Rethinking Follow-Ons for Early Stage Venture Funds

Understanding the Landscape

When Homebrew launched in 2012/2013, the standard mantra in early stage venture capital was that funds should reserve 20-50% of their capital for follow-on investments. This strategy, dubbed "double down," aimed to back promising companies and maintain ownership during critical market shifts. These established practices were rooted in several assumptions about the venture capital landscape, but as we approach 2026, it’s clear that many of these assumptions no longer hold.

The Conventional Wisdom

1. Picking Insight: Traditional thought suggested that early stage investors, having spent 12-24 months with a startup, could identify outliers with tangible performance data.

2. Pro Rata Advantage: The belief was that investors stood to gain from contractual pro rata rights and strong relationships, enabling them to consistently participate in follow-on rounds.

3. Pricing and Market Discipline: Fund managers relied on subsequent investments led by established firms, which were presumed to align with their return objectives and provide “independent” valuations.

4. Data Proof: Historical analyses pointed to firms that invested 100% of their pro rata having better performance metrics compared to those that didn’t.

5. Brand and Signaling Risk: The perception existed that failing to follow on would diminish a firm’s reputation with founders and co-investors.

A Shift in Perspective

Fast forward to today—13 years in the venture capital arena has led to a reevaluation of these tenets. Here’s why the old adage appears increasingly flawed:

1. Decreased Picking Insight: With the rapid pace of venture funding, follow-on rounds often occur just weeks or months after the initial investment. This expedited timeline limits the reliable data that could previously indicate a startup as a potential outlier.

2. Pro Rata Disadvantages: The cap table dynamics have shifted dramatically. Many firms are now left out of follow-on rounds and pressured to scale back their pro rata participation, as founders often prioritize minimizing dilution over existing investors’ preferences. This creates adverse selection risks—if a firm can’t secure more investment in the best companies, what does that signal?

3. Transforming Market Priorities: The landscape has changed, with new venture capital entrants and multistage firms with substantial capital disrupting established norms. Investors often prioritize brand and emotional connection over traditional financial assessments. As a result, funding dynamics resemble auctions more than disciplined evaluations.

4. Reassessing Historical Data: The last decade has transformed the venture ecosystem so thoroughly that relying on historical performance data feels outdated and potentially misleading. The phrase "garbage in, garbage out" rings particularly true in this context.

5. Minimal Brand and Signaling Risks: The risks linked to perceived reputation are often overstated. Investors might find themselves compelled to follow rounds led by other firms without seeing a clear benefit, especially if those firms lack a strong pedigree.

Rethinking Follow-On Strategies

Should smaller funds forego follow-ons altogether?

Not necessarily. The proposal isn’t to eliminate follow-ons, but rather to minimize reserves traditionally set aside for them. This reframing encourages a fresh evaluation of pro-rata opportunities relative to new investments, allowing for a broader array of investments rather than concentrating on a second check.

Navigating Dilution

With winners’ exits becoming disproportionately larger, concerns surrounding dilution are less pressing from a fund perspective. Additionally, soaring early stage valuations tend to result in lower dilution than historical averages—offering a silver lining for smaller funds.

Evaluating Investment Opportunities

Investors often grapple with the strategic dilemma of whether to follow on in the companies they believe in. Here’s how to navigate those decisions:

1. Equal to Market Belief: If an investor’s optimism matches market confidence, it might be prudent to execute the pro-rata.

2. Less Than Market Belief: When financing terms appear excessive, it’s wise to reconsider pro-rata commitments, opting instead for special purpose vehicles (SPVs) or securing capital from other investors. This approach mitigates risks while still positioning the fund for potential future gains.

3. Greater Than Market Belief: If an investor believes significantly more in a company than current market sentiment, it presents an opportunity to double down early, capturing additional ownership ahead of anticipated growth.

Communicating with Limited Partners

The stake that limited partners (LPs) have in fund models cannot be ignored. Clear communication about the rationale for changing reserve strategies is essential. Documenting and sharing these insights can foster understanding and alignment with LP expectations, particularly as newer methods for managing capital continue to emerge.

Embracing Change in Venture Capital

In the rapidly evolving venture capital landscape, adapting strategies and challenging conventional wisdom is essential for small funds. By focusing on new opportunities and learning from recent data, investors can position themselves to capitalize on the unique dynamics of the current market.