Yesterday we went over some the ways entrepreneurs can set themselves up for success with VCs by building a relationship far before they ever need funding. Part of that strategy involves picking the right VCs based on experience, success and, yes, even how well you get along. There are several factors that should be considered when finding the right VCs for your startup, and Atlas Venture partner Fred Destin reminds us this morning of another significant one – how a VC manages reserves.
What are reserves? As Destin explains, when a VC invests in a company, they typically provide a provisional amount and save some other funds in a safe place as a reserve for future funding of that company. The problem this creates, however, is as various companies in a VC’s portfolio perform differently, the investor must decide how they will allocate their reserves.
“Driving reserves to winners is absolutely core to fund performance. Few firms do this well.”
– Fred Destin
Two startups may get the same amount in the first round, but depending on their performance, reserves from one may be used to fund the other if it shows more potential. VCs, as well as all levels of angel investors, are forced to make these types of decisions for follow-on investments, says Destin.
“Driving reserves to winners is absolutely core to fund performance,” says Destin. “Few firms do this well. The major difficulty is human nature […] You need intellectually honest, courageous and aligned partners to do this well.”
NextView Ventures co-founder Rob Go admitted last month to being unaware of this aspect of the venture capital industry when he entered it. In a post titled The Preils of Follow-On Financing Decisions, Go notes some of the reasons investors may wrongly flood struggling startups with cash, one being to save face.
“There are a lot of reasons why follow-on financings might happen when they shouldn’t,” says Go. “The uber-reason this happens is that one is irrationally risk tolerant when trying to preserve capital. Or put another way, once you have a vested interest (time or money) into a company, you are willing to take irrational risks to protect your investment.”
Understanding this side of the VC game is all part of the larger task of acquainting yourself with potential investors before getting in bed with them. As Destin advises, “anticipating these issues gives you the time and capability to react,” so be sure to investigate your potential investor’s track record with reserve management.
