Imagine you’re a venture investor. You find a great company. You buy 16% of the company for $8m at $50m post-money valuation. Six months later, the company raises $100m at $500m. Things have gone very well.
Your 8m has 10xed. Naturally, you ride an imaginary horse around the room, galloping with glee.
Now you face an important strategic question: Do you invest your full pro-rata of $8m? Pro-rata is the right to invest more to maintain their percentage ownership. Venture firms reserve capital for these financings.
If you invest an additional $8m to maintain your ownership, the investment multiple falls to 3.3x: 80m / (8m + 16m). Two-thirds of your dollars are invested at a much higher price.
Which path do you pursue? Stay pat to maximize the investment multiple? Or double down to $16m and juice the holding value – the total value of the position?
This is one of the core strategic questions venture firms debate.
In the last ten years, the dominant strategy has been optimizing the holding value. Valuation multiples expanded; the public market lapped up high growth technology companies; acquirers devoured others at premium prices. Special purpose vehicles, growth/opportunity funds, LPs investing directly alongside VCs – these are all tactics to optimize holding value.
The recent 60% correction in the public market might compel you to consider a different view than the dominant one in the last decade.
What if the third round is a down round? Your investment multiple will compress and you may be forced to invest more to maintain your ownership – called a pay-to-play provision. Your great return might degrade to a mediocre outcome as a consequence. Investing $24m to get a 3x isn’t bad in absolute terms, but a far cry from the glory of your recent home office rodeo.
Fund size should factor into the decision. Suppose your fund is $75m. This investment, which is about 10% of the fund, will return the fund. Sensational.
Invest another 16m and 30% of your fund rides on one company. Is that wise? It depends on your outlook and confidence in the business (and whether your LP Agreement allows it).
Rather than doubling down, you could allocate those $8m to a new investment in an earlier stage company at a lower valuation. Which option will generate a better return?
The greater your confidence in stable prices in the fundraising market, the more likely you are to double down. The less confident, the greater your reservations about reserves.
How you answer this question for every company will influence your fund’s ultimate performance and how often you’ll be chewing gravel or be ace-high celebrating on your steed.