- Short Description:
- Reserve or hold back 50% or more of the fund for investing in existing portfolio companies during later rounds. The argument is that you know them better and have more time to observe the performance
- Benefits:
- Allocate more capital to companies that are performing better. A benefit is that it allows one to maintain a higher ownership percentage in companies that are doing well.
- Trade-offs:
- Follow-on for Love or Self-Protection: If you have money reserved only for portfolio companies, and those are the companies where you have the closest relationships and spend the most time, you hope to make better decisions, but you run the risk of making decisions driven by relationship considerations rather than higher return. Or do you follow-on into your own investments in order to prolong admitting to yourself or others that the company is going to eventually fail? There are many ways that your decision-making could be influenced to reduce the return per dollar invested.
- Limited Pool of Companies: For the pool of capital reserved for investing in later stages of your portfolio companies, you are inherently limiting part of your fund to invest only a limited set of companies. Ideally, those are well selected and will contain some great investments, but the trade-off is that by pursuing the strategy you are limiting yourself to only invest in those companies even if it is not the best choice at the time.
- Fewer Companies: By setting aside more capital for later rounds, you may invest in fewer companies although you could be putting more dollars to work earlier in the company’s life. If you have enough high-quality companies that you could have invested in, you may be missing out on the potential upside.
- Average Later Stage: You also end up investing across the lifecycle of a company which can mean your average dollar invested is invested at a later stage than your entry point. If you are designing and pitching a strategy that targets say, Series A investments, and then you invest in later rounds, you may, on average, be a Series C investor with lower risk and lower return profile. That may not match the type of investment or risk your LPs are interested in.
- Lower Returns: some argue that the returns on the follow-on dollars are likely to be lower as it is in later-stage deals and therefore will reduce the average return of the fund as a whole. Note: this is view is debated.
- Examples:
- Most traditional VC firms reserve some capital for later rounds in a company. It can be as much as 70% or more of the total capital in the fund.
Portfolio Construction: Double Down on Winners
