The Biggest Challenge In VC Investing — The “Follow-On” Decision

Roger Ehrenberg

While still a relative newbie in the VC business, I have been making early-stage investments for over seven years. During my tenure I have noticed that the single most difficult part of the value-creation process does not have to do with generating deal flow or idiosyncratic deal selection: it has to do with discipline surrounding the follow-on investment decision.

Speak to any early-stage investor brave enough to answer and they will surely agree. It is part of the VCs lot in life, and it can lead to deep soul-searching and many a sleepless night. For an investor whose model is predicated upon a series of more concentrated bets rather than a broadly-distributed “one and done” approach, this is the difference between simply returning capital and generating exceptional venture investment returns.

This decision-making comes in many flavours and is impacted by factors both related and unrelated to maximizing risk-adjusted investment returns. Let’s start with decision-making unrelated to maximizing LP returns. Consider one of venture capital’s perverse dynamics, the timing mismatch between realised investment returns and the need to raise additional limited partner (LP) capital.

From my vantage point, one of my roles as a VC is to keep my super-performing teams in their seats rather than to sell early. This involves being true partners with management, providing founder liquidity when appropriate and properly capitalising the business in order to optimise the chances of a high-ROI (and high absolute-dollars) outcome for all investors. But by definition, I am actively working to extend my time to exit, exacerbating the timing mismatch mentioned above.

Now, as a purist I don’t really care: I only want LPs that appreciate long-run value maximization and are willing to assess the body of my (unrealized) work in making their investment decision. However, I do know of others who may talk this way but want to see realisations before going into a Fund II. So this leads to GP sub-optimising behaviour #1: selling early in order to put points on the board to raise the next fund. This may result in a smaller-than-optimal follow-on round in order to keep the exit threshold low (which is just fine if this is what the entrepreneur wants), or acceptance of a lower exit multiple in order to say “we got an exit.” But bottom line, GPs are doing unnatural things to curry the favour of current and future LPs.

The flip side of this leads to GP sub-optimising behaviour #2: piling more capital into sideways companies in order to avoid having to recognise a loss while in the mode of trying to raise the next fund. This is a particularly dangerous practice, because while behaviour #1 can lead to truncating gains, behaviour #2 generally leads to exacerbating losses. My belief is that this is the hardest dynamic to manage within a venture partnership.

First off, most VCs (and, in fact, most human beings) have a hard time admitting they’re wrong. You spend a lot of time and money picking an investment, injecting capital, working with management to help the company succeed, and….sometimes it just doesn’t work. However, the measurement of “not working” is highly subjective and can be heavily influenced by – the VC. Let’s say that a company takes in seed or Series A capital, is executing their plan but is not hitting their key milestones. Unless the team has given up and/or its financial resources are nearly exhausted, a financial valuation firm (often used to generate LP disclosures) will frequently not push down the value below original cost.

Further, if the VC has decided to lead an inside round at a higher valuation, it may, in fact, mark the entire investment up (especially if other parties have agreed to invest at the new price). In the meantime, fund disclosures do not fully reflect the troubles at the company and the VC has the ability to defer likely pain. In poker parlance deferring pain is akin to “turning over more cards,” when, in fact, the odds are heavily stacked against you. Can the investment pay off? Yes. Is it likely to be successful? No.  These VCs will generally argue “The company has the right elements; they are just trying to find the right product/market fit,” when the financially rational step might be to say “Management gave its all. We tried our best. But these are the risks of early-stage investing and this, unfortunately, is one of our losers.” At this point the classy firm will help the firm’s employees find other roles as they wind down the unsuccessful venture. But this is not always the way it goes.

Making the right follow-on decision is insanely hard most of the time. It should be so regardless of fund size, e.g., just because you have a $400 million fund and can follow on in just about everything, it doesn’t mean you should. I break our own follow-on thought process at IA Ventures into three buckets: Simple. Not Simple. No, Sorry. Then there is a second dimension to the framework: deal leadership.

