Rethinking Follow-On Conventional Wisdom
Follow-ons are for making money from carry, not for building a track record.
I’m continually surprised by the relative lack of deliberation and consideration that often goes into follow-on decision-making processes, compared to initial investments, despite the typically larger sums involved. Of course, the approach to follow-ons varies across firms. Some adopt a nearly automatic stance of maintaining pro-rata investments until bowing out in later stages. Others utilize more discretion in deciding how much to invest into subsequent rounds of financing.
Contrary to popular belief, especially for those early in their venture capital career, aggressively advocating for substantial subsequent follow-on checks into personal portfolio companies may not be the most strategic career move. The inclination to increase investment in subsequent rounds can lead to more significant downside risk without proportionate upside benefits.
Your initial investment is typically made at the lowest cost basis and the smallest check size, setting the foundation for your investment's potential success. As you inject more capital, you're not only raising your entry price while diminishing your investment multiple but also possibly eroding the ultimate IRR on the position. The only tangible benefit is the ultimate absolute cash-on-cash returns, which of course is absolutely crucial if you're a General Partner or have a significant carried interest in the fund. “You can’t spend IRR,” my old mentor used to repeat. But if you're not in such a position to reap those cash rewards, your primary career focus should be on building a robust track record.
There's a common refrain in VC: “We always wish we owned more of our winning investments.” Regardless of how much you heavy up along the way as the company builds, this sentiment will still prevail at exit. However, continuously increasing investment in follow-on rounds elevates the average cost basis of your investment, impacting return metrics. More importantly, it's crucial to remember that the greater the amount of capital you invest, the higher the risk of a significant loss.
Lee, my partner at NextView, often reminds our team, “Failure is always an option.” While later-stage rounds might seem less risky, they are never entirely devoid of risk. Consider the final set of outcomes of any investment: a big win, a huge win, a loss, or a catastrophic loss. On the positive side, any form of win is beneficial for your career with early success. However, a substantial loss can be devastating, and it’s the one outcome to relentlessly avoid.
Nassim Taleb, in his book “Skin in the Game,” articulates that “Rationality is avoidance of systemic ruin.” This philosophy rings true in venture capital. Having witnessed industry peers continually heavily back a high-flying portfolio company only to see it ultimately fail, the follow-on career lesson is clear: don’t bet so big that you risk losing your seat.
Don’t misinterpret this advice and mis-signal weakness to your peers about companies in your portfolio which you actually do have confidence in. It would be a foot-fault to be sheepish about your winners in team meeting communications. Instead, the counsel is to take into account where you are in your career when you’re thinking about and advocating within your partnership for follow on participation. As you build your track record and stand to gain more from the absolute carry returned to the fund, either at your current firm or elsewhere, your approach to follow-ons should evolve accordingly.