Article adapted from Seraf: Portfolio Management for Early-Stage Investors
As your angel career develops, and you start to build a larger portfolio of companies, you are increasingly asked to make follow-on investments. Not only do companies need investment to get off the ground, the faster they grow, the more cash they need. Whether to follow-on, and how to follow-on, are questions which have long given rise to angel debate. We’ll tackle that topic in depth here, but I’ll start out by confessing to bias right up front: Christopher and I are both believers that follow on investments are essential to achieving good returns. We firmly defend and negotiate for pro-rata rights to participate in future financings. Our overall perspective is that with your earlier checks you are basically buying options on a front row seat which comes with the right to add more “smart money” into the winners as they begin to show promise.
Our bias is backed up by observational data. During the first couple years, most of an angel’s checks go into shiny new companies, but after a couple years, there tend to be more and more follow-on checks in the mix. Based on the behaviors we have seen in our own portfolios, observing many serious angels first hand, as well as the aggregate data we have seen from professional investor behavior in Seraf, we’ve observed experienced angels tend to have only about 30% to, at most, 50% of their aggregate investment dollars in “first checks” into a company and about 50% to as much as 80% of their money has gone into second, third and even later checks.
We feel that, over time, a successful investor should be able to look at the average amount of money into each failed investment and compare it to the average amount of money into each successful investment and see a ratio of at least 2:1 to 4:1 of dollars into winners over losers. In cases where an angel has really significant amounts of money to put to work, it might approach 7:1 to 10:1.
So if the hypothesis is that an angel should be biased towards follow-on investments, that still does not answer the question of how an angel actually decides which ones are “winners” and merit follow-on investment. What is the process of actually deciding to follow on or not? What should you look at and how should you decide?
Christopher has personally invested in a ton of startups, and as the Managing Director of Launchpad he organized and facilitated countless follow-on rounds for his investing colleagues. Let’s see if he has any perspective to share on the follow-on decision-making process.
Christopher, how do you decide whether to follow-on? Do you have a framework you use?
I should start out by saying that this decision is almost never cut-and-dried. Companies typically come back for money long before it is truly clear that they are out of the woods. This is particularly true of that crucial “second check.” Companies looking for a second check from you usually present a thorough mix of positive accomplishments and negative surprises. So, unless you are just going to follow your gut instincts, some kind of decision-making process is needed to make sense of the mix of plusses and minuses.
The process I use, and recommend, is probably best analogized to a decision-tree. The first question is whether you are in an offensive or defensive mode.
- Offense is where a company is doing well and you are looking to maintain or increase your ownership position.
- Defense is where a company has clear potential, but is struggling to bring in needed money; the terms for the new money are intentionally or unintentionally dilutive, or even punitive, to existing investors who do not put in additional money.
In defensive situations like that, where you believe the company really has potential, an investment might be justified because it could protect (or even enhance) the value of your existing investment. For example, I have seen deals where early investors who put in their full pro-rata were rewarded by having all of their stock elevated to a pari pasu position with the top of the preference stack, whereas investors who didn’t were left at the bottom of a now even more top-heavy stack. If you are feeling good about the company’s prospects, that is an opportunity to potentially enhance the value of your holdings.
Fortunately really defensive “pay to play” situations are not common and each one tends to have a pretty unique fact pattern you are probably going to need to weigh on a stand-alone basis. So I will focus mostly on offense situations. Many of the analyses and concepts applicable to the offense situation can actually help in defense situations too.
Offense situations typically present the classic follow-on conundrum. The company is doing reasonably well (it’s pretty rare for a company to nail or exceed their forecasts – those cases are pretty clear cut green lights), and you need to decide whether to put additional money in. My decision framework really has three main elements, each of which has its own analysis:
- Reconfirming there is still sufficient upside potential forward from this round
- Reconfirming the downside risk at this point is still acceptable
- Reexamining the opportunity cost of this investment given current climate
There is a bit involved in each of those elements.
Let’s start by asking how you think about the upside potential?
