The Debate Over Follow-On Investments in Early-Stage Investing

First Cheque

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Episode Summary:

In this thought-provoking episode of First Cheque experienced investors Cheryl Mack and Maxine Minter delve into the meticulous world of follow-on investment strategies. The episode serves as a beacon for those who wish to refine their approaches in early-stage investing, especially as they grapple with the decision of whether to follow on or not in subsequent investment rounds. The conversation explores the intricate balance between optimizing returns and supporting growing companies at various funding stages.

Cheryl represents the school of thought advocating for doubling down on winners, focusing on reserving funds for follow-on investments based on the company’s performance. Maxine, on the other hand, takes a contrarian view, emphasizing the importance of an initial strong pre-seed commitment without reserving for follow-on. Together, they unpack the underpinnings of each method, providing listeners with insightful, SEO-rich analysis centred on investment strategy, fund management, and the implications of the power-law in startup investing.

Key Takeaways:

  • A follow-on investment strategy involves investing additional funds in a company during later financing rounds, usually at a different share price.
  • Traditional wisdom encourages investors to reserve funds to double down on winning companies, but Maxine challenges this idea, promoting initial, larger investments at the pre-seed stage.
  • Discussion on the importance of pro rata rights and the potential signaling risks associated with not following on in subsequent rounds.
  • Cheryl shares her angel investment approach, which emphasizes growth metrics evaluation, fund allocation decisions against other opportunities, and backing companies that have shown significant progress.
  • The conversation highlights the need for personalized investment strategies that reflect individual goals and resources, as well as the potential influence of received wisdom on investment decisions.

Notable Quotes:

  • “The conventional wisdom… you want to reserve follow on money in order to double down on your winners.” – Cheryl Mack
  • “If you want to maximize IRR, then it’s deploying all of your capital in that first check.” – Maxine Minter
  • “The power law operates in our industry… it’s not necessarily a one for one trade off… you need to make resource allocation trade offs.” – Maxine Minter
  • “I really have to believe that I’m still going to get outsized value from this valuation further on.” – Cheryl Mack
  • “The only thing that stops you from getting squeezed out over time is adding enormous value and having a great relationship with the founders.” – Maxine Minter


This transcript has been A.I. generated.

Cheryl Mack: Three, two, one. Hey, I’m Cheryl.

Maxine Minter: I’m Maxine.

Cheryl Mack: This is First Cheque. Part of Day One, the network dedicated to founders, operators, and investors.

Maxine Minter: If you want to be a better early stage investor, this is the show for you.

Cheryl Mack: So TLDR, if you don’t want to suck at investing, listen up.

Hey, so today we’re talking about follow ons. To follow on or not to follow on?

That’s a great question. I think a lot of companies and founders and funds are all constantly thinking about follow ons, how they make them, how they garner them. It’s crucially important for lots of, uh, companies to get follow on for a lot of funds.


And for a lot of angel investors, they’re constantly thinking about how to follow on or not follow on. So excited to dive in. I think, uh, we also disagree on this, which is I’m excited to tease out the ways that we are different and not necessarily disagree, right? Like our fund, we don’t follow on and you seek to follow on that.

Maxine Minter: So I’m excited to kind of dive into those two.

Cheryl Mack: Yeah, for sure. Um, that was why we picked this topic, because I was like, I think we could have an interesting kind of debate about it. You know what’s funny, actually? I just thought, when I first started angel investing, I remember that the question of like, how much to reserve for follow on was probably the number one question that I was like, trying to figure out and like, Would always ask other investors and, and then like fast forward a couple of years.

And I get that question from people all the time, but you know what? It turns out it actually doesn’t matter that much. Like I didn’t really need a set number of like, Oh, you have to reserve 40 percent of your dollars for follow on rounds. It’s that simple. It actually just ended up being way more fluid than that and just didn’t matter as much.

And so I think it’s a really interesting conversation to have. But at the same time, I just want to point out that, like, you really don’t need to get to a number, especially if you’re an angel investor. Funds probably do. They need to have something set. But as an angel investor, it’s not, it didn’t end up being that important of a question.

Yeah, that’s super interesting. I actually, Never developed a follow on strategy as an angel. Cause it was just from a dollar’s perspective, like not tenable. Um, I also like, as we’re talking about this, I find myself wondering, like. Is there different strategies for angels or funds or is this one of those like unique opportunities or those unique topics where it’s kind of the same, right?

The like math is the same. The considerations is the same. I don’t know. I’m excited to tease that out.

Yeah, I think it’s different. My view is that it’s different. But, you know what we should start with? We should start with explaining what follow on True. What a follow on is. What follow on funding is.

Yeah. Do you want to hit them with the definition? Alright, so, I’ll give them, like, from an ANGEL perspective. Uh, actually, I think it’s the same from an ANGEL NVC perspective. Basically, follow on funding is It’s not the first time you fund a company. So if you decide to invest again in the same company, that is a follow on fund, follow on funding, follow on investment, follow on investment.

