to follow-ons is $15M – $6M = $9M.

As this example shows, the follow-on decision can have a very large impact on the profit you generate from your investments, sometimes generating even more value than the original investment decision itself. If we had taken an example where the successful companies require more than a single follow-on round, or one where we have a larger fraction of capital allocated to follow-ons, the incremental profit from the follow-ons would be even larger.

Early stage venture capital investments are in essence out-of-the-money call options with very high variances. It’s therefore critical to monitor the performance of your investments as new information comes in and to adjust your exposure accordingly. Follow-ons serve exactly this purpose.