The 10X Capital Newsletter

The 10X Capital Podcast is a podcast where David Weisburd and Erik Torenberg interview the world’s top Venture Capitalists and their Limited Partners.

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This week’s Liquidity Podcast 💰

Every week, we’re going to cover a topic that is widely acknowledged but often misunderstood in the venture industry.

The truth is, that much of how VC operates today is still opaque, and managers - especially emerging managers - have a hard time finding guidance that they can operationalize.

Our goal is to distill actionable advice that managers can use to raise venture capital in this market.

So without further ado, today’s topic: Follow-on investing 👇

How to think about your follow-on strategy

A successful follow-on strategy is a key component of portfolio construction and can lead to significant swings in a fund’s performance.

There are several questions to consider as it relates to a follow-on strategy:

• Should you reserve capital for follow-on?

• When should you deploy follow-on capital?

• How do you ensure that you have the right to follow on in your best companies?

When talking to managers, I’ve found that many VCs do not have good answers to several of these questions and some have not even considered them at all.

Should you even reserve capital for follow-on?

A successful follow-on strategy is about backing your winners. As an investor, you want to double down on the companies where you have the highest conviction. You do this in order to generate alpha for your LPs. 

Once you write your first check into a company, you have the opportunity to grab a front-row seat and watch the management team execute. Does the management team execute against the vision in elite fashion? This information can be extremely helpful when handicapping IF the company can truly be a breakout winner.

Once you determine which portfolio companies you want to double down on, how should you decide when is the right time to do so?

All else being equal, you should deploy all of your follow-on allocation in the very next round.

With a follow-on investment, your goal is to generate alpha which means achieving higher returns without the same level of risk. . 

A quick math equation on whether to deploy your entire follow-on for the company in the next round is:

Is the Expected Next Round Valuation * Expected Graduation Rate > Current Round Valuation?

Let’s review an example:

Let’s say Company A’s seed round valuation is $25 Million and the graduation rate (the % of companies that make it to the next round) from the seed round to the Series A is 50%.  You should be deploying 100% of your follow-on for that company if you believe the next round valuation will be over $50 Million.

Said another way, if the average graduation rate from the pre-seed to the seed round is 50% and the average markup between the rounds is 3x: 

50% X 3x = 1.5x.

You would be getting 1.5x higher equity value by following on in the seed round, rather than waiting until the Series A. 

If you have conviction in a company, it is best to use all of your follow-on capital in the very next round.

However, follow on, also known as pro-rata is not always guaranteed.  

In fact, it has a sneaky way of being unavailable at the very opportunities where you want to exercise it the most (the Sequoia or Benchmark-led Series A).

How do you ensure that you retain your pro-rata or even access super pro-rata in breakout companies?

Investors reserve the right to follow on in companies based on pro-rata rights. 

Pro-rata rights define the contractual agreement that gives an investor the right to, but not the obligation to, maintain their initial ownership by participating in future fundraising rounds. 

The right to follow-on is always earned never given by being a value-add investor.

Lead investors typically have minimum ownership requirements they must obtain while investing in a company. Because of this, when the round is oversubscribed, smaller investors are often asked to sacrifice their pro-rata rights at the request of the founder.  

If you want to maintain your pro-rata rights as an investor, you must show the founder that you are a valuable partner to the company so that he or she protects your pro-rata rights when that time comes.

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To learn more about this topic and many others, watch my Youtube channel where I interview the very top LPs every week.

Top posts of the week ✍️

Chart of the week 📈

Emerging manager tools 🔧

• Chris Harvey for fund counsel 

  • Reach out to Chris at [email protected].

• AngelList for fund administration

  • Get in touch by emailing the team at [email protected].