Follow on investment is an important strategy used by venture capital and private equity firms to provide additional capital to existing portfolio companies. This strategy allows VCs to double down on their top performers and maintain ownership stakes. However, implementing follow on investments effectively requires careful planning and execution. Some key factors for success include thoroughly evaluating company progress, maintaining reserve capital, negotiating fair terms, and aligning incentives with management. With the right approach, follow on investments can help VCs maximize returns while supporting the growth of their best companies.
Conducting thorough due diligence on company progress
Before making a follow on investment, VCs must carefully evaluate the company’s progress since the initial investment. This includes assessing metrics like revenue growth, product development, customer traction, market landscape, and management execution. The goal is to ensure the business fundamentals remain strong and additional capital will be used effectively. For example, if growth is lagging initial projections, the VC should dig into the reasons before investing more.
Maintaining sufficient reserves for follow on rounds
VCs should plan for follow on investments from the outset and maintain sufficient reserve capital. Typically 20-40% of a fund is reserved for follow on rounds. With adequate reserves, VCs can support their top performers with additional capital as needed. If reserves are insufficient, the fund may struggle to maintain ownership through future dilution.
Negotiating fair terms that incentivize performance
Follow on terms must be negotiated carefully to protect against downside risks. VCs should bargain for preferences like liquidation preferences and ratchets to ensure they get paid back first if the company is eventually sold at a lower valuation. They can also structure terms to incentivize management to meet milestones before obtaining additional capital.
Aligning incentives between VCs and management
Follow on investments represent an opportunity for VCs to align incentives with management for the next growth stage. This may involve negotiating additional vesting schedules or performance milestones for founder shares. The terms should motivate the team to focus on metrics that increase the likelihood of a successful exit down the road.
In summary, follow on investment is a key strategy for venture capital and private equity firms, but it requires thoughtful preparation and execution. By thoroughly evaluating progress, maintaining capital reserves, negotiating strong terms, and aligning incentives, VCs can successfully leverage follow on rounds to maximize returns from their highest potential companies.