There we go.

Fun. Funding. Fun. Yes. That’s a follow on investment, right? Essentially you’re investing. You’re battling down. It’s also a terminology that we use. You’re essentially investing again in the same asset, uh, usually at a different price. I think is the other thing to name that. So ideally you are investing again at a higher price.

In the last year or so, there have been circumstances where you are offered an opportunity to invest at the same price. I don’t know anyone who’s doubling down at a reduced price. Right. Where there’s a down round and they’re coming in again, I’m sure it happens though. They probably should. Yeah. They probably do.

Right. I think they still have conviction and they’re writing that check and I’m sure it does happen. So yeah, you’re essentially buying more investment, more shares in a company at a later stage, usually at a different price than what you originally invested in. Well, the thing I’d say is that, um, it seems to me that there are two versions.

One religion is never follow on the other religion is follow on, on your winners. Do you want to dive in a little bit for folks on why would you follow on your winners? Cause that’s your camp to the extent that we’re diametrically opposed. It is not actually that diametrically opposed to be honest, much more gray, but for the purposes of today.

Why would you follow on, on winners, and what does that strategy look like?

Yeah, so I think conventional wisdom has always, or at least the wisdom that I’ve always been told, and probably until I met you, actually, um, was that you, you want to reserve follow on money, uh, in order to double down on your winners.

Um, and I think there’s also an interesting, like, thread to pull there on, like, what does doubling down actually mean to different people? But for the moment, I will focus more on, like, Why would you want to double down on your winners, right? So ideally if you could write a small check In the beginning, when the company is most risky and learn for the next 6 to 12 months as to the quality of that company, and then see if they’re doing really, really well, and if they are doing really, really well, then be able to put more of your money on that company, and theoretically, you would, you’re kind of buying that right?

So, um, you know, maybe we’ll talk a little bit more about pro rata rights, but like, Theoretically, if you invest in their first round, then you have the right to invest in their next round. Whereas maybe another investor who sees that company is doing really well, they might not have that right in, inherently, or just, um, naturally to invest in that company.

So if you could find, like, pay a little bit to learn about the company, and then actually place, the big bets on the ones that are doing well, then that would be a really good strategy. And so I think that’s where a lot of us aim to go is to write small checks in the beginning and then put the money on the ones that we know are doing well.

I know in practice, it doesn’t always work out as perfectly. And maybe that’s where you come from when you say, you know, uh, from your perspective, um, you know, does it work out like that?

Maxine Minter: Yeah. I mean, I think The way that I think about it, right, the reason to follow on and build a fund or build a personal annual strategy that has follow ons is as an application of this idea that with more information we make better decisions.

And so the idea being that you have significantly less information at your first check, so you are taking a bigger risk from an information perspective, usually companies are more risky at that stage as well. And so you are taking that risk, but what you’re looking to do is kind of learn that space, learn about the team executing, learn about the kind of the opportunity space, maybe the, uh, theses that they are bearing out and then get an opportunity to invest.

The thing, as you mentioned, it’s pro rata, right? In not in all circumstances, but in some circumstances, investors secure pro rata of that first investment. And so you

Cheryl Mack: seek to

Maxine Minter: exercise

Cheryl Mack: that pro rata. Pro rata is. the right to invest. Yes. Again. So the right to follow on actually to use our, our first term prorated right is the right to make a follow on investment.

Maxine Minter: Right. It literally means same amount. So you are given the right to defend the same investment. You had ownership percentage in that company. That you had in that future one.

Cheryl Mack: And for the record in Australia, it’s also called preemptive rights, right? Oh, interesting.

Maxine Minter: Cause you get to buy like when the shares are available again, you get to buy the same amount to maintain your same ownership percentage before anyone

Cheryl Mack: else gets to buy it.

Yeah. I find that in, in Australia we tend to use preemptive instead of prorata. Fascinating.

Maxine Minter: So I think there’s probably a couple of other reasons why people run, uh, sorry, uh, follow on strategy, right? One is that for a big fund, it is not possible for you to invest the full amount in the earlier stages.

Right. Like you could imagine.

Cheryl Mack: Yeah. With Blackbird. Funds have this like ownership stake thing, right? Yeah. Where they’re like, I have to own at least 10 percent of a company. Right. But like, how do you own 10 percent without taking out enough of the, like buying, buying enough of the company in that first round?

Maxine Minter: Right. Well, yeah, it’s definitely that. There’s on, on downside, but for the, the big funds like Blackbird in Australia, I think their last fund was about a billion dollars. If they took that billion dollars and they didn’t have a follow on strategy. They’d be having to invest like, what, 66 million in every first check.

