Funneling through: Follow-ons and Reserves.
Updated: May 2
I hope you are all enjoying springtime in Europe. I have a good feeling for this summer and the rest of the year. While it will take some time for the markets to recover, (most) people did their homework and adapted to the new environment. Also at the early stage, I see great entrepreneurs being very pragmatic. Long-term value creation is back on the menu. If I combine this with all the tech innovations going on, one can only be optimistic.
If this market taught us anything, it is that the quality of investors matters...
One of the key topics that came up over the last weeks in my discussions with founders and investors was reserves and follow-on funding. Cash is King today, not only for startups but also investors. The good thing is that this is nothing new. Markets are cyclical. Over the last twenty years, we have seen our fair share of ups and downs.
So, here is the thing with VCs today: If they have deployed their funds too quickly and are left with no reserves, they are 'toast', especially in challenging late-stage rounds. Growth investors seem to have vanished from the face of this earth. Every day that goes by, the opportunities get better for them. So why rush? This chart says it all...
This is exactly the time when great VC firms not only step up to support their companies but also help them to funnel through. It can be a time of great opportunities. Let’s have a look at what this means.
1. Funneling through. The support of a cheerleader.
I recently crunched some portfolio data, and I updated this critical data point:
And >60% of those follow-on investors are other blue-chip venture firms. And these %ies will increase with the maturing of more recent investments. This is an important metric for us. For context, these are the odds of the ‘VC funnel’ we are up against…
Fundraising and network are the areas where VCs can add the most value to founders. Raising capital from a great firm obviously sends a strong signal to the market and gives you a headstart. But, fundraising is never an easy feat, and investors have to roll up their sleeves. For those who know me, I often say: ‘I love fundraising.’ I find the dynamics of these processes just fascinating. And it always is a challenge, no matter how great the outcome. I have gone through quite some processes by now. Each one is unique. I work tirelessly with my founders to get to that next stage. You can count on that…
Why do I bring this up today? Because we are facing a rash tightening not only of late-stage financing but also early-stage fundraising now. And this pullback from investors has created new dynamics around reserves... This brings me to my second argument on why you should raise from a great investor as early as possible.
2. Keeping reserves matters. The rise of seasoned venture firms.
Here is another key metric for us. This one is so crucial when it comes to strong founder support but also fund management.
What are reserves? Venture firms typically reserve a certain amount of their funds’ capital to support portfolio companies throughout their lifecycle. These reserves are essential to provide additional funding when necessary, meaning participating in follow-on investment rounds (usually required by future investors, see below pro rata section), to re-invest in companies that are doing great, but also to help companies weather unexpected challenges or market fluctuations as we face them today.
Most people think that VC is all about the initial portfolio construction, selecting the companies to invest in. But the truth is that is only half or less of it. Venture investing follows a power law. Reserves allow both, to support winners in difficult moments, and to capture significant upside if things go right while remaining disciplined.
This is one of the unique things about early-stage venture investing. Most other asset classes, such as late-stage, public market, private equity, real estate, and other popular classes typically involve a single or a time-limited series of investments.
2.1. Weathering the storm. The availability of reserves.
VCs are increasingly using bridge rounds (not to be confused with Safe’s, check out this post) to keep their portfolio companies afloat. This trend has now reached earlier phases as well.
One crucial thing that separates a strong VC firm from all other sources of capital is that the best VC firms reserve significant capital for follow-on financings of their portfolio companies. They participate in subsequent financing rounds and do everything they can to attract other follow-on investors. The former differs from angel investors, small seed funds, growth funds, CVCs, or other strategic investors. I definitely don’t mean to play down these other capital sources. They all are critical at various stages but have a different 'modus operandi.' They are also the ones usually pulling out first in a down market.
So, ask new investors how they are thinking about reserves in the DD process. Here are some examples I've come across recently. 2021 was the year of fast, large follow-ons. Many companies raised those follow-on rounds very quickly. Some firms were so optimistic that they did their ‘pro-rata’ in several quick rounds. The flip side is that they depleted their reserves more rapidly, leaving smaller reserves to protect their stakes today. On top, as the tide goes out, more companies than usual request inside now financing. With this double whammy on reserve management, firms have to focus their limited reserves even more. 2021 also saw a record of new funds. Many of those needed to make lots of new investments to show they are 'in the market'. Reserves weren't a focus. So, again, get a great VC firm onboard as soon as possible to avoid some of those challenges.
2.2. The right to re-invest. Pro-rata rights.
When the early-stage folks make an equity investment, they typically negotiate for something called a pro-rata right. This gives them the right to maintain their ownership in the company by investing in future rounds on the same terms as new investors. This does not mean that you can't raise your next round from just insiders (your current investors), but, as the term suggests, the goal is to get new investors on board.
To be able to exercise this right, reserves are critical. Obviously, ownership at this first investment is the most important thing. Still, the ability to maintain it by making additional investments comes close second and can be the source of portfolio out-performance.
We value this right and exercise it very frequently. We often make 2-4 investments in a company, including our initial investment. We have seen these rocketships grow in the past. As the first institutional investor, we know the teams well, and want to get as much as possible of those assets over time.
Founders and future investors welcome the participation of earlier backers, and often require it even. It is a strong sign of confidence, especially if this earlier investor is a great venture firm... Also, if a business is doing really well, I tell founders that we are ready to take up (but don't have to) more of a round than our pro-rata, especially if it helps to close the round in a difficult market like today. This is an 'excellent to have' for founders...
So, if you want someone you can count on your cap table, that would be a VC firm, particularly a top-tier VC firm. I am impressed and relieved by how many founders launching new ventures today get this. This is one of the reasons I am feeling great about the coming months... Onwards!
I was for some meetings in Nice and Monaco early last week. My friend Sylvain grabbed the opportunity and invited me over with some investors to his local accelerator to sit down with his founders. He called the session: ‘VC no bullshit’. The idea was to understand how venture firms work behind the scenes, to understand the ‘real dynamics’. Here is a pic of the soccer stadium in Nice in which the accelerator is based.
Life is awesome
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