Venture Fund Economics: Allocating Follow-On Capital
It’s time for another entry in my Venture Fund Economics series. This time I’d like to talk about the importance of allocating follow-on capital.
One of the great things about early stage venture capital, as compared to many other investment disciplines, is that you get to build your position in the company over time, sometimes over a very long (5-7 year) period.
So this allows the venture investor to allocate capital to the investments in his/her portfolio based on the performance of those investments. I’ve likened each investment to a hand of poker and it’s certainly a lot like that.
Let’s start with my 1/3, 1/3, 1/3 assumption that regular readers will be familiar with. This says that 1/3 of an early stage venture portfolio will be losers, 1/3 will get your money back or make a little money, and only 1/3 will deliver the kind of performance you expect when you make an investment (5-10x).
If each investment was allocated the exact same amount in a theoretical portfolio, this is how the 1/3, 1/3, 1/3 scenario would play out.
You’d get 2.2x your total invested capital on a gross basis (before fees and carry) and as we discussed in prior posts on this topic, that’s not good enough.
So let’s say you did a $1mm round in your losers, two $1mm rounds in your break evens, and three $1mm rounds in your winners. That would look like this.
You’d get 3x your total invested capital on a gross basis and that is not so great either although it gets closer to acceptable performance.
But fortunately, most companies need more capital as they grow. So let’s assume the one, two, three rounds is right, but that the first round is $500k, the second round is $1.5mm, and the third round is $3mm. Then the numbers play out like this.
This results in 3.7x on a gross basis which is about where you’d need to end up to generate a good return to your investors after fees and carry.
So it’s pretty clear that allocating capital is a key aspect, possibly the most important aspect, of generating good returns in a venture fund.