Valuations tend to go up with each progressive round (by definition, if the pre-money on the new round is not at least as high as the post-money on the last round, you are not in an offensive position and defensive issues come into play). Given the new higher valuation, a very significant part of your decision-making process about remaining upside potential is going to be a reapplication of the original valuation assessment steps you went through the first time you invested. But in addition to those original valuation factors, you now have some incredibly valuable additional information to review which you did not have the first time around: the company’s recent operating history.
How to make a valuation assessment is something we have talked about at length. Just as with your very first investment in the company, you are trying to gauge whether this new valuation is justified and represents an attractive opportunity. To determine that, you are going to need to take an updated view of:
- The exit realities this company is now facing
- The projected future financing requirements
- The deal particulars of this round.
Follow-on rounds are both familiar and different; they present essentially the same analysis as first rounds, except they are:
- More expensive
- Closer in time to the potential exit
- Presumptively less risky
It is up to you to look at the valuation factors in light of the new situation and determine whether the new valuation is attractive on a risk-adjusted basis. You need to answer the question “Is this still a good deal in pricing terms?”
It is worth pointing out as a side note that looking at the other investors in a round can help you benchmark your assumptions. Different kinds of investors specialize in different kinds of rounds (i.e. rounds at different stages), and each of them has unique expectations on both timing and cash-on-cash return multiple. For example, investors who go in extremely early, experience a lot of failures for every success and face long timelines, might require a 7-10X projection for an investment to make sense and offer a good IRR. Investors who come in the post-revenue, but still early stage, might need to model a 5-7X to go ahead. Much later stage venture capital or private equity investors, who view the company as very de-risked and very close in time to a potential exit, might only need to be able to model a 2-5X return to green-light a deal. Once you appreciate that, you can use this knowledge to help inform some of your thinking and assumptions about the returns on a round by looking at the type of lead investor behind the round.
Let’s look at an example of how to tackle this “Is this still a good deal in pricing terms?” question. In an early low valuation round, let’s say you hypothetically model and expect a 10X return in 7 years. This would yield you a very attractive IRR of 38.9%. Now it’s a couple years later, and you might determine that, realistically, the exit is unfortunately still about 7 years away (put on your sad resigned face – it always takes longer). Given the new valuation is higher, and given your best guess on the likely exit price the company is going to command, you estimate that your cash-on-cash return on this investment round is probably going to be more like a 4X. A 4x in 7 years is a still-attractive IRR of 21.9%. But it is lower than your expectations when you wrote your check at the first round by about half. What you need to decide is whether the risk of this new investment is reduced enough to make that lower rate of return acceptable?
What does your risk reduction analysis hinge on? It is a primarily factual question based on how the company has done and what has been learned since the previous investment. Fortunately, when making that risk assessment, you have many advantages in later rounds that you do not have in earlier rounds. You can see:
- Whether the company has been a good steward of invested capital
- How well the company has communicated with investors
- How the team has gelled and performed together
- The quality of hires attracted to the company
- How well the board has performed
- Whether the customer traction has been as good as projected
- How the competition has reacted
- How the company’s margins are starting to shape up
- How the market has developed and grown, and
- How the exit landscape has evolved.
That is a lot of insight. It should allow you to make a pretty good assessment of the risks the company faces. They are likely behind their original revenue projections, but if it is a fantastic team, you feel they are doing the right things, and you understand and accept the reasons for why they are behind, then maybe you are comfortable overall with where they are. Experience helps with this. After you’ve seen enough startups, you cease to be amazed or annoyed at the delta between projections and performance. Once you have reached your sense of comfort that this particular company is performing at or above acceptable levels, and that the new deal offers an attractive risk-adjusted return, then it is time to do a downside risk check and think about the opportunity cost question.
What do you mean by downside risk issues?
