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Most startup companies have a continuous need for funds to help grow the business. You will hear the term “Follow-on” as a frequent catchphrase for this type of investing. For example, it’s common to hear one investor say to another, are you planning on “following-on” in this round? Simply put, the investor is asking if you will invest additional funds in the company.
As an early investor in a startup, you can expect to hear from the CEO when more capital is needed. There are many factors you need to examine before you make your decision. As a way of tackling this subject, I asked Ham to examine the underlying concepts behind staging investment capital in a company.
Having invested in over 30 companies and participated in more than 90 financing rounds, Ham has witnessed many different situations and evaluated companies at different times in their financing history. Participating in follow-on rounds is an important part of his approach to angel investing. Let’s see if we can figure out why.
Q: Ham, tell us a bit about your philosophy for staging capital into a startup company. What’s your approach?
First of all, I like to invest at a very early stage in a company’s development. Typically, I invest before a product is released, and so, my initial investment is made at a very risky time in a company’s lifespan. For this reason, my first check is usually quite small. It might represent as little as 25% to as much as 50% of the total I plan on investing in the company. Because the valuation of the company is typically low at this point, a smaller check still yields a meaningful chunk of stock.
By making an initial, early investment, I gain the option to invest in future rounds of the company. If the company is doing well, I might increase my ownership percentage in a follow-on round. If the company is struggling, I may still invest, but I won’t put as much money in until I start to see some real progress. And in some cases, if I don’t like what I see at all, I won’t invest in the follow-on round. In this way, your first check is like buying an option on future rounds - you gain valuable insight and informational advantage that you can trade on as the company progresses.
When I look at my overall portfolio using the analytics built into Seraf, I see that a bit less than 50% of my invested dollars are the in first round of financing. And the remaining funds are scattered across the follow-on rounds.
Q: If the valuation is so good, why don’t you invest all your money in the first round of financing and be done with it?
Early seed rounds are very hard to price. The company isn’t worth much because they are still early in their product development and usually have minimal revenue. So investors and entrepreneurs come up with a valuation that works for both, but that valuation is usually well above what the company is truly worth - as Christopher likes to joke: how much should you pay for two engineers, a powerpoint and a dog? As the company matures and raises additional rounds, valuations tend to approach reality. So these rounds are actually a better deal since the risk/reward ratio improves for the investor. And, because more time has passed, you are closer to exit, so even if your return multiple is lower due to the higher valuation, your IRR is higher because the money was not tied up as long.
With my initial investment, I begin closely tracking the company. I can revisit the early due diligence work we performed before our initial investment and determine whether the company is addressing the challenges as well as we expected. As an investor, you should have (or should I say - must have!) access to how the company is performing versus plan. For the top performers in your portfolio, you want to invest additional funds. As noted, you may pay a higher price than you did in the first round of financing, but your IRR is often the same or better.
Q: Why wouldn’t you invest in a follow-on round?
In my case, there are two primary reasons why I don’t invest in a follow-on round. I don’t like investing in follow-ons where I think I am throwing good money after bad. It’s not unusual for an early, seed stage investment to not pan out. These “Fail Fast on Seed Only” investments are a part of almost every angel investor’s portfolio. When it is happening, you need to be honest with yourself and admit you made a mistake. There is a temptation to believe against all evidence because it is hard to throw in the towel and admit you were wrong. But that’s no reason to follow-on.
The second reason is when a company is doing a very large round of financing at a big uptick in valuation. Let’s say you invested in an early round where $1M bought the investors 33% of the company. Now, the company is doing great and new investors want to put $20M in for 25% of the company. My relatively small check isn’t needed by the company. And, to get a reasonable multiple -- say 5x -- on this investment, the company will have to sell for at least $400M. That doesn’t happen too often!
Q: Are there any special cases where you stage capital in a different way?
Yes… One example is in the approach I use for investing in Life Science companies. In most cases, I invest in these companies at a very early stage in their product development. Typically, the company needs to finish product development and perform a series of clinical trials to prove the efficacy and safety of the product. Instead of raising all the capital needed to get to FDA approval, most Life Science companies raise capital over a series of 3 to 5 rounds. So, given this approach to company fund raising, I tend to invest 15-25% of the total I plan on investing in sum total into each round.
Q: What’s the philosophy at Launchpad for staging capital?
With 150 members in our angel group, you should expect there will be many different philosophies for staging capital. And, you would be right! That said, Christopher and I do try to educate our angels and convince them of the value of our approach, as outlined above. We think it’s important to invest early when it’s relatively inexpensive but still risky. By adding our human and financial capital we can help de-risk the investment while simultaneously increasing the value of the company before subsequent rounds of financing.
“But,” you say, “as a smart investor, I will wait until you’ve improved the risk/reward ratio to the point where I can step in and write a big check!” Well, that approach will work sometimes, but not always. And often the times it doesn’t work are precisely the companies where you most want it to. At Launchpad, two of our best investments are companies that raised their first round of financing from us, and then, proceeded to take off. When new investors came in for the Series B round of financing, they didn’t allow other new investors to participate. If you didn’t invest in the first round, you were locked out of the investment. So keep that in mind when you are mulling over making that early stage investment… you just might want to write a small check to gain a seat at the table!
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