Making Pro-Rata Investment Decisions

I had a long conversation with one of my partners recently on the rationale of taking pro-rata in our investments.

We believe too many VC’s take their pro-rata “because they are supposed to,” or “to be friendly,” or to “avoid signal.” But these reasons, on their own, don’t fully justify the manager’s roles as fiduciaries.

The problem with doing this, is that this benefits the GP more than it benefits the LP. It may benefit the LP if they are in more than one fund, and so that the reputation the GP is earning by being supportive ends up being reaped by both parties. But we think VC’s making investment decisions based on signal and trying to preserve their brand is self serving and is at the cost of performance for their LP’s.

We want to be supportive to our companies, and spend a lot of time working with them to set expectations on what they need to achieve for us to be supportive and participants in their next round. But we don’t just follow blindly into the dark.

But the disagreement between myself, and my colleague was whether or not: “The ROI requirement and investment decision of a pro-rata investment should be as stringent as that of a “new investment.”

I believe there is a lower hurdle for making a pro-rata investment, because I think a lower MOIC hurdle is required on these specific investments, in the pursuit of making the fund perform better as a whole.

This is not mutually exclusive with trying to maximize ultimate returns:

(1) Being willing to invest across stages, and across return profiles is part of what allows Venture Capitalists to get into the best deals. W/o being ready to do so, we’d likely get less talented entrepreneurs, and therefore have lower returns.

Entrepreneurs want to work with investors who can invest across stages (just like we want to raise capital from LP’s who can invest across our next funds). If we are not prepared to do this, the best entrepreneurs will opt to work with investors who are. This is because having investors ready to follow on in the next round, if performance is good, gives founders a running start. This doesn’t mean we have to take our pro-rata just to be supportive, but it does mean we need to have reserved capital to do so if the opportunity makes sense, we’re ready.

(2) Taking our pro-rata has ancillary benefits for the value of the portfolio company that could make our initial investment more valuable:

a. If we take our pro-rata, it creates a positive signal to the market, and makes new investors more likely to commit to leading the round. New investors want to see if older investors, who presumably know a lot about the business, are excited to continue investing. If older investors are not, new investors begin to wonder if there is “an unknown, unknown they’re not aware of.” In many cases we need to have decided if we are likely going to be taking our pro-rata (barring a ridiculous valuation), before a round comes together, as that is one of the things new investors will look for before offering a term sheet (we have a lot more respect for the ones who are agnostic, FYI! But that’s reality). And even if we have not made an indication until a term sheet has been offered, if the lead investors finds out we are not participating, they may be less excited post-investment. A company with an excited investor base is more valuable because it has backers more likely to keep funding the business when there is a stumble. This better access to capital markets makes a company more valuable, and is another reason a follow on investment makes the equity from an old investment more valuable. So it’s impossible to look at pro-rata investments in isolation for this reason.

b. If we participate in the round, that creates greater demand for the equity of the business, and leaves the broader group of investors with more dry powder to keep funding the company if they need more capital than expected.

c. Continuing to invest in future rounds also allows us to participate in senior classes of stock, that sometimes come with different Liquidation Preferences, Major Investor Rights, and Voting Rights. Having that access makes the investment across the whole fund more valuable.

d. In short, making new investments can make the initial investment more valuable, which is sometimes work making on a blended MOIC basis. Here’s some simple math on why:

The assumptions below are:

· A pro-rata investment is projected to only return 2x our money (below our target return threshold of 3x).

· But taking our pro-rata would create greater value for the first investment, bringing its EV from a multiple of 3x to 3.5x.

· In this case, we should make the follow on investment, as long as we don’t assume we would otherwise return greater than 3.43x on the incremental $350,000 allocation we have in our pro-rata. And since our model targets a return of 3x, in this case it would be worth taking our pro-rata, to try and return 2x on the new capital, even though we wouldn’t make a new investment on the pursuit of 2x in isolation. This is because the return on the follow on capital is levered by the added benefit it brings to the initial investment (so it’s actually got a higher implied multiple)

(3) And finally, the return hurdle on follow on investments should be lower than it is on new investments, because they are less risky. (to be clear, all startup investments, we are just referring to the spectrum of risk).

So if we require an (Y)x projected return on new investments, we should require a (Y-N)x return on follow on investments, because our hurdle is lower.

If I could make 10 new investments with a projected return of 3.1x, or 10 follow on investment with a projected return of 3x, I would choose the latter.

Why are follow-ons less risky? It’s because by that time, we already know the company intimately. There is only so much an investor can learn when doing diligence. But being on the board, working with a founder, getting to know the team and the customers and seeing the velocity of the business provides information that is valuable in making a judgments call.

It is hard to quantify this, but there is some incremental benefit, we just don’t have a number fully baked into our heads yet of what it is.

[5'9", ~170 lbs, male, New York, NY]. I blog about investing. And usually about things I’ve learned the hard way. Opinions are my own, not CoVenture’s