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.

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Comments (Archived):

  1. Kyle S

    Fred,I enjoyed this post and the perspective it brings. When I was modeling out your earlier scenario “at home”, this is one aspect that I initially modeled wrong but when I fixed it the model made much more sense.I have a couple of questions. First, I assume you have to decide within a year or so whether a deal is likely to at least break even, because you run into needing another round of capital at that point. Have you ever had situations where it was a close call whether to raise another round or close the doors? How did you decide one way or another? I imagine it can be pretty difficult to get an entrepreneur on board with closing up their shop…

    1. fredwilson

      the close call happens all the time. as fnazeeri explains below, the temptation is to do another round. i think we certainly lean in that direction. it’s hard to be really mercenary in this business.

  2. fnazeeri

    From what I’ve seen, VCs find it hard to give 1/3 of their portfolio the stiff-arm after one round and 12 months of treading water. There’s always hope going into the 2nd round and usually there’s another firm walking around saying, “well Fred invested in it…” so they jump in and you can’t not take your pro rata so there goes the “reluctant round.” Add to that the fact that VCs are playing with OPM (“other people’s money”) and that the compensation structure rewards wins heavily but punishes losses lightly. And lastly, VCs don’t really want the reputation of bailing after 12 months and gaining a reputation amongst entrepreneurs as “fast money.”You make a good point though, that’s the way it’s supposed to be done, but, like most things, reality seems to get in the way…

    1. fredwilson

      correct on all counts

    2. Guest

      Excellent points! There is one other major factor, though: timing of write-offs relative to new fund raises. Because of the things that you mention (playing with OPM, living on fees) there is a very strong incentive not to write-off while you are raising your next fund…

      1. fredwilson

        Everytime VCs think about fundraising in relation to their investments theyare making a mistakeYou have to do what’s right for your portfolio and your portfolio companiesand let the chips fall where they may

        1. Guest

          Sure, it’s easy for you to say, you are a winner. I saw an amazing presentation a couple of weeks ago: more than 66% of VC have negative returns. For these folks the fees are their livelihood and the portfolio be damned…

        2. Guest

          Sure, it’s easy for you to say, you are a winner. I saw an amazing presentation a couple of weeks ago: more than 66% of VC have negative returns. For these folks the fees are their livelihood and the portfolio be damned…

    3. Guest

      Excellent points! There is one other major factor, though: timing of write-offs relative to new fund raises. Because of the things that you mention (playing with OPM, living on fees) there is a very strong incentive not to write-off while you are raising your next fund…

  3. Don Jones

    I’m seeing VCs allocate capital quite stringently these days, by quickly shutting down companies that they think are under-performers and re-allocating capital to their portfolio companies that are doing better or have better chances of success.

    1. fredwilson

      that’s what we are supposed to be doing, but it’s not that easy.

  4. Tim Dierks

    Why doesn’t your model account for the fact that return on a later round at a higher valuation is going to be lower? It seems to me that if you can get an overall blended 5x return on 3 rounds of investment in a single company, then the first round probably returned 20x or higher.

    1. Jake

      I imagine that the model gets much more complex if you want to work in the step-up in valuation. While the B or C round is probably more expensive, Fred is also probably putting in 5 million instead of 1. The return multiple on the later rounds is likely to be much less than the earlier rounds but a realization event is probably closer meaning that despite the lower return multiple, the IRR will be strong.

    2. fredwilson

      tim, you are right. the initial round in a winner is usually going to be 10x or higher

  5. charlie crystle

    Slightly off topic, and at the risk of pushing something stupid or illegal:Founders’ Exchange Fund….Founders are investors too. But they are fully invested in a single deal, typically–their own. This concentration of assets and energy is likely far riskier than any venture deal.Given that, I’d like to propose that the venture industry–or at least some firms that care about their founders–set up something likean Exchange Fund for founders to give them some diversification.Founders would contribute shares based on dollar-value equivalent to the fund, and get shares back in the fund. The fund acts sort of as an index. Let’s say round 1 is valued at $3 million post, and the founders have $2 million of that in shares. Maybe there’s a minimum buy-in of $50,000, so a founder would allocate $50,000 in shares (based on closing price of that round) and get back $50,000 of equity in the fund. Let’s say you get 10 other founders in your fund to do the same, so you have $500k in the pool, and they all get to participate in your investment expertise.This could be done on a per fund basis, but what enabling even more diviersification? Let’s say you get 10 top-tier funds together….Benchmark, KP, etc–and make it more than a benefit, make it a requirement of doing business,effectively forcing founders to participate as part of the deal, because it’s good for them to diversify.–recovering and relapsing founder with high concentration of wealth and energy focused in one place

