When I invest in a startup, it’s just the beginning. I’m scrutinizing every update to see if this will be one of the few, the proud, the Follow-On Investments.
The Feeler Bet
I make a series of bets on the best companies, not just one. My first check is usually what I call a “feeler bet” of around $5,000.
It’s just a small check that helps me get to know the founders. I start getting the investor updates and helping where I can.
This gives me the insider’s view of the company.
I see what’s going well. I also start to see problems that outsiders aren’t aware of.
Double Down
After a year or two, most companies are ready to raise more capital. At that time, I have to make a big decision: double down, or cut my losses?
I want to significantly increase my ownership in a handful of the best companies. I re-invest in around 20% of the companies I back.
For those winners, I usually want to increase my bet by 4-5x.
How My Bets Work
I usually make one or two follow-on bets. These generally come at the Seed Extension or Series A.
At that stage, I have enough information about the startup to make an informed decision. At the same time, the price is still low enough to give me a lot of upside.
Whether I make two smaller bets or one big one depends on where the company is at.
For a startup I re-invested in recently, I gave them $10,000 now, with another $10,000 earmarked for their next round. They were at around $3 million a year in revenue, meaning that I can probably invest again in the next round at a valuation below $30-40 million, my sweet spot for follow-on.
For another company I doubled down on recently, I coughed up the whole $20,000 at once.
They were already at $10 million ARR. The train was leaving the station.
Their next round could be at over a $100 million valuation — more than I want to pay. So it was now or never.
So Who Gets The Money?
I only do follow-on in the very best companies.
I want to see rapid revenue growth. Startups should be tripling revenue year over year, or at least doubling if revenue is over $1 million.
Burn must also be reasonable. I want to see a burn multiple at 2 or less.
Together, these metrics tell me the company’s product is catching on. They also tell me that the growth is sustainable and the company is unlikely to flame out.
The Power Law at Work
The fundamental rule of venture capital is the power law. The power law holds that a tiny fraction of companies give us almost all our returns.
I’ve invested in 26 companies. Realistically, one or two will probably give me almost 100% of my gains.
After a year or two working with a startup, I have a far better idea if it’s a leader or not. I then use that information to my advantage.
I increase my ownership percentage in those couple of winners, while standing pat on the struggling companies. This should magnify my returns in the top startups.
How Pro Rata Fits In
Pro rata is the right, but not the obligation, to re-invest in a startup. If you have pro rata, you have the right to re-invest enough money to maintain your ownership percentage in future rounds of funding.
Despite all the play pro rata gets in books on venture, it’s mostly irrelevant to my investments.
I almost never want to take exactly my pro rata share of a funding round. Either I want to take far more (“super pro rata”) or nothing at all.
Think about it — how likely is it that the exact optimal investment in a round just happens to be the $5,351 that you’re entitled to under pro rata?
That said, pro rata is valuable in competitive rounds. Maybe I can’t increase my ownership, but at least I can defend my position against dilution.
I have pro rata rights in almost every deal I do. You should certainly get them if you can.
Having to Say No to Great Founders
The hardest part of follow-on is having to say no to great founders. Just recently, a very hard working founder in my portfolio asked for another check.
I knew that he’s toiled tirelessly, day and night, to make the company a success. I have great respect for his dedication.
But the progress just wasn’t there. So I passed.
If you give more money to everyone, your returns will stink. What’s more, it’s not fair to those companies that have done everything you’ve asked, and more.
The good news for that founder is that the situation can change! If his company starts crushing it, I’ll be beating down his door to put in another check.
That’s why my answer is never “no,” but “not yet.”
Wrap-Up
Follow-on investing is a superpower.
You gain bigger and bigger slices of your winners. Re-investments and markups can make your top investments dozens of times larger than your failures.
Be ruthless in your follow-on decisions.
Only the best companies should get those extra checks. Throwing good money after bad doesn’t work.
You can still support the struggling companies with introductions and advice. But this is a business, and coffee is for closers.
Do you do follow-on investments? Why or why not?
Leave a comment and let us know!
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