How VCs Can and Should Invest in Later Rounds

You have to know when to hold them and know when to fold them.  So when a company in which I’m an investor is raising a later round, should we (the VC investor) keep our pro rata or get diluted?  

My view is that one should always make this decision on an individual company basis.  Almost all VC investments include pro rata rights. These give the right to invest more money in a company sufficient to keep the same percentage ownership, for so long as we have both the cash and the appetite.   In practice, sometimes we cannot exercise these rights, as company management may ask us to make room for certain desired new investors.

However, VCs almost always have the same problem: we usually can’t exploit all of these pro rata rights out of the original fund.  If we did so, we’d grow rapidly out of our core strategy; run out of capital; and hit our risk limits. For example, most VCs would not normally invest more than 10% of the fund in any one company; many VCs have a much lower risk limit.  But let’s say we invested in a startup, and in a subsequent round the dollars required to fully exercise our pro rata rights plus our earlier cash investment could well exceed our risk limit. If we think the investment is a wise one, we need to find some other mechanism to source the cash.

There are four main options that VCs use to address this challenge.  Ranked in descending order of frequency of use, they are:

1) Syndicate the investment out to coinvestors, without charging any fee.  I recently wrote about How VCs Structure a Syndicate and Recruit Coinvestors.

2) Raise a single, larger fund with flexibility to invest at later stages.  Today’s mega VCs all started as high-returning small VCs.  When they saw a chance to raise a larger fund, most of them did so.

3) Raise a separate “overlay” fund (also known as “sidecar”, “overlay”, or “bolt-on funds”).  These are designed to allow an institutional investor to invest followon rounds in existing portfolio companies.  Accel Partners; Ronny Conway; Andreessen Horowitz; Battery; Foundry Group; Greycroft; Union Square Ventures; and many others have created variations of such funds.   See Brad Feld: The Opportunity / Growth Fund Trend.

4) Create a Special Purpose Vehicle.  A special purpose vehicle in this context is a new legal entity, created for the narrowly defined purpose of investing in one specific company.  Typically funds only do this when the investment opportunity is outside of their fund’s mandate because of its stage or because of risk limits. For more on SPVS, see:

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For further reading:
Fred Wilson: The Pro-Rata Opportunity
Abe Othman: Should Seed Investors Follow On?

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