Everyone knows the average relationship between a successful entrepreneur and their VCs lasts longer than the average marriage — so founders should think carefully before coupling up with a VC. Savvy founders look to understand what the VC is trying to achieve — up front — and how they fit into the VC’s broader strategy. This series highlights the questions founders should ask, and the VC strategy behind the answers.
Some VCs hold back (“reserve”) money to make further investments into existing portfolio companies — known as “follow-on” capital — while others do not. It’s important for founders to know this up front.
Core questions for founders to ask
- Do you follow on?
- How often do you follow on?
- How much do you reserve for each company after your first cheque?
Why is it important to ask?
In short, knowing what the VC’s approach is gives the founder clarity on the future financial support that is on offer. VCs that never follow on may support the founder to raise the next round(s), but they won’t directly contribute capital. Those that do follow-on may do so automatically, or selectively. Founders can count on future capital from the former group (as long as they can find a new lead investor), but they know they need to sell subsequent rounds afresh to VCs that selectively following-on. Whatever the answer, it’s best to know, both to improve fundraising plans and because it may alter the way in which you interact with your investors.
What is the strategy behind the “follow on” questions?
There are many strategic issues related to following on, but the main one is: “should I reserve capital for follow on, or commit all capital in ‘first cheques’”? Confusingly for founders, there is a disagreement between funds on this — even between larger funds, where there are no concerns about having sufficient diversity in the portfolio, or ownership in each company.*
There are large funds that take a “first cheque” strategy, building a diversified portfolio of larger cheques on entry, with higher ownership, but reserving nothing for following on. Then there are funds of the same size that take a “follow on” strategy — building the same sized portfolio with “first cheques”, with lower initial ownership, reserving capital for following on at subsequent funding rounds. That’s because there are arguments in favour of each strategy; reasons that shape a lot of VC behaviour with their founders.
Reasons a “follow on” strategy might outperform a “first cheque” strategy
- Company-specific knowledge when following on gives you an edge in decision making vs new investors
If a VC is a hands-on investor, regularly engaging with the founder, and (if possible) has formal information rights, they should have far greater knowledge about the company by the time a “follow on” decision is required — certainly far greater than a standard “first cheque” investor before their initial investment. This is an investing edge over the open market, which can be used to make superior investment decisions. These investors would see staking all their money on the company with a “first cheque” as being irrational: it would mean they never benefit from the superior position that they build while an insider in the business.
2. The legal right (i.e. pro rata) to invest gives you an edge on the market
Given that shares (usually) cannot be freely traded, having the legal option (i.e. a pro rata right) to buy into the company can have value — in particular, when the deal is competitive. The market is not “efficient” in that it does not reflect demand in the broader market: pricing is set by balancing expectations and requirements of the founders, existing investors and, crucially, the VC/ set of VCs that the startup actually wants to participate. As a result, it is often true for many hotly competed deals that the startup could have raised at a higher valuation, but the founder instead agrees a lower valuation that works for the VCs they want in the round. It’s why there is some evidence to suggest that the largest, most successful funds — that are usually most desirable for founders — frequently pay lower prices for investments than other, less credible funds do in comparable deals.
Pro rata access to these hotly competed deals essentially creates value for the deal participants, right at the point of investment— “follow on” VCs understand this.
3. Leverage with the startup can be higher if a VC has the option to follow on — both at the entry point (getting in), but also as they go through the rounds
There is a lot of focus on how VCs can win competitive deals through value add. While we 100% agree with this (Form’s regulatory/ policy strategy value-add being a case in point), the potential provision of additional finance in later rounds is also a differentiator, and one that can definitely win deals. Some founders are attracted by the idea that their seed investor might contribute in successive rounds — reducing the amount of external capital they need to find — and believe that the following-on investor is likely to play a greater role in helping make that round happen (essentially marketing the round for the founder) if they themselves are committing new capital.
On top of this, “follow on” VCs hope that the ability to participate in future rounds means that founders may be more engaged with them after their investment. In these situations, the founders are incentivised by the desire for follow-on financing for its own sake, but also by the desire to avoid the risk of “negative signalling” (see 3 below) if the investor does not follow on.
Reasons a “first cheque” strategy might outperform a “follow on” strategy
- A lack of stage-specific expertise can put you at a disadvantage to first cheque investors in later rounds
For funds that “follow on”, the importance of specialist round / stage knowledge presents a risk when making follow-on investment decisions, next to a dedicated “First cheque” fund that only invests in their “sweet spot” round. For example, a seed fund following on at Series B may well be less clued up on what good looks like at Series B, versus a fund that writes first cheques into B-rounds. The diligence requirements at Series B, inevitably, are different. Without a firm commitment to understanding the round/ stage-specific dynamics at series B, a seed fund risks making investment decisions that are — on average — worse than “first cheque” investors at that stage.
Those pursuing a “first cheque” strategy might claim that a fund is far better off specialising in a single round, to optimise investment decision making. On the flip side, “follow on” funds can mitigate this risk by trying to be experts in more than a single funding round — larger funds often do this with dedicated teams at each stage (e.g. see Sequoia’s seed team vs their growth team).
2. Investment decisions in follow-on rounds can be sub-optimal — by not being treated as fresh, straightforward investment decisions
There are many temptations to not treat “follow on” investing with the same seriousness as investing a “first cheque” in a new startup, and this means that these investment decisions can be less rigorous than a “first cheque” investor’s approach at the same round. The narrative around “protecting yourself from dilution” can be unhelpful in this regard — it makes the new investment sound like it is part of the old investment, which lowers the bar for the new investment decision.