And if they want to invest early, like that doesn’t work, right. They’re buying more than the value of the business. The math is like, does not work. There is like a follow on strategy that makes a big multi stage stage fund possible. So there is. One reason is that the risking over time. Second reason is it allows you to build a bigger fund, but still participate in the early stages.

The third reason that our people talk about is, as you mentioned, to kind of defend their ownership stake. Right? Yeah. Like you want, the theory is you want to own as much of the best companies as possible because of the reality of power. If you don’t own enough of your top two companies, your fund can’t be successful.

And your top two companies have to be really successful for you to make venture scale returns work. That’s been fascinating. I was looking at Kauffman’s data, I’m sorry, no Sapphire’s data on, uh, funds in their portfolio. That had. Uh, Sapphire is a big investor into funds. So LP or fund refunds into funds.

And they were saying for their top performing companies, so they’re top performing funds in the funds portfolios, the top company on average returns 90 X average. Wow. 90 X that’s wild. Yeah. But if you don’t own enough of that company, right, this is the argument, right? If you don’t own enough of that, that company, Then it’s really hard to make the rest of your fund work.

Their second best company in the average portfolio is a 25 X. So it’s like almost four, a fourth of the size wild, the Delta between those two. And then that’s the power law at work. Right. And then. Every, like, the company’s, like, number three at the low, if you average them, they’re 1x.

Cheryl Mack: That is, like, that is the perfect example of the power law working, like, wild.

And so this is, this is the point, right? Like, if you don’t own enough of the 90x and the 25x, then when they exit, how is that ever going to return your funds? And, like, if you don’t have, um, a follow on strategy, then you’re just going to get diluted out to not owning enough of that company. Yes, that is the

Maxine Minter: argument for running a follow on strategy, right?

Is to like defend your position the whole way up. I believe Blackbird has done an excellent job of maintaining most of its ownership, but not all of its ownership the whole way up as well. So that’s what makes Canva such an incredible investment for Blackbird. So those are the reasons that you invest that stage.

There’s also the like, bias. That with just a little bit more time, a little bit more effort, someone might be able to be successful. And so, you know, just with a little bit more time, a little bit more effort, companies might be given an opportunity to become that first 1 or 2, as opposed to being somewhere in that averaged 1%.

So that’s the theory.

Cheryl Mack: I think on that point, though, like, we kind of know that, like, founders are pretty bad at estimating how long it’s going to take them to get somewhere. And so us as investors being like, okay, well, you know, you’ve raised for this much runway, and then they get to like, you know, 75 percent of that and realize that they’re not going to hit those milestones.

Like, we actually don’t know. Like, that’s pretty normal. It’s pretty common, right? Like, I feel like we should, we should know that that is likely to happen. We’re all pretty bad at that. And so, investing a little bit more to help them actually bridge that. So, like, reserving a little bit of money in order to help some of those companies that are promising.

But haven’t necessarily hit the, the milestones in order to raise that next round. It could be a good strategy because otherwise it’s, well, you know, the company fails, right? So if we normalize, if we agree that it’s normal for founders to be bad at that, then saving some money to bridge that to me makes sense.

Yeah, exactly. I mean,

Maxine Minter: like it can help you keep more companies alive. But what it does mean is that you spend more money on your losers. So it dilutes your IRR, it dilutes your overall return as a multiple of invested capital because you’ve invested more, but you haven’t got materially more out the other side.

So the reason that I find a follow on strategy to be challenging, right? I think something that we haven’t built into our funders for a couple of reasons. One, for our strategy, where we’re investing only at bright state. We want to own as much of the company as early as possible, and to deploy all of our firepower into that risk check.

Because I think we can all agree on average. The price per share at pre seed is less than the price per share at seed, and which is less than the price

Cheryl Mack: per share. And

Maxine Minter: so on. And so on. Right? And so if we can buy the majority of our position at pre seed and not, you know, reserve money and hold it for that next 18 months waiting for seed to come around where that, um, entry price is going to be higher.

Then we will have a much higher return on our investment. We are taking

Cheryl Mack: more risk. On that point though, like, wouldn’t you, couldn’t you also say that you’re spending more money on your losers? Like power law would say that you, that most of those companies are investing those first checks in are also going to be losers.

So couldn’t I also make the argument that you’re spending more money on your losers? Uh, I

Maxine Minter: think not

Cheryl Mack: relative to

Maxine Minter: a follow on strategy, right? Because. We wouldn’t be, that would be the same if we were deploying the same amount. So if we were running, let’s say a 30 million fund, where we deployed, you know, 600 to 700 K per check or a 200 K check up the front or 150 K check up the front.

And then a 450 to 500 K check at seed, right? That would be what would be necessary for us to buy the same ownership percentage on the average 3 seed and seed round, right? Because on average, you go all 3x.

Cheryl Mack: Yeah. So, like, would you say this only works at small funds? Like, once your fund is past, what, 20 mil, do you have to have a follow on strategy?

