What your investor does with reserves when you underperform

Let's look at how investors manage a portfolio of startup investments and what that means for you as an entrepreneur.  You may not like it.

When investors commit to your company, they will invest some money upfront (say $2M) and allocate reserves for future funding (say $6M).  Why ?  Well, we know from experience that successful businesses take real capital to get to the finish line.  Yes, even in the age of Ultra Light Startups (groupon, facebook, foursquare, you name it). 

The question that matters to you is: what happens to these reserves over time ?

I was prompted to write this post by a great contribution from Lisa Edgar (Paul Capital) on PE Hub entitled "are we going to make money on this fund ?".  A good read if you don't know how funds operate, in particular:

I would suggest that picking the winners from the losers—and more importantly, effectively managing the fund’s capital—is specifically the role of the GP (and for which the limited partners pay a management fee).

What I’m looking for is the fund manager’s view of which companies look like winners and which companies aren’t quite cutting it, so that they can manage the portfolio to support only those that deserve additional capital. I understand this is an extremely difficult exercise—especially for very early-stage companies or when the outcome is truly binary, like with many health care investments.

In practice, this means that as the portfolio of investments matures, the people investing the money will start to make decisions about where they want to drive the reserves in order to maximise the outcome, both positive ones ("I want to find a way to invest more money in company X") and negative ones ("company Y looks impaired and I will strip it of its reserves).  Because driving reserves to winners is absolutely core to fund performance.  Money invested in the past is a sunk cost; what matters is really the marginal return on the money invested.

Few firms do this well.  The major difficulty is human nature.  Being selecting about reserves means letting investments you believe in (typically) become disadvantaged, or it may mean driving dollars to another investor in your group who may get all the glory whilst you'll never know what would have happened if you had more dollars to feed your own baby.  You need intellectually honest, courageous and aligned partners to do this well.

You'll notice I use investors generically here, not "horrible venture capitalists" or "stuffy fund managers".  I think the same principles apply to "exgtremely friendly superangels" who manage larger funds and decide where to put their follow-on money.  It also applies to those building options portfolios (lots of small investments) and who invest in emerging winners only.  One of the benefits of option portfolios is that you can be extremely evidence-based in determining success and deploy very limited capital to test theses.  Fail fast / fail early.  The theory, at least, is compelling, although surely accurate selection in large option portfolios is hard too.

Before you say "here comes another non-risk taking VC", remember that some of the best returns come from supporting some companies through times of hardship, complete restarts and pivots and other contrarian investments (as usual, read the other Freddy).  You need to be contrarian, but right :-)   That's why deal picking is hard.  But the reality is also that companies that under-perform early (poor execution, damaged thesis) tend to continue to do so.  In any event, choices on where to allocate resources will and do happen.  That's the game.

So if you are an entrepreneur in a maturing company, you would be well advised to know where you stand and how your investor is thinking about the use of his or her's (naturally scarce) reserves.  Anticipating these issues gives you the time and capability to react.

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