We’re on to lesson seven of the ten lessons we’ve learned since the beginning of our venture capital journey in late 2020.
If you read the three previous posts on The Power Law, and why Entry Valuations and Graduation Rates matter, it follows that VCs are motivated to try to retain as much of a company as possible, all the way through to exit.
If a fund invests in 25 companies, and typical VC math shows that ⅓ of the companies in a portfolio will die and ⅓ will return 1x to 2x, then the remaining ⅓ of your companies had better pay off big. Or you don’t perform well and don’t earn the right to raise your next fund.
Because of this dynamic, it’s really important for early-stage investors (like Automotive Ventures) to have an opportunity to put more money to work in future rounds of your “winners.”
Many early-stage investors negotiate “Pro-Rata” investment rights, to allow them to continue to put money to work in future rounds, to maintain their ownership percentage. Sometimes, you can win the right to participate “super-pro-rata” and take more than your share to increase your shareholding percentage (typically you win the right to earn super-pro-rata only if the founder sees you as a true value-add investor).
Some early-stage funds have a philosophy of not holding back any of their capital for follow-on investments. Instead, they spread more initial investments across a greater number of companies, in the hopes that they’ll find more winners in the portfolio. The drawback with this technique is that you can’t “double-down” on your winners (but many of these funds will spin up stand-alone special purpose vehicles (SPVs) and/or offer subsequent round capacity as a perk to their limited partners (LPs)).
At Automotive Ventures, we structure funds that make 25 initial investments, holding half of our investable capital back for follow-on rounds. We believe that 25 investments per fund strikes the right balance between diversification, but allows us to really dig in and help our 25 founders, not getting spread too thin from an attention/bandwidth perspective.
If your winners in the fund have to make 50x+ returns on the initial capital, then it follows that it’s very important to maintain as much ownership as possible in your winners through every successive round of financing.
Here’s some example math for how this works:
Automotive Ventures makes $250k initial investments into Seed-stage companies with valuations of <$20 million.
A $250k investment into a $20 million company gives us an initial 1.25% of the company,
If this company goes on to raise three more rounds of funding (Series A, B, C), doubling their valuation each time, in order to maintain our 1.25% ownership position, the math looks like this:
Seed Investment: Valuation $20m
$250k initial investment
Total investment in company = $250k
$250k/$20m = 1.25%
Series A: Raises $8m at a valuation of $40m
$100k additional investment required
Total investment in company = $350k
Series B: Raises $16m at a valuation of $80m
$200k additional investment required
Total investment in company = $550k
Series C: Raises $32m at valuation of $160m
$400k additional investment required
Total investment in company = $950k
So the investment in the company grows from $250k to $950k over four successive investment rounds. But you still end up owning the same percentage of the company as you had in the very first round.
If this hypothetical company then exits at $1.0b, our 1.25% would be worth $12.5m.
All of this is easier said than done. While you might be able to successfully argue for “Pro Rata” rights in early funding rounds, and you earn the support of the founder to continue putting more money to work in subsequent rounds, VCs leading later rounds might not be so receptive to allowing you to continue to invest. We see this dynamic play out frequently. Sad, but true.
If you’re doing your job as a value-add investor, you can stay top of mind and be perceived as valuable to both the founder as well as in the eyes of the investor who is going to lead the next round. As a result, you may even get “super pro-rata” rights (or the ability to invest a greater amount than your pro-rata right would otherwise warrant). We’ve successfully accomplished this for a number of our most successful portfolio companies.
The takeaway?
VCs are motivated to maintain as much ownership in their winners as possible through each successive fundraising round, so they can ensure the highest % ownership at exit. The best way to continue to earn your pro-rata rights is to continue to work hard to provide outsized value to your portfolio companies.
Join us on the journey,
Steve Greenfield