  • Simple, deal lead. This is where IA Ventures works closely with management to try and lead the next financing round. These are situations where we first invested very early, feel very passionately about the team and the market opportunity, believe our specific set of competencies, relationships and experiences can have a material positive effect on the outcome and where management is executing the plan extremely well (e.g., at the outer reaches of the bell curve, read: significant outperformance relative to expectation). When the company can benefit from additional financing we want to step up and drive the round, both helping management build the optimal investor syndicate and increasing our percentage ownership in the company. These situations are what we strive for as venture investors. Easy peasy.
  • Not Simple, deal lead. This covers the lion’s share of lead-managed situations. The company is performing kind of eh to well (e.g., within the fat part of the bell curve) and it is time to discuss a new round of financing. A big part of the consideration here is our relationship with management and our belief in their commitment to the mission. Assuming the team has proven to be as expected (smart, hard-working, honest and ethical, coachable, etc.), the issue isn’t whether or not we’ll do our pro rata but whether or not we want to take a leadership role. Often we’ll have learned more about the kind of help a company needs, and that can heavily influence our decision as to whether to source a new deal lead or to considering leading ourselves. However, there are situations where the relationship with management is broken and where we neither want to lead nor do our full pro rata, but where the company is performing. In these cases raising third-party capital is not the challenge, but figuring out how much IA Ventures needs to invest to avoid adverse signaling. We work with management to figure out exactly where this threshold is and “do the right thing,” which is a combination of helping the company get its round done while managing our overall exposure to the company when we have fundamental issues.
  • No, Sorry, deal lead. This happens when there are deep problems with a company’s plan and our relationship with management. Perhaps trust has been lost. Maybe the founder isn’t the right person to execute the plan (in our opinion). Could be we poorly estimated the amount of capital required to penetrate and disrupt a market. Regardless, there is generally a “go/no go” decision where everything is on the table with management. If they want to raise capital from other parties and soldier on, we’re supportive. If they want to do an orderly liquidation and move on, we’re ok with that, too. At this point our main objectives are (a) protecting our LPs capital by not seeking to turn over more cards, the cost of which is generally value destroying to the partnership, and (b) protecting our reputation by being extremely clear with management about what went wrong and helping them to achieve their objectives, whether it’s continuing to move forward without us or seeking a graceful exit. These situations suck but are part of the high-risk business of early-stage investing.
  • Simple, not deal lead. A fact pattern much like the above, except where we sadly are not leading the deal. In these cases we often try to find ways to increase our ownership in the company by demonstrating our unique value (as a Big Data-focused fund with partners who possess extreme experience in several high-value verticals and across leading-edge technologies), and having both management as current investors as advocates for our doing so. This is a fundamentally unnatural situation because whatever we get generally comes directly from the founders and the current investors, but we have successfully navigated this thicket on a few occasions and hope to do so in the future. This is where we need to demonstrate our clear thought-leadership and value as investors, advisors and mentors in order to prove that money from IA Ventures can increase enterprise value to a greater extent than money from another venture firm.

  • Not Simple, not deal lead. Analysis similar to above, but where we will work with the deal lead on how to best structure the round. We are very disciplined but pragmatic, e.g., if deploying small incremental dollars helps get a round done and show support for management (whom we trust) and the company (which we like, but which may have had some stumbles and problems in executing their plan), we will do it.
  • No, Sorry, not deal lead. No. Just no.

It is how the follow-on decision is played that big money is either made or lost. We at IA Ventures work hard to be brutally honest and transparent with ourselves, management and our LPs. While it’s early in our evolution we’ve already learned a lot about how to think about this complex issue, and where we philosophically stand vis a vis key constituencies. This task will invariably get harder as our portfolio matures and we have more and harder decisions to make. But this is exactly why we feel that a disciplined decision-making framework is critical for making prudent – and admittedly challenging – decisions with our partner’s capital.