This analysis is really about nasty things you observed or may have cropped up that you have not been thrilled with. Some of them may be small concerns, and some of them are what friend and experienced angel John Huston likes to call “show-stoppers.” Whether you consider them a formal checklist, or just some things to watch out for, you need to consider whether any of the new issues are too important to overlook. Here is my list of the big ones, with an annotation next to ones I consider show-stoppers):
- Any sign of integrity issues or concerns about honesty, transparency, openness (showstopper);
- Any sign of bad judgement or poor decision-making on the part of the team suggesting that the IQ might not be high enough or a low EQ is driving impulsive decisions or an inability to get or use help and coaching (showstopper);
- Lack of board director support for the round – not every director needs to invest heavily in every round, but if none of the directors is investing anything in the round, what does that tell you?
- The round is a total slapdash financial band-aid that was not in the original capitalization plan or forecasts and was done on an emergency basis because the CEO let the company get down to fumes;
- The competitive situation turned out to be much worse than expected;
- The company’s investor reporting has been insufficient or non-existent;
- The investment thesis was IP-based and the IP situation has turned out to be much weaker than hoped (patent rejected, infringement claim, competitor issued a blocking patent);
- CEO doesn’t know how to build or execute a real sales process and instead keeps trying to pivot;
- Round puts the company squarely on a “big capital” path where they are going to require VC support and a huge, low-probability exit to become a winning investment;
- Angel director is being thrown off the board, or the board has not been fully formed, or the board is weak and not adding sufficient controls or value (potential showstopper);
- Founder alignment has drifted from starting point and team now feels they would only except one very specific exit scenario;
- COGS is higher than projected or margins are otherwise not able to approach what was expected;
- Sales cycle is much longer than expected, value prop seems to be weaker than expected or product’s customer buying priority is lower than expected (potential showstopper);
- Badly needed key hires were not made, or low quality hires have been brought into key roles (showstopper);
- Founder relations have deteriorated and the team is not on the same page or actively feuding (or marrying or divorcing each other!);
- Science (and or trials) or product technology not working out or not looking sufficiently promising (showstopper);
- Investor support and enthusiasm already waning – low interest or participation in this round suggests future rounds may be even harder and money may be stranded.
Needless to say, as you read that list, you probably had a visceral reaction to a lot of those items, and maybe an unpleasant flashback or two. That is what I am talking about when I talk about downside risk!
What do you mean by opportunity cost?
Opportunity cost really refers to a couple of issues more personal and specific to the individual angel in question. One is a portfolio construction question. If you believe that adequate diversification is key to your overall returns, you always need to balance the decision to up your portfolio concentration by doubling down on an existing company against the opportunity to add a new company to the mix. Hopefully you are seeing good deal flow and have opportunities to invest in interesting new companies. In the case of most angels, if both rounds are compelling the right answer is to do both. If funds are so tight that you are having to starve your “winners” of follow-on money to add new companies to the portfolio, you might want to reevaluate your overall angel allocation and make sure you are going to be able to reach sufficient diversification for acceptable risk-adjusted returns. But weighing that issue is half of the opportunity cost issue.
The second is a parallel issue revolving around the question of what I sometimes refer to as “psychic returns.” With first checks, there are always lots of psychic returns. It’s exciting to add a new company to your portfolio, the company is young and dynamic and fast moving, there are lots of ways to help out – it’s loads of fun. But with third, fourth, and later rounds, the excitement dies down and it is more about financial investment strategy. At some point, a company is far enough along that it is out of the woods, the rounds are much larger. Your relatively small check is not really going to make much of a difference to the company, garner much influence, or change your ownership percentage much.
By that point, even if it might be a fully-justifiable investment on a cash-on-cash returns multiple and an adequate IRR, it can still be less appealing emotionally. With these much later rounds, admittedly some very deep pocketed angels say “Emotion? Are you kidding?” and slam a massive check into the round. Many other angels, however, decide they are done with the company and choose to put the check into something newer and more exciting, where the money is much more badly needed and they can have a much bigger impact (and they can still model the magical 10X).
Needless to say, the follow-on decision can be a tricky and nuanced. But with a good process such as the decision tree above, you can get your bearings in terms of offense vs. defense, you can verify that a good upside case can be made, you can check for the presence of showstoppers or other major sources of downside risk, and ultimately weigh the opportunity against other options in the context of your overall portfolio goals.