Thread by @eriktorenberg

How should VC firms think about follow-ons?

VC is about getting paid for the risk you take. (h/t @m2jr)

If you're a seed fund you can get paid for the risk you take in two ways.

1/ Investing in series A firms so you pay less money per % that you own.

2/ Pro-rata.

So seed firms say, I'm going to make a number of bets and then reserve for follow on to double down on winners.

But this is artificially limiting your pool.

The best series A firms don't just look at your companies, they look at every other good firm's companies too.

More broadly, if you're going to put $1 into something, that dollar has to compete with every other investment opportunity you've got

If you put $1 at seed for every $2 in reserve for A, then what you're saying is you're basically a series A fund. And a disadvantaged one at that

Most venture funds don't know what the return on the reserves are.

But it's often worse then their first check

So why do they put more into reserves than first check?

Sometimes b/c they truly have an advantage

Deep down tho, b/c it fits their model of what it means to be a VC

Often, price gets bid up faster than risk has gone down.

Other times, best deals get bid up fastest.

& paradoxically, you may want to invest more b/c every incremental dollar will return a 10x

Unituitive thing about power laws: the average increases the more exposure increases

The case for follow on is that you have differentiated insight into the co b/c of your proprietary access.

Yet, if so differentiated, why not pre-emptively lead the round, even if you led previous?

The most inefficiently priced deals may be the ones already in your portfolio.

Often VCs have an ownership threshold, but maybe it's not as constructive to think about ownership as it is to think about what % of NAV is in a deal.

If you invest 400K & own 10% & company returns 30x you still only get $12M.

What is my NAV & what is my multiple opportunity?

VCs are told 2 different things:

Invest in contrarian bets other VCs won't invest in

Stay in your lane—only lead pre-seed

This means, 18 months from investment, unless it's turned from contrarian -> obvious, others won't invest

Presents a challenge—&opportunity to double down

Conclusion:

- Don't follow on blindly b/c every follow on $ competes w/ every other company that could be invested in

- VCs have to identify winners before they have them *and* when they have them

- Double down if you see an inefficiency in the market within your own portfolio

h/t @ashfontana & @AliBHamed for conversations that led to latter half of this thread