The standard advice in venture is to hold capital back for follow-on rounds. When we were involved in setting up a venture fund, target ownership and follow-on reserves were written into the allocation strategy from the first draft of the investment thesis, so that the fund could keep backing the companies that started to work and defend its stake as they raised larger rounds. A firm without a fund has no such reserve, and to many investors that looks like a structural weakness.
We rarely follow on, and we think the reasoning holds up better than the convention suggests. It has limits, which we set out at the end.
What a Reserve Is For
In a fund, follow-on reserves solve a portfolio problem. A manager backing thirty or forty companies at seed cannot know which few will carry the returns, so the capital is spread thin at first and concentrated later, once the winners become visible. The reserve is how a fund turns a broad portfolio into a concentrated one.
That logic follows from how a fund is built. It tells a manager how to allocate a pool across a portfolio, and it says very little about whether any single follow-on The amount a single investor commits to a deal.More in glossary is a good investment at the price on offer. Power-law arithmetic explains why funds need reserves, but it makes no claim that the marginal capital they deploy earns an attractive return.
We invest deal by deal, so the portfolio problem does not arise in the same form. We have no portfolio to concentrate and no reserve to deploy, and our aim is that each investment works on its own terms. That aim is never fully met, but it changes the question we ask when a company comes back for more capital.
Every Follow-On Is a New Investment
A follow-on is a fresh investment at a higher price. Knowing the company well is an advantage in assessing it, but that history does not make the new shares any cheaper, and the success of the first ticket says nothing about the return on the next one.
A simple example shows how far apart the two tickets can be. The numbers are illustrative and ignore A term that entitles certain investors to be paid back first, usually their original investment, when a company is sold or wound up.More in glossary and later rounds. An investor puts CHF 10,000 into a seed round at a The value of a company immediately after a round, equal to the pre-money valuation plus the new money raised.More in glossary of CHF 1 million, for a stake of 1 percent. The company does well and raises CHF 1.25 million at Series A on a The value agreed for a company immediately before new money is invested.More in glossary of CHF 5 million, and a few years later it is sold for CHF 20 million.
| No follow-on | Pro-rata follow-on | |
|---|---|---|
| Seed ticket | CHF 10,000 | CHF 10,000 |
| Series A ticket | CHF 0 | CHF 12,500 |
| Stake after A | 0.8% | 1.0% |
| Total invested | CHF 10,000 | CHF 22,500 |
| Proceeds at exit | CHF 160,000 | CHF 200,000 |
| Net profit | CHF 150,000 | CHF 177,500 |
| Multiple | 16.0x | 8.9x |
Following on earns more money in total, which is why it feels like the right decision. Judged on its own, the second ticket tells a different story: CHF 12,500 invested at Series A buys 0.2 percent of the company and returns CHF 40,000 at exit, a multiple of 3.2. The seed ticket returned 16 times its cost, and the blended 8.9 times is an average of two very different investments.
So the decision rests on a forward-looking assessment: does this injection of capital have a high probability of compounding well at the new valuation, or is there a better risk-adjusted place for the same money? In the example, that means asking whether 3.2 times on a company that has already proven part of its case beats what CHF 12,500 could earn in a new seed company at a lower entry price. In most cases we have looked at, the seed company has won.
Our scope reinforces this. We invest up to Series A, and anything later is outside it except in very unusual circumstances, because later rounds call for a different kind of analysis and a different kind of capital.
Where Our Influence Comes From
Funds also follow on to protect their position. A falling percentage can mean a lost board seat or less weight in the next negotiation, and pro-rata participation is how a fund keeps its voice.
Our influence rests on other things. It comes from a close working relationship with the management team, from the strategic advice we give, and from An investor who joins a deal alongside a lead, usually with a smaller ticket and through the same vehicle.More in glossary who bring their own networks and experience to the company. A founder who finds that relationship useful keeps listening when our percentage shrinks, and one who does not would not listen more because we owned an extra half point.
Bridges Are a Different Decision
There is one pattern we use often that can look like following on. Before a priced round, we sometimes extend an early round through several A loan to a company that converts into shares at a later financing round, usually at a discount or subject to a valuation cap.More in glossary tranches. In one portfolio company we signed three tranches, each time to bring in new co-investors who could act as strategic advisors and open doors to clients the company needed.
These are extensions of the seed stage rather than follow-ons at a higher price, and each tranche had a specific purpose. Founders should still treat them with care, because stacked notes carry the The reduction in an existing shareholder's percentage ownership when a company issues new shares.More in glossary risks we have described elsewhere, and every tranche should bring something the company could not otherwise get.
Where This Reasoning Can Fail
The first weakness is price and risk. A higher valuation is only expensive if the company's future growth no longer justifies it, and the 3.2 times in our example was earned on a company that had already survived its riskiest years, which no new seed ticket has. If a company is still underpriced relative to its eventual exit, the follow-on ticket can earn an excellent return, and a firm that defaults to new seed deals will sometimes leave that return on the table. The protection is to judge every follow-on on its own forward-looking merits instead of by habit, which is why we say rarely and mean something short of never.
The second is the down round. Indifference to our percentage works when later rounds are priced fairly, but it stops working when they are punitive. Pay-to-play provisions can convert the preferred shares of investors who do not participate into common shares, and a heavily dilutive recapitalisation can leave an early ticket with little economic value. In those situations, sitting out can impair the investment we already hold.
Part of the answer has to be negotiated at entry. Swiss company law gives shareholders a subscription right in capital increases, although a shareholder resolution can withdraw it for important reasons, and shareholder agreements commonly add a contractual An investor's right to invest in future rounds in order to maintain their percentage ownership.More in glossary in later rounds. We have not made that right a point of negotiation so far, and we intend to, because it costs nothing to hold and it preserves the option to follow on in exactly the situation where sitting out would hurt most.
The rest is the same forward-looking question asked under pressure: whether new capital would be defending a viable business or subsidising one that no longer has a path, and that question needs an answer before the A short, mostly non-binding document setting out the key terms of an investment before the full legal agreements are drafted.More in glossary arrives.
The First Ticket Carries the Weight
A fund can afford a loosely priced seed ticket because its reserve gives it a second chance to concentrate. We rarely take that second chance, so the first ticket has to be priced, structured and supported as though it will be the only one, and that is the standard a deal-by-deal model holds us to.