Follow-on investments – why it's so important to get funding from real VCs

We live in a world where you could hit an angel investor randomly just by taking your car onto the streets of Palo Alto, San Francisco, New York, London or even Paris. While most angels cut checks in the range of $10k~$50k, more and more super rich angels are cutting checks north of $100k, close to the level of a single VC investor's amount in the pre-seed or seed rounds.

While angels are an important part of the eco-system, if founders spend too much time having too much fun raising from them with convertible bonds, they are gonna miss several important things that could launch them on a real growth trajectory.

Among all things missing with pure angel investments, the option to get a follow-on investment is an oft-ignored one.

Especially at Pre-Seed, Seed or even Series A, the first ticket from a VC is usually more like an informational ticket. It allows them to work closely with the most promising startups. And if some of them are progressing exceptionally well, the VC will be able to double down on their bets by participating or even leading a follow-on round.

It is true that the follow-on rounds will have higher valuations but on a fund level the decrease of the risks outweighs the increase of valuations. Follow-on investments are therefore a way for VCs to control the risk and benefit from information asymmetry.

VCs could be doing follow-on investments in anywhere from 30% to 50% of all startups that received their first tickets. The follow-on investments will come in the amount of the later round so are usually higher in amount. 

For example, when a startup gets a $100k Pre-Seed investment from a VC, its implied amount is not only $100k, but rather:

$100k + 30% * $500k = $100k + $150k = $250k

assuming the average ticket size this VC does in a follow-on Seed investment is $500k and it does follow-on in 30% of all its 1st-ticket pre-seed startups.

Note that in this case the expected value of the follow-on investment ($150k) is actually higher than the 1st ticket itself ($100k). This is the main monetary difference between a $100k check from a real VC and an angel – angels don't do follow-on investments systematically. A $100k check from an angel usually means just that, $100k.

In general I am not a big fan of entrepreneurs delaying raising money from real VCs. Even if they have so many family and friends that could sustain them through 2 to 3 years, they're not getting that option on a follow-on investment from a real VC that could put them on a real venture fund-raising path.

What's is to take an angel's $100k instead a VC's simply because the financial terms are slightly better.

When I see an early-stage entrepreneur turning down a VC's investment (whether it's from us or not) for reasons such as a 10% difference in cap or a 1% difference in convertible interest rate, I would shake my head and mark that particular entrepreneur as a bean counter rather than an entrepreneur.

It's very likely that he or she would never get my investment ever again because such choice shows that the entrepreneur lacks a long-term view and is inclined to optimize for short-term paper gains. We can't expect such founders to be able to build a great team and navigate through all the challenges in the next 5, 6 or 7 years.

"... and we are profitable!"

Believe it or not: 90% of the VC job is sell-side, not buy-side