Maxine Minter: Right. That is one of the reasons why it is all this universal. Right. Is because it is impossible or it is inadvisable to deploy. More than 30 million into actually probably 25 million is probably the maximum time size before at the current average pre seed valuation, before you would have to start doing a follow on strategy.

So that you didn’t just like disadvantage founders by investing into them. And as a reminder, the business model for funds is a 2 and 20 model. So you get 2 percent management fees on community capital. That is the money you have to run the businesses. So there is like an incentive to pack very big funds so that you have more people to support the companies that you work for and to help you manage the

Cheryl Mack: funds.

Right. So, so it’s not that you’re like just totally against follow on. No. It’s just that right now that this is the best strategy for your fund because you’re targeting pre seed with a small fund.

Maxine Minter: Right. Also, I would say my argument is it’s the best strategy for. Any funds that is doing this wanting to maximize IRR.

So the trade you’re making here, there isn’t, it’s a false setup because they are, there’s not one right answer, right? Like all, like lots of things. There’s not one right answer, but for a strategy where you were looking to maximize IRR, so maximize the percentage return you get per year. You want to buy as much of the ownership of companies as early as possible.

Because even if you say, bought 12 percent of a company pre seed and on average dilution, you would still own about 6 percent of it by sea and spend no money doing that. Whereas if you invest a tiny amount as a learning check in the first one, let’s say you only buy, Like 5 percent at the beginning and you want to build back into it.

Even after dilution, you still end up around that kind of like three or 4%. So you’re much better off deploying your capital at that first check and buying a significant portion of the business. If what you’re trying to achieve is ownership and like cost adjusted ownership, you’re much better off buying as much of the company upfront as possible than trying to build your way in.

The other thing. That I think is challenging with a follow on strategy. So, if you’re thinking about building it for your angel portfolio or for your fund, is how you make sure that you don’t put more capital into, uh, The, you know, third place and below in your fund. The only way that this strategy gets you a better IRR, then deploying all of the firepower in that front end is if you only double down on number one and number two.

Yeah. But as a decision making framing for that, it’s really hard.

Cheryl Mack: Cause the average across the rest of them was one.

Maxine Minter: Was one. Knowing that you are investing in number one and number two at series a is really hard. And it’s brought with all kinds of kind of loss mitigating, some loss, some cost fallacy, decision making influences.

And so thinking about how to build a system to make sure that’s not the case. I think that’s doable to be clear, right? Like we run a syndicate where we make a pro rider if we do have a need and follow on opportunities available to our LPs and to our community syndicate. And so I do, I’m not saying that there is no value in the second third.

For this opportunity to invest at definitely not saying that, but if you want to maximize IRR, then it’s deploying all of your capital in that first check. But if you’re wanting to maximize dollars returned, not as a function of how much you originally invested, but maximize dollars returned, then you have to run a follow on strategy because you can’t deploy enough capital into preceded seed rounds to run a big.

50 plus million dollar fund strategy.

Cheryl Mack: What about, like, the, the signaling, right? Like, if you’re, if you’re a fund who invests only purse checks, or even an investor, like, as an angel, and even if you tell them, like, look, it’s not, It’s not in my portfolio strategy. Like even as an angel, if you’re like, look, I don’t follow on, I still think it creates this like negative signaling risk for you as a and as as an investor, I guess in general.

Because if the next investors say, oh, well they’re not following on. Even if you explain to them, which often you don’t have the chance to do and the founder is doing on your behalf, sure. There’s still a bit of like negative signaling risk, be like, oh, you’re like your main investor, or like this high profile, like as an angel, you know, I sometimes I’m called high profile of if a.

A company is like, Oh yeah, our, our biggest angel isn’t following on it. That can be totally a signaling risk. And then for you as an investor, how do you factor that into the risk of like, well, I’m creating this risk for my company.

Maxine Minter: Yeah. I think it’s a really interesting question, right? Like, because follow on is so ubiquitous in the ecosystem and not a lot of people have, Spend time thinking about that.

Why follow on, right? Like it’s part of the receipt we all get given when we first start investing. Right. Correct. Thou shalt follow on. Thou shalt

Cheryl Mack: reserve. Reserve money for follow on. Reserve money for follow on. Say it after me.

Maxine Minter: Right. Right. And so the only, and we use that follow on to double down on our winners.

Of course, the like logical conclusion then for everyone else that it’s digesting that received wisdom is like, they didn’t follow on because they’re not a winner. And so I think there is a market education that has to happen of thinking about, well, like, actually that’s not true. And I will say there’s lots of funds in the U S and lots of angel.

And it was in the U S that don’t do that, right? Like, I don’t know that it’s under the UK and EU, right? Like, I don’t know that it is as gospel over there as it is here. Well, maybe it’s just here.

