Let No Pro Rata Go to Waste: How Smaller Funds Make Their Money

One question entrepreneurs sometimes don’t ask when raising seed financing is “will this investor be able to follow on in future rounds.” That is, assuming they have pro rata rights, will they look to maintain their ownership stake in the A Round, B Round, etc. Most VC financial models assume they are going to “double down on their winners” which means reserving capital from their fund to put additional dollars into a company. Traditionally smaller funds were at a handicap because their fund size optimized for initial investment and perhaps one additional round. This meant future dilution -> seeing the value of their initial stake increase but losing out on the chance to invest more dollars in a growing company.

As Brad Feld wrote earlier this week in “The Opportunity/Growth Fund Trend,” an increasing number of venture firms are raising separate funds specifically dedicated to later stage investments and primarily (or only) following on to their previous seed or A Round commitments. This is certainly one way to ensure you can pledge support to a founder while also maintaining your ownership, but it’s not the only approach. Another is to selectively create side vehicles on a deal by deal basis for future pro rata investments. This is the model we expect to take at Homebrew.

Our $35m Fund I reserves 2/3rds for follow on but our expectation is most of those dollars will be allocated to A Rounds. Come B Rounds and beyond, the amount we’d need to contribute to maintain ownership would likely be too large to responsibly commit from a $35m fund because it would overweight the portfolio towards that one company. Instead – and this is one major reason we raised money from traditional institutional investors – we would look to create individual side funds with the sole purpose of funding, say, our pro rata in the B Round of a very promising company that we previously backed. Our LPs have a history of interest in this area and the economics are usually pretty standard (low/no management fee but some carry on profits).

So if you’re putting together a seed round and want to make sure you have one or two investors who, assuming all is going well, will be there to fund you come A or beyond, make sure to ask during your diligence.