The reasons “follow on” investors can fail to treat follow on decisions as a fresh investment are varied, but circumstances that catch some VCs out are:
- Emotional entanglement — emotional investment and unwillingness to step back from the company or say “no”
- The easy life — a follow-on investment is ready-made, requires no sourcing, and VCs may feel they can skip most of the DD they would normally do
- Optimism bias — we have already committed to the business, and therefore have a psychological bias towards its success
- Perverse incentives — in particular to avoid marking down a loss. A case of “throwing good money after bad” — which can be tempting when trying to present “impressive” paper returns to your next fund’s investors
Recognising these pitfalls, funds with a “follow-on” strategy try to ensure that each “follow on” decision is treated with the same seriousness as “first cheque” decisions.** Again, splitting out the investment teams is one way funds do this — but also by segmenting investment performance by “first-cheque” vs “follow on”, and on a “round by round” basis, to check that follow on decisions aren’t under-performing their initial investments.
3. Negative signalling as a risk to portfolio performance
The spectre of “negative signalling” is often discussed as a risk to a VC and their portfolio. In short, “negative signalling” refers to the negative “signal” that you are sending when a fund chooses not to follow on, when the market knows that the fund takes a “follow on” strategy, not a “first cheque” strategy.
In fact there are two ways that negative signalling can negatively impact a fund’s returns, and both are reasons some VCs avoid a “follow-on” strategy.
a. Negative signalling to other VCs
This is the downside to the point above: “company specific knowledge gives you an edge on the market”. If a VC has this knowledge, and their judgement is trusted by the market, and they choose not to follow on , then this will be counted against investing in the startup. This will be even worse if the VC invested a lot in the previous round — suggesting a high degree of conviction — or worse still if multiple funds invested, and none of them are following on.
Funds obviously vary with regards to how contrarian they are — some positively try to avoid investing in “hot” trends; on the opposite extreme, some funds won’t invest in a deal unless there are notable co-investors alongside them. But either way, most funds value the judgement of certain other investors — whatever they say, they will want to interrogate why a previous investor that they trust isn’t participating in a round.
For a VC that takes the “follow on” strategy, mitigating the risks to the portfolio that signalling poses is difficult. The better you perform as a fund, the more highly your negative judgement will be considered by the market, and the more your judgement will count against a startup that you choose not to follow on in.
Elad Gil made some interesting recommendations for minimising the impact of negative signalling — not by the VC behaving differently, but through actions of the founder, e.g. by claiming that the VC has made a competitive investment, so that they can’t participate; that they have spent no time with the startup, thereby mitigating the sense that the VC has additional, negative information about the startup; or by raising a bridge round, without the participation of any funds, essentially “wiping the signal clean”.
The reality is that the risk of negative signalling is a factor that can’t be entirely mitigated, and just increases the degree to which follow on investing is the VC “stacking its chips” — i.e. concentrating its resource— on potential winners. The startups that a VC doubles down on benefit from additional capital, as well as a degree of positive signalling/ the VC’s brand halo; those that do not receive follow on miss out on the capital and have to deal with a negative signal.
b. Negative signalling to the founder
Arguably, this form of negative signalling is just as important — negative signalling to the founder. When a VC chooses not to follow on, they are risking damaging the relationship with the founder in a way that there is no risk of doing with the “first cheque” strategy. The risk to the VC is twofold:
- That the founder stops caring for the substantive economic or governance rights of the VC. If the founder does not believe that you have their back, then they are likely to be far more willing to sacrifice your rights in future funding rounds. Ultimately, a founder, plus new investors, often have a large degree of discretion over how early stage backers are treated in each new funding round — if a seed investor doesn’t seem supportive, they can’t expect the founder to defend their position, either.
- That the “soft” relationship breaks down, so that the fund loses access to the founders, and is therefore no longer able to help the founder. In addition, the founder is unlikely to be positive about the fund, potentially damaging the fund’s reputation, its dealflow, etc. In an era of review platforms like landscape.ventures, ‘founder NPS’ is rightly becoming a more important consideration for VCs.
For “follow on” funds, mitigating this risk is often a matter of maintaining a strong relationship despite not putting more money into the company. If a VC is a value add investor, who is both present and helpful, a rational founder will still want to maintain the relationship, and is far less likely to compromise either the VC’s economic/ governance position, or to compromise the “soft” relationship. A strong, productive long term relationship also makes the “we’re not following on, here’s why” conversation far easier — the best funds do this well.
Ask your VCs (/ potential VCs) about their approach to following on — and think carefully about their answer, as the reasons that underpin it are likely to shape how they behave for years to come.
Stay tuned for the next two in this series:
- Ask your VC (part 2): how will you support me?
- Ask your VC (part 3): how big do I need to get?
- *AngelList carried out an analysis of this that suggested that there is no material difference in outcome between those who took S1 — “First cheque”, versus those who took S2 — “Follow on” in all the startups that have been invested in through AngelList. The scenario modelled for S2 (described as “double down”) simply modelled following on in startups that “at least doubled in valuation” in the follow on round. This amounts to the question: “will I perform better by investing at seed, or investing at series A exclusively in startups that have had a 2x or more multiple since seed” — to which we should not be surprised that the answer is “they return roughly the same amount”. A useful empirical study would be to look at the performance of follow on investments in actual “follow on” funds (who make new investment decisions at follow on, rather than following a simple rule re. growth multiple since seed), versus their own first cheque investments, and versus first cheque investments in funds following the S1 strategy.
- **For follow-on investors, the key exception to “treating different investments in the same company as completely distinct” is that the outcomes can be interrelated — e.g. when a follow-on investment in a potentially fund-returning startup is needed to keep a company alive — in which case, the due diligence for the follow on investment should include the impact on the “first cheque” investment. This accounts for the “internal” rounds that funds can (often not-publicly) provide an existing portfolio company, in tough periods (e.g. Covid-19).