Cheryl Mack: Yeah. I think it is here though. Like until that changes here, I think it does create signaling risk. If you’re not, if you don’t even, if you don’t have a follow on strategy, regardless, you’re still kind of creating that signaling risk.

Maxine Minter: Yeah. It’s interesting. I mean, I think for us, we’re just like, we’re happy to talk to any investors that you might be. Like chatting to, they want to chat to us, like why we’re not, not following on. Um, very often though, the LPs that we work for and our communities syndicate, they take up pro rata.

Cheryl Mack: So

Maxine Minter: for all intents and purposes, the Qt Ventures community is going along for the journey, right?

They’re like doubling down. They’ve watched these companies operate, they’ve watched them, you know, do their bit and they’re really excited about the opportunity and they want an opportunity to invest again. Yeah. It’s just, we don’t do it out of fund. And for the IRR reasons and the decision making hygiene reasons that are mentioned before.

So that probably softens the blow, and I

Cheryl Mack: Yeah, I think, and that kind of addresses the next thing that I think is a reason to follow on, which is like, if you, if you’re talking to founders and they’re like, well, do you follow on? And you say, no, often you run the risk of losing the deal because they want investors who are happy to keep deploying checks.

So I think as an investor, like following on is really important because of that. Like ability to you founders generally want, even if sometimes later on, they don’t actually want your follow on. They want to know that you can follow on when they’re initially taking your check.

Maxine Minter: Totally. Yeah. And I, like, I think the, for founders and there’s a bunch of funds in Australia that do this, right.

I think Airtree is one of these where like, essentially if they invest once they’re investing again, right. They expect to invest in like two rounds. From that 1st check. And so that’s really valuable to know that you have that next round de risk. So I think it’s going to anchor back on. Investors are essentially delivering different products for founders and they’re optimizing for different things, right?

I don’t, you couldn’t ever work with an institutional, like big super fund. And around a 25 million strategy, right. It’s just like, not going to work. Yeah. And, but their strategies, right. They’re like 700 million with their last fund. That’s their, their strategy they need to do follow on and they can build ownership in companies over time.

And it works really well for them. Right. Like Australia has some of the best performing funds. In the world, the best funds in the world have follow on strategies. And so I think it’s more the kind of hope here that folks will get is that they will think more deeply about their follow on strategies.

Think more deeply about like why follow on what circumstances will they follow on. Um, you know, one way of doing this is just follow the lead. Some of the best follow on strategies in the world. That’s what they use. They don’t net new, make the decision.

Cheryl Mack: Actually, yeah, Startmates.

Maxine Minter: Yeah, Startmates

Cheryl Mack: does that.

Yeah, Startmates Continuity Fund. Um, they just, as long as they’re the lead investor in the round, then they will follow on. So, that absolutely makes sense. That’s a strategy that you could also run as an angel as well. You could say, cool, I’m going to follow on if there is a lead investor. Yeah, one of the other threads that you pulled earlier that you mentioned earlier that I want to pull is you said I didn’t you didn’t run a follow on strategy as an angel simply because the funding was just untenable, but like, maybe let’s think about it for a second.

Because, like, to me, I think there’s two ways as an angel. Um, to run a follow on strategy. One is this like concept of doubling down. So you invest a small check and then the next check that you follow on with is double or triple or sometimes even quadruple the amount that your first one is. So let’s say you invest five grand, then your follow on check is 25 grand.

And that makes a lot of sense if you absolutely know that that’s your winner. Um, I’m in the same bucket as you. I don’t have enough funds to run that strategy, but my My follow on strategy is to maintain my equity. So that’s the other option. If you’re, if you do run a follow on strategy as an angel is you can just maintain.

And so when I follow on, I’m just maintain, I’m investing enough to maintain my equity for as long as possible. At some point in their rounds, you know, when they get to the series A, B, C, and all the way down the alphabet, then oftentimes I cannot. invest enough to maintain my equity, but I will do so if I believe in that company for as long as I possibly can.

So what if you, let’s say in your early days, what if you had, uh, unlimited funds, what strategy would you have implemented if you could have had a, if you had enough for a follow on strategy?

Maxine Minter: I mean, that’s a super hard counterfactual to run. Like back when I was complete novice, I had no idea what I was doing.

I probably would have followed Received Wisdom if I had had Infinite Dollars. I

Cheryl Mack: think

Maxine Minter: I, it’s definitely a question we get asked all the time, right? As a fund, like, do you have follow on? Why don’t you have follow on? Like, thou shalt have follow on, but you’re not doing follow on. So like, what’s wrong with you?

And it will be something that when we kind of come up to fund too, like it’s going to be a question I think that we get as well there. And I don’t plan to build a follow on strategy. For The kind of investor that I want to be for the way I want to work for the founders that we work for. I want to have the courage of my convictions and put all of my firepower.

