Dynamics of Follow-On Investment Strategies for VCs

Success in venture capital, particularly during the initial funding stages, relies heavily on the strategic allocation of follow-on investments. Fund managers often need to increase their stakes in the most promising ventures, a practice commonly referred to as "doubling down on winners." This strategy underscores the importance of pro-rata rights, which are essential for investors to preserve their stake in a company and are, therefore, highly sought after and valued.

As Sequoia Capital's Alfred Lin aptly put it, "The best venture capitalists double down on their winners."

Primary Follow-On Investment Approaches in VC

Venture capitalists typically adopt one of the following strategies for their follow-on investments:

1. The "Percentage of the Fund" Approach: This strategy involves earmarking a predetermined portion of the total fund for follow-on investments, typically between 40% and 60% of the fund.

2. The "What's Left" Approach: Here, the focus is initially on making new investments, with the residual fund balance being allocated to follow-on investments. For instance, in a $100M fund, whatever remains post initial investments and management fees is used for follow-ons.

Overcoming Challenges in Follow-On Investment Strategy

Simplistic follow-on strategies can create complex challenges. Allocating an excessive portion of the fund to follow-ons could limit the manager's capacity to make significant initial investments, which are critical for securing follow-on rights. Identifying which companies are most deserving of follow-on investments is another complex task, particularly when these decisions precede the completion of all initial investments.

A more sophisticated strategy, termed the "Graduation Rate Follow-On Strategy," addresses these issues. This approach includes analyzing graduation rates, assumptions, and dilution in follow-on rounds, and determining follow-on investments by round.

Refining Fund Size and Portfolio Construction

Implementing the graduation rate strategy requires careful consideration of the overall fund size and factors such as initial investment size, desired ownership stakes, and the number of companies in the portfolio. This method advocates for a more deliberate determination of fund size, allowing the manager to focus on specific aspects of the fund and let these priorities guide the fund's scale.

Concluding Thoughts on the Blend of Art and Science in Follow-On Investments

The strategy behind follow-on investments is a critical, yet often overlooked, aspect of venture capital. Adopting a nuanced and adaptable approach to these strategies can enhance fund performance significantly. Best practices include making real-time adjustments and aligning strategies with actual developments, effectively blending the artistic judgment and scientific analysis inherent in early-stage VC investing.

As Peter Thiel highlighted, "Following-on is critical – As with Blackjack double-downs, you must press your winners. - 66% of the money in a VC fund should be reserved for following-on. This is the process of investing in the future rounds of existing portfolio investments. By following-on, an investor can maintain its ownership percentage in the startup, without being diluted. This provides governance and absolute dollar return advantages at exit."

These insights and strategies underscore the critical role of follow-on investments in the success of venture capital funds, and the need for a thoughtful and adaptable approach to maximize their impact.

• Sources:

  • GoingVC - Follow On in Venture Capital

  • Beauhurst - How Top VCs Balance Follow-On Funding with New Deals

  • Toptal - 3 Core Principles of Venture Capital Portfolio Strategy

  • Venture Capital Careers - What is a Follow-on Investment

Snowball

During the recent holiday week, the startup funding landscape experienced a noticeable slowdown, a common trend during this season. Notably, there was a sustained focus on sectors that have shown resilience and potential for growth, such as AI. This indicates that, while the frequency of deals may decrease during holiday periods, the strategic pursuit of promising opportunities continues unabated.

In particular, growth-stage startups in their Series B rounds stood out by securing funding. This trend suggests that investors are keenly interested in supporting startups that have already demonstrated market fit and are poised for expansion. The holiday week, therefore, didn't dampen the enthusiasm for startups that are seen as ready to scale.

Early Stage

• IrisandRomeo: Standing out in the beauty industry, IrisandRomeo closed an $8.1M Series A round, bringing their total capital to $9.3M. The brand is recognized for challenging the traditional beauty hustle with its 'less is more' philosophy.

Growth Stage 

• Zeal: secured a $14.5M Series B round, reaching a total of $29.9M in capital. They are redefining payroll services, empowering companies to develop unique payroll systems.

• Petlibro: A new player in the pet care market, Petlibro closed a $14M Series B round, with a total capital of $24M. They specialize in advanced automatic and camera-enabled pet feeders.

• Lily AI: With a $12.4M Series B round, increasing their total capital to $51.9M, Lily AI is bridging the gap between brands and consumers with their AI-driven solutions that enhance customer engagement and brand loyalty.

Valley Connector Extraordinaire: Zahava Stroud

In the fast-paced world of startups and investors, Zahava Stroud stands out as a remarkable figure. As the President and Co-Founder of Angel Launch, she has built a strong reputation as a dedicated network builder, bringing together promising startups and enthusiastic investors. Angel Launch has become synonymous with providing a platform for angel investors to advance their collective initiatives.

A graduate of the University of California, Berkeley, Zahava's impact goes beyond mere introductions. Her creative and no-nonsense approach is evident in the seamless execution of impressive events and platforms, fostering meaningful connections that drive progress. Her signature orchestration involves executing major events with a lean team, ensuring that each interaction sparks a new opportunity.

Zahava's contributions extend far beyond events, weaving her into the very fabric of the valley ecosystem. Despite her significant efforts often going unrecognized, we proudly acknowledge her as a valuable partner and collaborator as we step into 2024.

As we look forward to the year ahead, we celebrate Zahava, Angel Launch, and the countless connections forged. The valley's entrepreneurial landscape wouldn't be the same without her.

Upcoming Events

• Jan9: The AI Hustle: Happy Hour for Startup Founders & VC (San Fran)

• Jan10: JPMorgan Chase Ignite + Open Future Investor Networking (San Fran)

• Jan11: Venture Vision 2024 - Module 2 (Remote)

• Jan17: Ignite Path Ahead (Palo Alto)

• Jan29: AI User Conference (San Fran)

Interested in collaborating or presenting at the next Ignite event? Reach out to us and get on our events list!

Podcast We’re Listening To:

Thanks for letting us Ignite your Morning ☕️

Our number one goal is to provide you with valuable, insightful content that meets your needs and interests. So please, don't be shy! Let us know what you think - your feedback is essential to making our newsletter the best it can be.

As we continue to grow our community, your input will play a crucial role in shaping the direction and relevance of our publication. Together, we can build a truly amazing resource that serves our community's needs.

Logan Lemery
Head of Content // Team Ignite