Should Your Early Investors Always Follow On? - 8/6

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📰 Today's Edition: Should Your Early Investors Always Follow On?

You're six months into raising your Series A. Your seed investors who were so excited about you are not following on in their investment. Now every new investor you pitch is asking why your existing investors didn't participate.

You're spiraling. "What do they know that I don't? Is something wrong with my business? Will this kill my entire fundraise?"

In most cases, your seed investors not following on isn't bad signaling at all. In fact, for many early-stage funds, following on doesn't even make mathematical sense.

This matters because founders waste weeks stressing about investor decisions that have nothing to do with their company's potential. Worse, some founders avoid great early investors because they heard "you should only work with investors who promise to follow on."

Let me break down the math that explains when follow-on makes sense (and when it doesn't) so you can stop panicking and focus on what actually matters for your fundraise.

What's really happening when investors skip following on?

Before you assume the worst, you need to understand how your investors actually make money. This context changes everything.

Investors put money in at one valuation (your entry point) and hope to get money out at a much higher valuation (your exit point). The multiple they make is determined by the spread between those two numbers.

Your accelerator might have invested $100K for 10% of your company at a $1 million post-money valuation. If you exit for $50 million, that's a 50x multiple for them (Assuming no dilution).

But a fund that came in at your $10 million post-money seed round? Same $50 million exit only gives them a 5x multiple.

Same amazing outcome for you as a founder. Wildly different returns for your investors. The difference? Entry point.

When your seed investor passes on your Series A, they might not be bearish on you at all. They might just be doing math.

What does this mean for your fundraise?

Let's walk through the decision your early investors are actually making. Understanding this will help you predict who will follow on and who won't.

Say one of your investors manages a seed fund that has $1 million total. They put $100K into five companies at $2 million post-money valuations, getting 5% of each. And say one of those companies is your company. That's $500K deployed, with $500K remaining.

Now you're crushing it. You're raising your Series A at a $10 million post-money valuation. Your seed investor loves you and wants to support you. But they have to make a choice.

Door number one: Put all their remaining $500K into you at the higher valuation.

Door number two: Invest in five new companies at $2 million post-money valuations.

Most of the time, for pre-seed and seed funds, door number two is the better financial decision. Not because they don't believe in you. Because math.

When your valuation goes from $2 million to $10 million, they're paying 5x more for the same company. To get a 100x return at the $2 million entry point, you need a $200 million exit. To get 100x at the $10 million entry point, you need a $1 billion exit.

Your company might absolutely be capable of that billion-dollar exit. But statistically, there are far fewer billion-dollar exits than $200 million exits. For an early-stage fund trying to maximize returns across their entire portfolio, spreading bets at lower valuations often makes more sense than concentrating at higher ones. The question becomes, is it more likely for you to hit a billion-dollar valuation or for your investor to get at least one $200 million outcome with five new shots on goal?

So when should you actually expect your investors to follow on?

If your investor's initial check was at a fairly similar valuation to your current round, expect them to at least consider following on. If they came in at $8 million post-money and you're raising at $10 million, they're not paying up much. The math can work for them.

If you're raising from multi-stage funds, follow-on is usually part of their core strategy. After all, the only reason they're doing early stage investing is to be able to see a lot of companies that they can deploy the vast majority of their capital in at the later stages. 

But if your accelerator or pre-seed fund came in at $2 million post and you're now raising at $10 million or $15 million? Don't build your fundraising plan assuming they'll participate. They might if you're an obvious breakout. But it's not their typical move.

Look at what stage each investor is known for. That tells you way more than what they say in the moment about "always supporting our founders."

As a purple hippocorn who's watched countless fundraises, I can tell you: The investors who participate in stages they're not known for are the exception, not the rule. Plan accordingly.

How do you explain this to new investors who are asking questions?

This is where understanding the math really saves you. When a Series A investor asks "why didn't your seed investors participate?" you need a confident answer.

Here's the script: "Our seed investors are primarily pre-seed and seed focused and don’t usually follow on. We have strong relationships with them and they've been incredibly supportive, but this isn't the stage they invest at."

That answer works because it's true and it's normal. Nobody questions why Y Combinator doesn't lead your Series A. 

Now here's when you should actually worry: If a Series A fund invested in your seed (taking an option on you), and then passes on your actual Series A, that's real negative signaling. They invested outside their core stage specifically to get access to you later, and then decided not to take that option.

The difference is critical. Pre-seed and seed funds passing on your Series A? Expected and normal. Series A funds passing on your Series A after investing in your seed? That's a red flag.

How should you build your cap table?

Here's your tactical playbook for avoiding signaling issues:

Strategy 1: Match investors to their natural stage. When you're raising your seed, prioritize actual seed investors. Yes, it's tempting when a Series A fund offers you a seed check. But unless you're absolutely confident you'll hit their Series A metrics, you could create a potential signaling problem.

Strategy 2: If you take money from later-stage funds early, bring in multiple ones. If three Series A funds invest in your seed and only one participates in your actual Series A, that's not as concerning as if you had one Series A fund that passed. Diversification of "option" investors reduces signaling risk.

Strategy 3: Be explicit about expectations upfront. When a late stage investor outside their typical stage wants to invest early, ask directly: "What would you need to see to participate in our [next round]?" Get specific numbers. If their bar is unrealistic, you might be better off with investors who are at the right stage.

Strategy 4: Don't optimize purely for brand names. That fancy Series A fund offering a seed check looks great on your cap table today. But if they pass on your Series A, you'll spend half your fundraise explaining why. 

To be clear, this isn't to say that you shouldn't accept money from them, but you should definitely do your homework and ask questions before doing so.

Until next time,
Dunky, the "following up" hippocorn

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