Behind that first check so that I am there on a hundred percent, no options, no kind of get out later on kind of dynamic. And I think it works for our strategy and what I’m planning to run a strategy for fun to do, like that, that will be the plan, but that doesn’t mean again, like, that doesn’t mean it’s a bad strategy.

There are, you make the majority of your dollars on the bigger check. I could, you know, if I was to rebuild a personal angel angel strategy, what I want to do follow on. I don’t know. I’m pretty convicted as you can probably tell on this, um, on this strategy, but you definitely could like, and people run really effective strategies in LA and like build really profitable personal angel investment portfolios and fun portfolios.

You know, if you have a larger pool of capital that you’re looking to deploy, it can be an excellent way to get in early. I think one thing that I struggle with as a decision making dynamic is the risk of adverse selection bias in that strategy. In that every hot follow on round I’ve ever been part of, there has been a discussion of not taking your pro rata, not taking your preemptives to make For great investors to come in at the later round, you mentioned, and to kind of explain that a little bit, like most funds have ownership minimums that they’re buying.

So for us at Pre Seed or, you know, when I used to invest as an angel investor at Seed to Series A, you would invest at the round that you would invest in, and you would then have an opportunity to double down, potentially, like the legal right to double down in the event that they raise again. But the company might want to own or sell 20%, say, of their company in that next round.

You have two great funds that want to join. Each of them have a range of 10 to 20 percent ownership minimums. You know, commonly it’s that kind of like 10 to 15 percent for both of them to join. They might dilute down and take, let’s say 8 percent each, leaving just a tiny slice of additional cap time for All of the other previous investors that I’ve provided are trying to compete for that piece.

And so what ends up happening is let’s negotiate. With the previous investors to for them not to take their follow on. And so very often by the time you’re getting to the traction points of less so C, but series a series B, it starts to become clear who’s breaking out from the pack. And so your company number one and company number two become more and more obvious, the further along you go and harder and harder to participate in.

And so follow on strategy. Where it becomes harder and harder for you to participate in number one and number two by its very definition, trends you to the circumstance where you just put more in at a 1x, an averaged 1x, which as a growth stage strategy, isn’t great.

Cheryl Mack: So if I understand what you’re saying, it’s like, Your follow on strategy doesn’t mean shit if you can’t actually get into the follow on rounds that are the ones that are going to break out and be the one and twos.

Yes. And you’re unlikely to get it if they are really the position one and position two of the fund. But as an angel, Like, yes, I, I have also been asked to waive my pro rata rights. Um, so I can say that like, that is, that is absolutely something that happens. But if your check is small enough to squeeze in there and you’ve added, added enough value, then theoretically you get to come back in.

So, and I think this also raises another point as well as to like, you know, should investors get pro rata rights by default? And does it even matter, right? Because even though you have them, sometimes you get asked to waive them anyway. And if your choice is between waive it and you know, Sequoia comes in or don’t waive it and Sequoia doesn’t, then the company died six months later than like, obviously you’re going to choose to waive your rights.

So should, do you think investors should get, um, pro rata rights, especially in the early days by default, or do you think it doesn’t matter anymore? Spicy.

Maxine Minter: Um, I. It’s such an interesting question, I think, for the ecosystem, because it’s so default, right? For most big farms, like, they require pro rata, right?

And they will fight hard. We don’t, like, we don’t have a, it would be weird for us to require pro rata with no follow on, right? Like that would be No follow on strategy. So that probably goes without saying, I didn’t need to declare that, but like, we don’t require it. I think it’s one of those ones where, uh, it’s a helpful tool to have in your toolkit in the circumstances where the founder is in that negotiating position, right?

Like the default position is you have the right. So I think that the default position is it gives you an opportunity to play and at law you can enforce that right. I think LPs feel better about it. I think fund managers feel better about it. I think in practice. In every early stage deal I’ve seen, and I get this question all the time, which is like, how do you make sure that you don’t get squeezed out over time in practice?

What I’ve seen, the only thing that stops you from getting squeezed out over time is adding enormous value and having a great relationship with the founders. That’s the only way.

Cheryl Mack: Yeah. Law. A hundred percent. That’s the only times I’ve ever been fought for as an investor is when the founder is said to that lead investor.

Like. Uh, I can squeeze some of them out, but like, really need this person.

Maxine Minter: Yep. And I think that’s a wonderful incentive, right? Like, at the end of the day, we venture, not angel investing, but venture is two sided marketplace and the founder is one side of that marketplace. The companies that you work for, they are your customers.

And so the incentive there is to deliver great value for them so that you can continue to earn the right to participate. I think it does set up, like, this norm of pro rata rights does set up friction for most companies as they’re transitioning into that next round. I think I have seen many circumstances where Investors like really go to the mat, fight for their pro rata.

Cause that’s kind of that job for the other side of their marketplace, which is LPs and do a lot of damage to the relationship, you know, with the founder of that period. And it’s a tough dynamic, right? Like it’s really tough incentive structure to set yourself up for, but I also don’t think that’s been solved for that.

