Learn More About Follow On Investment in Subsequent Funding Rounds
Follow on investments are most commonly associated with institutional investments from venture capital or private equity firms. However, the same concept can be relevant to individual investors, deciding whether or not to make a subsequent investment in a startup during a later named funding round. In this blog, MicroVentures shares more about follow on investments for individual investors, and some things to consider before putting in additional capital to a startup’s subsequent funding round.
What Is a Follow On Investment?
A follow on investment, or follow on funding, refers to an additional investment made by an investor who has already invested in a particular company. This usually occurs during subsequent funding rounds, or during follow on offerings if it’s a public company.
When making the decision to participate in a subsequent funding round for a startup, investors should still conduct due diligence. The startup may have pivoted or evolved from when the first investment was made, new competitors could have emerged, and there may be new partnerships or growth to consider. However, before conducting a new round of due diligence on the startup, investors should first conduct an internal assessment.
Internal Due Diligence
Whenever an investor makes a new investment, they should consider their individual scenario before expanding their due diligence efforts.
Financial Capacity and Allocation
The golden rule of investing in “never invest more than you are willing to lose”. Before making a follow-on investment in a startup, an investor should ask themselves if they have the available capital to make an additional investment without compromising their overall financial stability. Investors should consider their asset allocation, liquidity needs, and emergency scenarios whenever making any new investment, even if they have already invested in this startup before.
Portfolio Diversification and Strategy
Investors also should consider the current level of diversification within their portfolio. Concentrating investments in a limited number of startups, industries, growth stages, or asset classes can be risky. Doubling down on one specific startup increases an investor’s exposure to risks should that startup fail. An investor should determine if increasing their stake in a startup helps to meet an investors current portfolio needs and diversification strategy.
Investment Thesis Alignment
Equally important in making new investments, investors should also weigh follow up investments against their investment thesis. Does the startup still align with the sectors, stages, and risk profiles that the investor is comfortable with? Regardless of a startup’s specific performance since the original investment, if making an additional investment does not align with an investor’s investment thesis, they may want to reconsider making that investment. Past performance does not guarantee future results.
Startup Due Diligence
Just as due diligence is an important component of making original investment decisions, due diligence efforts should not be skipped over when considering making an additional investment. Depending on how much time has passed between funding rounds, the startup may have evolved significantly. While general due diligence principles are typically consistent for an original investment compared to an additional investment in a later named funding round, there could be additional things to consider for follow on investments.
Performance Against Milestones
When an investor made the original investment, the startup likely made future goals to reach with timelines. Since the original investment, has the startup met these milestones? Were they met in the original timelines? If they weren’t, what stood in the way of the milestone or timeline? Has customer traction and retention increased? Is the product developing on schedule? Are there any missed targets? Without credible explanations, investors may have concerns about future growth potential.
Financial Health and Burn Rate
Additionally, take a look at the current financial statements. If financials were provided at the time of the original investment, compare calculations like burn rate and runway to the original set of financials. Also, assess the efficiency of capital deployment—how did the company use the funds from the previous round of investment? Did it help the startup meet its goals or milestones?
Market and Competitive Landscape
Depending on how much time has passed since the original investment, new competitors may have entered the market or regulations could have been passed that impact the startup. Investors should re-evaluate the total addressable market and the startup’s competitive position. Has the market evolved as expected? Has competition intensified?
Team
Since the original investment, how has the startup’s team evolved? Have founding members left the team? Does the startup have high talent retention? Are new team members well equipped to help the startup grow? Is the startup hiring new employees based on actual need? Signs of integrity issues, poor judgement, high turnover, or deteriorating relationships should be scrutinized.
External Perception and Press
Investors can also use news and press in order to understand the general perception and sentiment towards the startup. Since the original investment, has the startup partnered with well established companies? Has it been featured in major press sources? How does the general public view the startup? Positive press can be validating, while negative press may raise additional questions.
Key Considerations
Pro Rata Rights
As startups raise subsequent funding rounds, equity dilution occurs and investors’ ownership stakes decrease as new equity shares are issued. However, if your original investment came with pro rata rights, then you may have the option to invest in future rounds to maintain your equity position within the company. If maintaining ownership percentage to help manage dilution is important to your investment thesis, then it may make sense to make a follow on investment.
Valuation
Investors should consider the valuation at which the new funding round is being offered. Is the valuation significantly higher? Is this new round a down round? Are other offering terms like price per share, liquidation preferences, or other rights materially different in a way that could negatively impact your portfolio?
Sunk Costs
Investors should be aware of the sunk cost fallacy—where a person is reluctant to abandon a course of action because of the amount of time, money, or effort that has previously been invested, even if abandonment would be more beneficial. Investors do not have to make subsequent investments in startups.
Final Thoughts
Choosing to make an additional investment into a startup during a subsequent funding round is a highly personal decision. Investors should consider their current financial standing and portfolio first, and if they have investable capital, then they should still conduct thorough due diligence on the startup, comparing its current standing to when the original investment was made. If an investor has capital to invest, the subsequent investment aligns with diversification needs and investment thesis, they value maintaining ownership percentage, and they are comfortable with the new investment terms of the new funding round, then a follow on investment may make sense. However, investors should not fall victim to sunk costs – follow on investments are not required and it may not make sense to make a follow on investment in all, or even any, portfolio companies.
Are you ready to invest in startups? Sign up for a MicroVentures account to start investing!
Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:
- How to Evaluate a Founding Team
- Checklist for VC Due Diligence
- Early-Stage Investing: SAFEs Explained
- Assessing a Startup’s Defensibility
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.
