Follow on investment is a crucial strategy for venture capital and private equity funds to maximize their returns. By providing additional capital to their portfolio companies, funds can help good companies become great. This strategy allows funds to double down on their top performers. However, follow on investment needs to be planned and executed properly. Funds should set aside enough reserves, thoroughly analyze portfolio companies before investing again, and establish clear milestones. With a thoughtful follow on approach, funds can boost their winners, catalyze growth, and generate outsized returns for their limited partners.
Follow on investment helps companies scale and prevents dilution
The key rationale for follow on investment is to fuel the growth of a successful portfolio company. Often the initial investment is not enough capital for the company to fully realize its vision. Providing additional capital through follow on rounds allows the company to pursue expansion, enter new markets, or roll out new products. This growth might not be possible if the company instead turns to new outside investors and gets diluted. By backing its winners, a fund enables portfolio companies to stay on their high-growth trajectory.
Reserves give funds flexibility for follow on investment
In order to properly execute a follow on investment strategy, funds must set aside reserves upfront. Most funds allocate around 50% of capital for new deals and 50% for reserves. For funds that plan to heavily support their top companies, reserves may be an even higher percentage of committed capital. The exact reserve amount depends on a fund’s investment pace, portfolio diversification, and conviction in follow on rounds. Reserves provide flexibility to continue investing in a fast-growing company without needing to immediately raise a new fund.
Rigorous analysis ensures capital is deployed effectively
Before making a follow on investment, funds should thoroughly analyze the company, market, financials, and growth prospects. The investment team needs to confirm the initial thesis still holds true and evaluate the new incremental opportunity. Some key questions to ask are: Has the company hit milestones? Is the market expanding as expected? Are unit economics improving? Does the valuation make sense? This diligence ensures capital will be deployed effectively to the companies and opportunities with the highest return potential.
Milestones and continued oversight enhance follow on execution
Funds can improve their follow on investing by setting clear milestones for companies to achieve more capital. These milestones demonstrate progress and give the fund decision points to gauge a company’s trajectory prior to investing again. Ongoing board involvement also positions the fund to monitor a portfolio company and recognize when an additional investment may catalyze growth. Hands-on support and defined milestones reinforce a thoughtful follow on process.
In summary, follow on investment allows venture capital and private equity funds to double down on their top performers, fuel growth, and maximize returns. By planning reserves, thoroughly analyzing opportunities, and setting milestones, funds can execute this strategy successfully.