Allocating for follow-on dollars, also known as reserves, is an important tool in the arsenal of every fund manager. Nearly every early-stage manager I encounter has a reserve strategy incorporated into their fund model. In our portfolio of fund managers at Sapphire Partners, we see a variety of follow on strategies, though the majority cluster around a 1:1 initial/reserves ratio. 

I have been both looking at our portfolio and running some hypothetical numbers on how reserves are deployed. To be bold and transparent –  when we see outperformance, it almost always comes down to making investments in great companies and generating outlier multiples on each subsequent financing into these winners. Reserves, therefore, impact funds based on the returns they generate. And while reserves can occasionally boost returns, they can, and more frequently do, bring down fund multiples. They also (dare I say) sometimes create potential conflicts of interest with LPs. This is why LPs want to understand how a GP thinks about using reserves.  

Why have reserves at all?

The rationale for reserving is clear: de-risked dollar deployment. GPs make an initial investment into a company. Because they are now partnered, they have a close relationship with the team and strong insights into company development. When it comes time for a subsequent round, GPs can use this proprietary information to make a better-informed investment decision. Follow-ons should therefore be de-risked and more likely to succeed than an initial check. This can bolster financial returns.

Easier said than done

While the premise is simple, there are a couple considerations that complicate things: 

–   Reserves mean you need to return more capital. By having a reserve strategy, GPs are essentially increasing the size of their fund to accommodate the extra dollars. If a GP is committed to investing $50M into initial checks but also wants a 1:1 reserve ratio, they now need to do two things 1) raise and/or recycle to reach $100M and 2) return $100M several times over. This means exit events need to be larger. If a GP of a $50M fund has 7.5% ownership at company exit, they need a $666M exit to return the fund. If they use reserve dollars in subsequent funding rounds to protect their ownership (increasing it to 10% at exit), the required exit value still climbs to $1Bn in order to return the (now) $100M fund.

–   Reserve dollars have to be concentrated into winners to improve fund performance and there usually aren’t many of them. Early-stage venture remains a power-law business, and many portfolios come down to one or two winners. We have been fortunate enough to partner with numerous GPs who have 5x+ funds (though, of course, there are many funds who haven’t, including underperforming funds). Of these 5x+ funds, the top company in each fund’s portfolio (some realized, some not) is held at an average of ~90x MOC (!), with the second best company at a ~25x. The average mark for the remaining investments in these portfolios is 1x.¹ This means that a successful reserve strategy will require a GP to successfully identify the top companies in the portfolio AND put substantial reserves into them to maintain a high multiple on the overall fund. If reserve dollars are mistakenly funneled into companies that become a 1-2x outcome or are written off, it can significantly lower overall fund returns.

–   A hot market makes things more challenging. While the current market is changing in real-time, over the past few years financing rounds (many preempted) have been happening so rapidly that there may not be time for a company to develop operationally between rounds. Conceptually, a company should become a “safer bet” as it matures and grows from seed>Series A>Series B, etc… But the rapidfire fundraising we’ve seen means companies may not be actually de-risked (aside from having a longer cash runway). Another complication is timing. With the acceleration of rounds, GPs may have to make follow-on decisions about some companies before they fully understand the opportunity set in their portfolios. 

– Adverse selection is a thing. There may be adverse selection concerns for the very best deals. Top companies may have very limited room in follow-on rounds (despite pro-rata rights for existing GPs), or they may have a valuation so high it makes following-on challenging. In the Q4 Pitchbook NVCA report, the median early-stage pre-money valuation is $46.0M but the 75th percentile is $100.5M. That’s a big difference.

Reserve Scenarios

Top-Down

Reserve math is particularly hard to model as there are so many different scenarios and strategies, each specific to a GP and market. Still, a vastly over-simplified model is helpful to think through potential impact and considerations.