You know, if you run a follow on strategy, which you have to, if you want to run a big fund, then you have to fight for those pro rata rights. And. You will have down the pressure on those pro rata rights in your best companies, but it is actually crucial for the strategy that you participate in those follow on.

So I just think it’s like a pitch and people just need to kind of keep a cool that as they go through it.

Cheryl Mack: I heard that YC tells the YC companies now to not include pro rata rights as default and to tell investors that they have to earn it. Do you know if that’s the case?

Maxine Minter: I don’t think that’s right because YC takes pro rata.

I have heard of many circumstances where YC has actually tanked a follow on deal because they refused to rata. They take it every time. Interesting.

Cheryl Mack: But I’m actually not sure. Maybe they just, like, ruled for thee, but not for me. Yeah. Could be. Maybe. Yeah, yeah.

Maxine Minter: That kind of situation. Maybe. I mean, I think it is It’s in the founder’s interest not to commit to pro rata rights.

It is one of the topics of negotiation.

Cheryl Mack: Yeah. And for investors to like earn it instead. Yeah. Yeah. Do you know what’s also interesting? In Australia, it’s not included in the standard safe note that AIC provides. Like if you look at that document, it is not included. Um, default included. So actually at Aussie Angels, we, so we see tons of companies and especially they’ll upload their draft like safe note and we will, we’ll end up seeing what those terms are.

And oftentimes those rights are not included because they’ve just pulled the AIC document. And so we cannot include pro rata rights on the deal note as a term that’s actually included in people be like, but why? The founder said that actually they do want to. You know, give us pro rata and it’s like, well, it’s not in there because it’s just not in there by default.

And nobody thought to like actually negotiate that yet. Usually by the time the round closes, then somebody thinks of it and it gets added in. Interesting. But a lot of time when the deal launches, it, it’s not.

Maxine Minter: Yeah. Very interesting. Do you, do you guys track the stats of like in what percentage of companies ProRare is included?

Or would you have that data? I guess you would. We

Cheryl Mack: would have the data. Yeah, we would have that data, but I haven’t actually looked at it. Let me, I’ll come back to you. I’ll look at, I’ll look at it and come back to you. We can do like a sub note on the podcast. One other thing I wanted to cover on this was the, like, let’s say we are running a follow on strategy and let’s pretend for a moment that you are as well.

Um, how do you decide? You know, there’s got to be metrics, right? And you said that you agree that there are ways to run a good follow on strategy. And actually, Rain is probably a good example. We did a podcast with him where he, his whole thing is like doubling down, right? He invests small checks on lots of companies, sees which ones are the breakouts, and then doubles down or even quadruples down, uh, on the winners.

So, like, let’s talk a little bit about how we decide if we were to do that.

Maxine Minter: Yeah, I think it’s an interesting one because there’s a defensive element to it and an offensive element to it. Right. The defensive element to it is that, like, defending your existing ownership position in companies, you know, if you only, if you don’t own enough of the big winners.

Then your fund is going to fail or your investment strategy is going to fail if you’re investing as a proceeding investor. Angel portfolio. Yeah. Yeah. Sorry. Angel investor. So I think there’s like the math of how much do you have to invest to maintain your ownership through one to two rounds, depending on how you do that.

And then I think that’s, that works. Cause we just talked about like start from the moment you make your first investment. And then there is the kind of. Offensive piece, which is you are making a net new investment decision. In theory, you should have enough information or better information than other investors at the table to make a good investment decision.

But I think there is, I think a good follow on decision looks like making a net new investment decision and try as best you can to break out of that sunk cost fallacy. And not make the decision based on your previous investment. I think what I have seen is like mental models where you watch for moments that you say, I think, you know, they can do just a little bit more, or if they just had a little bit more, they would get that.

If you hear your brain say that to you, I think it’s a red flag for you to ask the question.

Cheryl Mack: Just a little, just a little. You know, those three words, just a little, just a little, it’s like that episode where the doctor is always like, just a little,

Maxine Minter: right? Right. I think it’s, uh, from a fundamentals, as I said, I’ve never run this strategy.

So I’m kind of just like the timing on what I think good decision making would be in that context. But from what I’ve seen, right, like making it as a net new investment decision, making it, you know, Trying to break out of like previous biases. So for some funds, the strategy you’ve seen them run is the decision making hygiene around a follow on investment looks different than a decision making hygiene on the initial investment.

Maybe you need more yeses to get it over the line. You know, we, Michael Batgoe talked about like, we only follow, you don’t try and make that lead. Decision because of the incentive of price and share inflation, um, and the complexity of making that decision. Yeah, I think those are the big ones that popped in my mind.

