How Top VCs Balance Follow-On Funding with New Deals

Speaking to Emma Steele, she tells us how there are generally two main schools of thought for General Partner/Limited Partner funds. First, there’s the ‘portfolio construction’ approach, where a fund will look to increase its ownership stake of its most successful portfolio companies over time, to maximise returns at exit. This involves carefully structuring investments, looking closely at target stakes and valuations, and being strategic with follow-on funding for portfolio winners.

Alternatively, there’s what she calls the ‘high volume’ approach, where a fund will spread its tickets across as many deals as possible, increasing its chances of getting 100X returns on just one of them. The rationale here is that these kinds of returns, regardless of your stake in a business, will outweigh any potential returns from follow-on rounds—especially as average dilution per round tends to be ~20% each time.

Portfolio support tends to be lower with the high volume route, and follow-on investment more ruthless. This approach is often taken by VCs with access to a large volume of quality deal flow. But for Emma, “it doesn’t take a few tangible issues into account, like the fact that if you dilute the relationship you have with founders by never following-on, you make yourself more vulnerable to hostile takeovers by later-stage investors. You also have fewer defences against diluting events (like massive option pools) introduced later on in a company’s journey.”

At Episode 1, Hector Mason and his team “have a fairly even split between new investments and follow-ons, with roughly half the fund allocated to each.” According to Hector, “there’s a challenge with doing this because you never know exactly how many of your initial investments will go on to raise future rounds…We always want to double down on our most successful startups, meaning we have overweight positions in some of our runaway successes.”

Hector explains “this is fairly standard for the industry, though it depends on the stage you’re investing at—some early-stage funds will aim to improve their chances of finding a unicorn by spreading their capital across lots of startups, while leaving little to follow on with. For our size of fund and investment stage, we feel it’s important to leave enough to double down on winners. There’s a lot of educated guesswork involved here but it’s important work all the same.”

Likewise, at Ascension, “the rule is around 50% reserved for follow-on, with a high degree of selectivity for portfolio winners.” But again, there’s no one-size-fits-all approach, and Emma emphasises that funds “need to understand the nature of the deal flow they’re getting (market size, likelihood of raising massive follow-on rounds etc.) and the opportunity cost of using their capital for follow-on versus new investments.”

According to Simon Menashy at MMC, it’s crucial to be clear on your fund strategy from the start—how big does the fund need to be, how concentrated or diversified, and so on. This then informs how many new companies a fund should expect to invest in over its lifecycle, and prevents teams from making too many decisions on the fly about new opportunities versus follow-on. 

Of course, funds will still need to review their portfolio strategies over time. Simon adds: “I always say that the best-performing companies will end up raising money sooner than expected, both to accelerate and because lots of investors are interested in them. But the companies that underperform the most will also require capital sooner than expected. So that’s the most challenging thing to predict, and can change the amount of follow-on capital we deploy in a particular year, versus what we’d planned.”

An alternative to this, if a fund’s most successful portfolio companies are significantly skewing its follow-on strategy, is to look to other sources of capital. This could be in the form of an opportunities fund (a pot of capital to back a small number of portfolio winners, possibly with new investors) or by raising additional capital into the main fund, midway through its life cycle. Or for later-stage investors, it could mean putting together a special purpose vehicle (SPV) to back a handful of their best-performing businesses.

This is something that MMC has done a few times in recent years, and which is becoming increasingly common in the UK’s venture landscape. In 2019, MMC set up a new scaleup fund, raising £100m to put into its most successful breakout companies in their later-stage rounds (past the point where MMC would be making follow-on investments from its main fund).