Mapping the herd: the UK's unicorn companies in numbers. Download the full report

How Top VCs Balance Follow-On Funding with New Deals

| Lucy Wilson

At the start of the coronavirus pandemic, when lockdown first came into effect in the UK, investors up and down the country were forced to pause and evaluate their course of action. Some stopped backing new opportunities altogether, whilst others tentatively continued, unaware of how the economic fallout of lockdown would play out in the long term. 

But even when we’re not on the precipice of a global crisis, these kinds of decisions are happening all the time. So how do investors go about allocating capital between new companies and their existing portfolios? We’ve spoken to investors from three of the UK’s top VC funds to find out how they make this decision.

Who did we speak to?

Simon Menashy is a Partner at MMC Ventures, where he leads on the firm’s investment strategy. MMC is an early-stage investor which funds transformative tech companies that are shaping 

today’s economy, such as fintech companies, enterprise software startups, and consumer and digital health apps. Whilst it does have a Seed fund, MMC tends to lead investments at Series A, and has backed the likes of Gousto, Signal AI, Senseon and Bloom & Wild. 

Simon Menashy is a Partner at MMC Ventures, where he leads on the firm’s investment strategy. MMC is an early-stage investor which funds transformative tech companies that are shaping today’s economy, such as fintech companies, enterprise software startups, and consumer and digital health apps. Whilst it does have a Seed fund, MMC tends to lead investments at Series A, and has backed the likes of Gousto, Signal AI, Senseon and Bloom & Wild. 

Emma Steele is an Investment Director at early-stage VC Ascension. Emma heads up all of Ascension’s impact funds, which look for mainly Pre-Seed to Series A opportunities where impact and 

return go hand in hand. These include the Fair By Design fund (aimed at tackling the poverty premium) and Good Food fund (looking at childhood obesity in low income households), as well as two EIS structures: an EIS fund which co-invests with the main Fair By Design GP/LP fund, and the Conduit EIS Impact fund, a joint venture partnership with Conduit (focused on economic opportunity, health and sustainability).

Emma Steele is an Investment Director at early-stage VC Ascension. Emma heads up all of Ascension’s impact funds, which look for mainly Pre-Seed to Series A opportunities where impact and return go hand in hand. These include the Fair By Design fund (aimed at tackling the poverty premium) and Good Food fund (looking at childhood obesity in low income households), as well as two EIS structures: an EIS fund which co-invests with the main Fair By Design GP/LP fund, and the Conduit EIS Impact fund, a joint venture partnership with Conduit (focused on economic opportunity, health and sustainability).

Hector Mason is a Partner at Episode 1, a seed VC fund that invests in B2B software, deep tech and marketplaces. Episode 1 has backed some of the UK’s fastest-growing startups, including carwow,

Zoopla and Attest. Hector’s role involves finding the most exciting companies in the UK for the fund to invest in. Alongside this, he has also founded The Seed Stage demo day and co-hosts Riding Unicorns, a podcast all about growth startups.

Hector Mason is a Partner at Episode 1, a seed VC fund that invests in B2B software, deep tech and marketplaces. Episode 1 has backed some of the UK’s fastest-growing startups, including carwow, Zoopla and Attest. Hector’s role involves finding the most exciting companies in the UK for the fund to invest in. Alongside this, he has also founded The Seed Stage demo day and co-hosts Riding Unicorns, a podcast all about growth startups.

How do these VCs balance new investment opportunities with follow-on rounds?

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). 

How has COVID-19 affected investment decisions?

During COVID-19, many businesses looked to bridge rounds or loans, such as through the Government’s Future Fund scheme, to tide them over until their next raise. Some will have been in distress, while others will have simply been bridging a delay in traction—but which companies were which isn’t fully clear yet. As a result, Emma suggests we might see “some funds being a lot more selective in their approach to follow-on opportunities, as post-COVID traction starts to unpick who’s actually winning”. 

Meanwhile, when asked about the impact of COVID-19 on MMC’s follow-on strategy, Simon stresses the difference between 2020 and 2021: “In the early days of the pandemic, my team’s conversations focused on how we could give our companies additional runway, bridging them through the uncertainty, while we waited to see what would happen. But then in 2021, we were very much past recovery and in ‘accelerate into the opportunity’ mode. The conversation shifted to how we could proactively deploy follow-on capital to accelerate the growth of those companies.”

Going forwards, he thinks “we’re still going to see a lot of new, exciting funding rounds in 2022, but there won’t necessarily be that same catch-up effect we saw in 2021—that huge wave of rounds that didn’t happen in 2020 because of the pandemic.”

Where are we headed?

At Beauhurst, we’re optimistic about the future of the UK equity market, with more capital being deployed than ever before. We expect to see investors capitalise on the opportunities arising from the pandemic, with the UK’s next generation of innovative startups and scaleups now more adaptive than ever.

Get the latest startup news and research straight to your inbox, every Thursday.