What have you seen as someone who runs this strategy? What does good look like? Yeah,

Cheryl Mack: so for me, I’ve got a couple of things, um, and this is coming at it from an angel perspective, right? So I don’t have the complexities of, uh, like fund construction. Um, portfolio strategy to, to manage, but I have my own portfolio strategy to manage.

Um, so like, first of all, evaluating performance is the, is the main thing. Like one of the things I, you know, I heard rain saying is like, you really, you know, when there’s a company that’s doing really well. So what I look at is like, you know, have they doubled, you know, that are tripled, right? Like it’s the growth that you want to look for is like a kind of that rule of thumb is like three, three, two, two, or three, three, three, two, two, which is triple, triple, triple, double, double, double.

So. I’m really looking for that, like, are, have they tripled that growth? And that, like, really exponential, like, up and to the up. Right, right into the, it really should be right and up to the up, instead of up and to the right. Because up and to the right could easily be like this. We’re looking for the right and to the up.

That kind of hockey stick growth in whatever metrics that is really important for that business. It doesn’t necessarily, for me, especially at the earliest stages, where like I’m investing pre seed, they often don’t have revenue. So if we’re looking at like exponential user growth, then that’s okay too. Um, so I really need to feel like, one, is their growth going crazy?

Two, um, have they said what, have they done what they said they were going to do? And if, Not, and sometimes that’s the case, like do they have a good reason? Um, if they haven’t met certain metrics, then like what has been the reason and do I think that that’s reasonable or not? If those are like big yeses for me, then the next thing is like evaluating the, the valuation in terms, I really have to believe that I’m still going to get outsized value from this valuation.

Further on. So, like, if it’s, you know, if it’s a valuation that’s triple what I invested in, do I still believe that that company is going to generate enough value in the future for me to get my money, like, to get my return, but now it’s like a weighted average between the two? Because I have the earliest investment, which is awesome, but then this one, so then you kind of have to weight it between them.

Um, so it’s not just this one. And I think a good rule of thumb that Rainn also said that I sometimes follow is like, do I still think they can double the valuation from here? Uh, and like at the next round, not just ever, but at the next round. And then also I look at like, who’s, who is the lead investor and, you know, do I trust them to set the right terms for where this company is at?

And, uh, and then the other, I think for, um, and maybe this is relevant for funds as well, but like, I also have to evaluate, like, I only have a certain amount of money in my angel portfolio and often it is coming from income. So I can only make a certain number of, uh, investments in a certain time period.

Like I couldn’t, I’m, you know, I make 10 investments over an 18 month period. I can’t make all 10 of them in one month. I can only make one every like month or two. So I have to look at what are my opportunities. This reinvesting following on this one or a net new one. And if there’s a really exciting net new one that month, then I might want to, I’m just have to make that call.

Whereas I think a fund doesn’t have to do that because they, their job is to deploy a certain amount of money in a certain, say two years. But they could, they technically could deploy all of that money into a two month period if they found all of the amazing companies only in those two months, whereas, like, I have to be more cash flow optimized, I guess, as an angel, so I have to evaluate that follow on against other opportunities.

And sometimes, actually, they’re also follow on opportunities. So sometimes something might lose out simply because. There is another follow on that’s better at the exact same time or another net new investment that’s better at the exact same time and not because I didn’t want to follow on, but simply I just don’t have the funds to do all three at the same time.

Maxine Minter: Right. I actually think that that is a wonderful forcing function by quality decision making because the reality is that the power law operates in our industry, right? And it is a relative statement. It is that like, you know, we aren’t talking about finite resources, finite market at the type for certain.

Things finite capital to go around across all of them, right? There are like winners that most of the opportunity occurs to over time. And so there is, there are maybe unfair, but reality, like you need to make resource allocation trade offs and it’s not necessarily a one for one trade off. Right. Like you might find there is an opportunity for you to invest at a net new and invest in a follow on, and they should Be made as net new decisions.

And so actually evaluating them net new gets net new Is a better way to think about it as well. I think it’s a better way to think about it and versus like doubling down. So it’s probably a great thing.

Cheryl Mack: Yeah. So I often ask founders, I’m like, what’s your timing on this? Like any chance you’ve got like an extra month?

Maxine Minter: Yeah. Yeah. I think it’s an interesting question. Well, I think hopefully that was educational for folks as they’re thinking about building their own follow on strategies, both as individuals and as partners. I think I would love to hear from the ecosystem what they think.

Cheryl Mack: Yeah, that’d be great. Or just send us like two, two to three lines on what your follow on strategy is and we can learn and get a whole bunch of input and get it like a weighted average of what the average follow on strategy is in Australia.

I love that. Actually, that’d be great. Can everybody, everybody please just send us like one or two lines on your follow on strategy. If you have one, or just send us and say, nope, no, N O, N O, maybe subject line, follow on strategy, Bonnie. No. Great. Excellent. Amazing. Thanks. Thanks so much. Thanks everyone.

Thanks Maxine.


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