Contrary to what one might think, the biggest problem for VCs isn’t making an investment in a company that fails.  All VC’s invest in lots of companies that don’t work out.  It’s a known risk, and the main one everyone thinks about. But this is not typically where VCs really get into trouble. The much bigger trap is around follow-on investment decisions. Here’s why:

Typically, a VC fund will invest in something like 20 – 40 companies in a fund. Some investors do a lot more, few do much less. Also, most funds reserve some capital for follow-one.  Most VCs invest at least 2X as much money for follow-ons as they do initial investment dollars.  Some investors reserve much more.  So, this means that a typical investor might be putting 1-2% of the fund at risk in any one investment after the first check. Here’s the math:

• Let’s say we have a $300M fund
• Let’s that fund invests 1/3 of the capital into the initial rounds. That’s $100M
• Let’s say that $100M is spread across 25 companies. That’s $4M per company.
• So, the % at risk is $4M / $300M = 1.3%

So, the downside of a bad initial investment is pretty minimal to the fund overall. What IS problematic is putting a lot more capital into follow-on rounds for a company that ends up not working. And so, the VC death trap happens when one of their companies seems really hot, raises a lot of money really quickly, and ends up failing. Here’s a typical path for an investment like this, for a fund similar to the example above.

• The $300M fund invests in a big seed for a company. Let’s say they invest $2M
• Things are looking great! They want to pre-empt the series A. There is a lot of competition, so the fund ends up investing $5M into the A round at a pretty high price.
• 6 months later, the company is really taking off. A fancy firm puts down a term sheet to invest $40M in the new company. This looks like a winner, so our VC fund does as much of their pro-rata as they can. Let’s say they do another $10M. At this point, the firm has invested $17M (2 + 5 + 10).
• 10 months later, there are a few warning signs starting to show, but growth is still great. Also, tons of investors want to invest after the fancy firm that led the B. The company gets a term sheet for another $50M. The firm decides this is the time to go big or go home! They invest another $15M.
• Things are starting to go sideways, or the market has turned. No worries – insiders do a $20M round to get the company another year. The fund does a $5M chunk of this round
• Things are now falling apart. No one wants to invest in this company. The last round’s investors is willing to lead another round, but is putting some structure in place to penalize anyone who doesn’t participate. The fund has $37M into this company already, they have to keep going. So, they do another $3M.

At this point, the firm has now invested $40M into this one company. They invested $2M initially, but now have invested 20X that amount, and it’s not looking great. This company may end up salvaging some value in a sale, but it could also be a near total loss, which is tough to swallow. Assuming this fund targets 20% ownership, they would need a $200M exit from a different company just to dig out of that hole.

Poor decisions during follow-on rounds, especially when these decisions are steered by fundraising momentum is really the biggest risk of value destruction for VCs. Being great at follow-on investments might not turn a 1X fund into a 5X fund, but it does have a significant impact to overall performance, and is really tricky, nuanced stuff. A couple other observations:

1. As unicorns come down to earth, this scenario (or worse) will play out multiple times over the next several years

Over the course of the late stage frenzy over the last few years, a lot of funds have made aggressive follow-on investments into companies that will end up not working out. We’ve been in a period of unnatural financings, both in terms of valuation and the amount of capital that has gone into companies relatively early in their life. As an existing investor, it’s very hard not to try to pour more money into companies that seem to be getting lots of external investor validation, even if you suspect that the company doesn’t warrant it. This is compounded by the fact that many LPs have shown an interest in investing directly into individual companies in recent years, and have looked to their underlying mangers to try to get them access to these high-flying unicorns through opportunity funds or SPVs. This can lead to a fund not only investing a big % of their fund into a failing company, but getting some of their own underlying investors to put even more capital into these companies, without the benefit of broader diversification. This double-whammy will be tough for funds and their investors to swallow.

2. Time and dollars are strangely mis-aligned in VC decision-making

There is not a linear relationship between the amount of capital a VC invests and the amount of time spent making these decisions. What I mean is that most VCs spend most of their time and effort deciding on an initial investment. The level of effort and diligence that goes into a follow-on investment is typically much lower. Although this makes some sense given the work involved with getting to know a new company, the level of disparity is still puzzling given that 65% – 75% of fund capital (or more) goes into follow-on rounds.

You would think that it would make sense to allocate time in a way that is roughly equivalent to dollars being invested at each step of the way. But this is not anything close to what actually happens. In high-momentum follow-on rounds, it’s hard to check yourself and not aggressively do your pro-rata, especially since there are probably other buyers trying to do as much as they can as well. In less aggressive rounds, a series A or series B lead will need to do their pro rata as well, because it otherwise sends a very weak signal to other investors and can put the round in jeopardy. In either case, the time and effort that goes into these decisions is minimal relative to the dollars in. Where I think funds do start having hard conversations around follow-ons is when they need to lead inside rounds or protect themselves in down rounds. But often, these are for relatively smaller checks AFTER a bunch of capital has already gone into a company.

This might not be true of all VC funds, and I know a number of funds that have a mantra that they treat follow-on rounds like “a new deal”. But practically, I think that doesn’t happen as often as we lead ourselves to believe, and I think a lot of funds would agree that they could do a better and more thorough job with follow-on investment decisions, especially since that’s where the vast majority of their capital is actually going.

3. Hit rates and outside leads can be very misleading

One metric I see mentioned from time to time is the idea of a follow-on hit rate. For example, what % of the time a seed fund’s companies get to series A. Or what % of companies that raise a series A from a particular fund end up raising an outside led series B. The assumption here is that the higher the better.

I used to think that this was an important metric, but I’m not really sure any more. A high hit rate isn’t necessarily a great thing. Typically, investors that put significant capital into follow-on rounds try to concentrate as much capital as possible into the small number of best performing companies. This is particularly true in the VC business where typically, the best 1-3 companies in a fund far outperform the rest of the portfolio. A high hit rate makes it tougher to concentrate this capital, and makes it easy to stumble into the VC death trap.

The opposite of this is also true. Many of the very best companies in portfolios I know are ones where there was little or no outside investment interest. These are cases where there was going to be no impressive markup, or impressive Techcrunch headline announcing a unicorn valuation. But the investors with inside knowledge of the company had conviction, continued to invest in these companies, and were ultimately rewarded with outsized ownership in exceptional businesses. One very experienced and successful investor remarked to me once that he had “begged” someone on his “hands and knees” to invest in a company, which ended up being a massive winner for both funds’ portfolios.

One might say that from a founder’s perspective, a high hit rate can be a good thing. It means that taking money from a particular firm can reduce financing risk down the road. But as I think we are starting to see, too much money too soon or with the wrong expectations can really hurt a company and ultimately not help anyone involved.

The point of this long post is that follow-on investments are really hard. It’s probably the easiest way for investors to get themselves into trouble. It has the fewest internal checks and balances. It also has the most external pressure from the founder, market, and one’s own sense to greed or pride to just follow inertia and invest. This is not just a matter of failing to spend enough time making decisions. Time alone doesn’t lead to better decisions. But I think the issue is primarily about making intentional and independent decisions. We all try to be independent thinkers with our initial investments, but given that the majority of most VC’s capital goes into follow-on rounds, it’s equally critical to make follow-on decisions independently too, and not get sucked in by momentum, fancy co-investors, or other similar forces.