    1. davidu

      Some funds (Greylock, for example) provide an opportunity for the executives of their portfolio companies, and other founders they work with, to participate in the funds to a limited degree.

      1. charlie crystle

        sure, but in an equity exchange or cash investment?

        1. davidu

          Not an equity exchange, although those exist as well.

    2. fredwilson

      i’ve seen this done a bit but it can end really badly for some

    3. vincentvw

      I’m not sure if I agree with that reasoning. Yes, founders carry more risk, but they also need to feel the pain in order to bring their venture to a success. As soon as they are diversified, their motivation & attention risks to be diluted, which can’t have positive consequences on their own ventures. I imagine it’s an even worse problem if you introduce this scheme to venture-employees, as they then have the incentive to just work for the best-performing business.

  6. Anonymous

    Does expecting 1/3 to fail make you less likely to do everything possible to try and save a business? It seems Twitter is hell bent on self mutilation and destroying all loyalty of their user base. They clearly need someone with half a brain to step in and take the reins, the backroom geeks are simply causing one PR disaster after another. Why haven’t the investors insisted on this?

    1. fredwilson

      Can you be more specific about the issues you are concerned about? Stabilityhas increased significantly in the past month as has user growth.

  7. David

    While I agree with the general gist of the article, it seems that your model ignores the fact that subsequent investments in “winners” will be done at higher valuations and therefore reduce your investment return multiple.In other words, aren’t the “winner” entrepreneurs able to extract more value if they are good?

    1. fredwilson

      Please don’t get caught up in the model, those were very simpledemonstrations of the point I wanted to makeYes, absolutely the follow on rounds in the winners will be done at muchhigher valuations and that will lower the return on themBut the blended returns on the winners will generally be between 5x and 10xif you do this business right

  8. sethlevine

    fred –one things i’ve noticed in my venture career however is that often times the very best portfolio companies require less than average capital (in some cases they are acquired earlier in their lifecycle, in others they end up attracting later stage capital at attractive step-ups where the earlier investors participate only limitedly, etc.). on the other hand, there’s a great tendency to assume that business that are not succeeding are simply “taking a little longer to develop” and the existing syndicate continues to fund. it’s an interesting perversity of the venture business – not unlike the tendency of poorly performing portfolio companies to take up more time/attention than well performing ones. i have been thinking a lot about this capital allocation question that you raise and the corollary i’m bringing up here – having the discipline to walk away early and focus on winners (as well as the fortitude to double down on your best investments) is not easy, but in order for the portfolio model you describe to work, it’s necessary.i’m curious if you’d agree with this and how you guys deal with this at usv.seth

    1. fredwilson

      Yes and that’s why you have to ‘starve’ the poor performers and force them to be lean if they want time to developA poor performer that is capital efficient won’t kill a venture fund’s performance but a capital sucking big burn one will

      1. FN

        But you also need to ‘gorge’ the winners. The question is what to do when a late stage PE investor comes in with a round of $25MM at $75MM pre and you only have $5MM invested at that stage. You won’t have the opportunity to build your position. If you’re not lucky, it can quickly turn into an heads-they-win-tails-you-lose scenario.

        1. fredwilson

          It happensIf you have a small fund, it’s not as big of a deal as if you have a largefundA $5mm investment can still ³return the fund² if you get 20x on itAnd that’s not impossible

  9. O.M.A

    Great post, thanks.You seem to assume the return on series C in a good company would be the same as the return on series A.Is that just to simplify the model, or as a result of liquidation preferences (that should not matter much in a good exit) or other things?

    1. fredwilson

      Its just to simplify the model. That’s obviously not true but I did that post in about 20 mins including the spreadsheets so I had to take some shortcuts