“I want to support the founder.” Whenever I hear myself say that, I throw my checkbook in the river.

Follow-on investments can massively increase your returns. But done wrong, they can sink you.

When Pro Rata Works

Let’s back up and explain what I mean by follow-on and pro rata.

A follow on investment is an additional investment in a company I already placed a bet on. Pro rata is one form of follow-on — the right, but not the obligation, to maintain my ownership percentage in future funding rounds. Basically, it’s a right to invest a certain additional amount in each new round.

Wisely investing follow-on capital can really juice your returns. A study from Primary VC showed that if good funds (3.5x average multiple on invested capital) had done more follow-on, they would’ve returned 8x or more.

Throwing Good Money After Bad

The problem with pro rata is when it becomes about saving a company. Then, we throw good money after bad.

So often, investors put more cash into a company because they “want to support the founder.” That choice of words already implies the company isn’t performing.

If it were performing, we’d say, “I want to jump on a rocket ship!” We wouldn’t be talking about “support.”

That’s our job as investors: jump on rocket ships. Anything else is a waste of time.

That might sound kind of harsh. But it’s really difficult to make money investing in startups.

The vast majority will go out of business. To even return a 1x of what we invested, we have to disperse our funds very carefully.

How I Handle Follow-On Investments

I recently had 2 companies go out of business. I did not invest any follow-on capital in either of them, even though I had the opportunity to do so.

This keeps my losses on those two startups very small. What I don’t want to do is concentrate capital in a company that isn’t performing, then lose it all.

When a founder you invested in asks for more money, it’s hard to say no.

You like them, you like what they’re doing, and you want to support them. What’s more, founders are some of the most persuasive people in the world.

But I have to say no. I need to save that money for the successful companies to help them expand.

I still support the founder in other ways. I’m always happy to help with intros and advice. But I can’t put more cash into companies that aren’t performing.

Wrap-Up

My job as an investor, small though I may be, is to starve poorly performing companies of money. Then, I give that money to the high performers.

Is that a difficult process? Absolutely.

But it’s necessary. That’s how we get innovation.

Venture capital is not a charity.

If we lose all our money, we won’t be able to keep making investments. Then, there will be no venture capital for anybody.

More on tech:

What To Do When a Company Fails

Lessons From My 3 Most Challenged Investments

Learning From My Top 3 Investments

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