To Follow-on or Not to Follow-on, Part 2 of Un-learnings from a VC-Turned-LP

In the investment world, FOMO, fear of missing out, runs rampant. VCs and LPs both dread “missing out” on those asymmetric exits that generate millions or billions of dollars. When it comes to investment psychology, Kauffman Fellow Ben Choi (Class 11) borrows from a distinct series of experiences as both a Limited Partner and a VC. Choi is currently an LP at Legacy Venture, a venture capital fund-of-funds, which aggregates nearly $2 billion from over 500 philanthropic investors. We got the chance to pick Choi’s brain on several “un-learnings” in his transition from VC to LP. In Part 1 of this post, we wrote about: ways to frame risk as “acceptable” and fostering a productive relationship between VCs and LPs. In this post, we’ll be going into differences in follow-on investing intuition for VCs and LPs. Every great investment brings a future investment decision when the company raises new financing or the VC raises a new fund. FOMO can influence VCs and LPs dramatically when considering deploying more capital into existing portfolio investments.1 - For Venture Capitalists, such opportunity comes in the form of follow-on funding: the option to reinvest in an existing portfolio company during a future series of funding. 2 - For Limited Partners, the decision comes with each portfolio VC’s next fund. Often, LPs must decide on the next fund before the investment thesis in the most recent fund has materialized in any material performance.On the surface, a VC making a follow-on investment in a portfolio company looks similar to an LP making a follow-on investment in a portfolio VC. However, they are fundamentally different investment disciplines; understanding the difference will serve VCs and LPs well.Note: Check out Part 1 to learn more about risk and general intuition.

The VC Dilemma: To Follow-on or Not to Follow-on?

When a VC considers a follow-on investment in an existing portfolio company, they have to look forward to the potential of the company and look backwards to their existing investment in that company. Sometimes, the follow-on investment decision can be driven more by looking back than looking forwards. As a VC, your initial investment is bound to get diluted if and when a company goes and raises another round. For example, let’s say you invested $1M for 10% in the Seed Series of an innovative (and made up) on-demand coffee company called Kauffy, giving it a “napkin math” valuation of $10M. Just a few months later, Kauffy announces it wants to raise a Series A for the development of its machine-learning blockchain coffee registry, at a $100M valuation. Congratulations, you just 10xed your initial investment; however, now your ownership will decrease due to the new equity issuance required to raise the round. As a result, your 10% is now less than 10%. In these situations, investors usually have specified pro rata investment rights as part of their agreement to invest with the project. That way, investors in the prior round have the right to participate in future rounds to maintain their percentage-level ownership in the company. Basically, your pro rata investment rights give you the option to contribute additional capital to Kauffy, at the Series A valuation, to maintain your 10%. For VCs, a follow-on investment is a way to protect their original investment and existing ownership. Focusing on the original investment is “looking backwards” for the VC. “There is an offensive and defensive element to follow-on investment for GPs,” Choi says. “In good situations, you want to invest to keep or even increase your ownership stake in great companies. In some bad situations, choosing to not follow-on could result in getting washed out of all prior ownership, for example if a pay-to-play provision is included.”Why do VCs exercise pro-rata rights in a follow-on investment?Investors usually do so if they think that the company is still underpriced at its current valuation, and they follow-on because they have greater confidence that the company will bring on higher returns. This is the forward-looking thinking that all investors focus on for new investments. For example, if the company has made a lot of progress and created value, a VC may determine that a follow-on investment can still generate outsized venture returns on its own. There may be less risk at this stage, another factor that can boost future returns. “Follow-on investments allow VCs to maintain their ownership in companies that they expect to be worth even more in the future,” Choi notes. But VCs often have a larger motivation than the return potential of the follow-on investment itself. VCs also have a signaling incentive to make follow-on investments; after all, what new investor would be excited to invest in a company that the existing investors don’t want to invest in? If a VC does not follow-on, new investors have to believe that the investment opportunity is great despite existing investors (with presumably better knowledge of the company) choosing to not make a follow-on investment. This signal to new investors is a powerful tool to protect a VCs existing investment, regardless of their confidence in the potential for outsized returns from any specific follow-on investment.Why would a VC choose to not follow-on?Of course, if an investor feels that the company won’t bear the increased price or might not be successful, then they would decline further investment. However, some investors with strong confidence in the company might choose to not follow-on. Here are a few examples:

• Stage focus: If you’re a VC with a seed stage investment thesis, the Series C growth round simply isn’t a fit.
• Round is too small: If the round doesn’t have enough capacity the company may want existing investors to “make space” for new investors to get more ownership by giving up their pro-rata rights to make a follow-on investment.  
• Round is too large: If the round is too large, smaller investors may not have the reserves to make their full pro-rata follow-on investment.

Regardless of their rationale, existing investors have an interest in saying good things about the company as they still have a stake in the company.

The LP Dilemma: Do I Take a Leap of Faith?

When LPs consider investing in the next fund from an existing portfolio VC, it might look similar to a VC making a follow-on investment in an existing portfolio company. However, in contrast, LPs focus little on their prior investment and almost exclusively on looking forward both to the return potential of this next fund as well as to preserve the option to invest in future funds. Here’s where it gets interesting: if an LP commits to VeeCee Fund #1 (for example), there likely won’t be enough information to indicate how the fund is performing by the time VeeCee goes to raise VeeCee Fund #2. So, the LP is faced with a dilemma—should they take on the risk of investing in Fund #2 without knowing the full results of Fund #1? “A common narrative for LPs is that by the time the second fund comes around, you don’t have enough information on the first fund’s returns,” Choi affirms. “So, you’re likely going to have to make the decision for Fund #2 with limited supporting data. In fact, the biggest signal is an absence of major catastrophes like partnership blow-ups or massive write-downs the portfolio in the first few years.”While the lack of Fund #1’s performance makes the decision inherently riskier, many LPs will invest in Fund #2 simply to demonstrate a commitment to VeeCee and keep the option to invest in Fund #3 open for whenever it’s announced.Here’s why. Let’s assume our fictional VeeCee lives up to its high-performing prestigious reputation, and Fund #1 absolutely crushes it. New LPs are going to be banging on their front door with the hopes of getting into Fund #3, #4, and so on. VeeCee is in the business to invest in companies, not collect new LPs, so they will give preference to existing LPs when they raise new funds. The VCs are also decent human beings who appreciate loyalty, and they, like most VCs, usually demonstrate that with their LPs. LPs who invested in Fund #1 but declined Fund #2 have a slim chance of getting back in. “When it comes to LPs, you may have concerns for the new fund you’re considering,” Choi comments. “But, you don’t know if this fund or the fund after will find the next Facebook, so sometimes you invest now to keep the option to invest again for the fund after this.”

Final Thoughts

Both LPs and VCs operate with fundamental differences in intuition, particularly when it comes to intricacies such as follow-on investment psychology. “LPs investing in follow-on funds and VCs investing in new rounds are essentially two different games with different prizes,” Choi highlights. “Both situations deal with making new investments built off of previous investments, but they are both unique enough to warrant different approaches.” 1 - For VCs, follow-on investing protects earlier investments in addition to the stand-alone opportunity for outsized returns.2 - For LPs, follow-on investing preserves the opportunity to invest in future funds in addition to the stand-alone opportunity for outsized return. These differences might seem like a matter of semantics, but when it comes to investing at scale and finding the next Facebook, mindset can be everything.Written by Collin West and Nihar Neelakanti