How to Follow On
Matt Compton
January 2025
Follow-on investing in venture can either be a proprietary advantage or huge drag on returns for an early stage venture fund. At OVF, we feel the difference comes down to a consistent, disciplined approach plus a sprinkling of open-minded creativity for proprietary opportunities.
Securing outsized positions in winners is a key to delivering top quartile returns. Unlike public company investing, private investors are free to leverage proprietary information. This can come into play in a meaningful way with subsequent rounds, a.k.a. “follow-ons.” Understanding which portfolio companies are high probability winners before it’s obvious is the game here and then continuing to build positions in those winners. A less frequent but enormous return potential situation can occur when leveraging proprietary information about a company’s prospects that is not understood or fully appreciated by the general venture community. This is a tantalizing idea and can be true in some cases, but it is also a very slippery slope because it’s easy to convince yourself of your unique, misunderstood brilliance, when in fact you are putting in good money after bad.
Follow-on investing can also be a major drag on returns. Funds often convince themselves to re-invest to protect earlier investments or to keep a company alive longer than it should. There are many case studies of a fund’s returns being squashed by poorly assessed follow-on investments in a GP’s favorite company.
There is a balance here, though, that is part of the art of helping build companies. When OVF is the lead investor, we do believe in giving an early-stage company a real shot to play out the initial thesis, which sometimes requires two rounds of funding. This second round can take the form of a seed or series A extension. The key is to see through the hypothesis versus extending runway on a failed strategy.
At OVF, our follow-on approach is extremely transparent and has four criteria:
The round has an outside lead.
The company is performing well against agreed upon milestones for the previous round.
The company is communicating well, and transparently, with appropriate cadence and treating us as partners in building the company.
The terms of the investment stand alone as a good venture investment. A follow-on investment may have lower upper limit return potential along with lower risk/more information, but we can we still underwrite to at least a 40% IRR from the investment.
Many funds will state how much capital they reserve but will keep their follow-on decision process opaque. We’ve found that upfront transparency around our criteria is actually a better approach and is appreciated greatly by entrepreneurs and co-investors.
As part of our initial investment, we communicate our follow-on criteria to the CEO and align on milestones that will be used to evaluate company performance going into the next financing round. We document the milestones in our investment memo and then work like heck to help the company achieve those milestones. If the next round meets our four criteria, we are likely to invest our pro-rata and sometimes more. Simple as that.
We do recognize that building startups is not linear nor fully predictable. Adjustments, or even outright pivots, can be important to ultimately delivering a successful outcome. As early-stage investors, we need to be flexible and open to exceptions to our criteria and have our antennae tuned for opportunities with asymmetric information. This flexibility, though, must come with fact-based rationales and rigorous assessment, not just feel.
For example, if a company had a material learning or discovered a key insight that requires changing milestones or justifies providing a longer runway, we do consider exceptions to the outside lead criteria and/or the performance against original milestones criteria.
Where we don’t make exceptions is with the “communicating well” criteria and the stand alone venture return potential of the investment. With transparent communication, we can work through almost any challenge with a CEO and leadership team. As good stewards of our LP’s investments, every dollar we put at risk needs to have the appropriate level of return potential. We feel this is critical to delivering our top quartile performance year after year and fund after fund.
In 2024 we made follow-on investments in six companies totaling over $8M, representing about 50% of our invested capital during the year. Let’s look at an example of one of these investments against these criteria:
Hydrolix, a provider of enterprise data management software that reduces storage costs by as much as 70%, completed a $35M Series B round in Q2 led by S3 Ventures.
Led by S3 Ventures. They were a smaller existing investor, but this represented the first check of material size for their fund. Outside lead? No.
At the time of investment, the company was growing ARR at 75% QoQ. They ended the year with 10X customer count growth and 8X ARR growth to $27M. Performing well? Heck yeah.
CEO Marty Kagan provided regular updates and was always available for questions as needed. Despite us being a smaller investor at this series B stage, we were one of the earliest investors in the company and we retained board observer rights. Communicating well? Check
The round was priced at a fairly high multiple on the previous year’s ARR but, given the growth rate, the multiple on current year forecasted ARR was fair and still allowed for significant upside in a highly valuable space of enterprise data infrastructure. Venture return potential? Check
OVF was eager and proud to invest our pro-rata.
Follow-on investing strategies are often opaque and rarely discussed. Yet they represent a huge part of a fund’s total deployed capital. Disciplined follow-on investing is critical for early stage funds to meet the two objectives of fully supporting portfolio companies and driving venture returns. Conversely, an unstructured approach, or worse, with follow-on capital reserved and deployed, regardless of company performance, is a sure way to sink a fund. At OVF, we feel we’ve found a system that supports founders, is clear and consistent, and will help us continue to deliver top quartile returns.