What happens when your fund runs out of follow-on capital

A named failure pattern

Fred Wilson has been direct about this for a long time. Writing about reserves, he identifies a characteristic mistake among new managers: they do not sufficiently reserve for follow-on investments, and consequently run out of money and cannot participate in follow-on rounds. He puts the difficulty plainly, noting that what happens to a portfolio after it has been selected is the other half of the job, and the harder half to learn.

A capital shortfall can prevent an investment the fund would otherwise want to make. That is different from choosing not to participate because of price, concentration or another investment judgment. Keeping the distinction clear helps explain the decision.

Three situations to distinguish

Running short does not arrive as a single event. The platform distinguishes three situations, and they call for different responses.

• Follow-on deployment has passed the planned reserve

  The fund is still inside its total capital, but it has spent more on follow-on than it set aside. Everything from here comes out of capital earmarked for something else.

• Total deployment has passed fund size

  Check the fund’s recycling arrangements and the underlying data. Deployment above original fund size can be permitted by fund terms; the comparison alone does not establish an error.

• The reserve is intact but the portfolio needs more than remains

  Nothing has been overspent. The companies still to raise simply need more than the reserve left can cover. This is the state that arrives quietly and the one worth catching early.

The third situation requires a forward-looking plan. A current balance can be accurate while still being insufficient for the follow-ons the fund expects to consider. Compare remaining capacity with several plausible financing paths, rather than treating every future round as certain.

What it costs beyond the money

Not participating can dilute the fund’s ownership. It may also prompt questions from a company or other investors about why the fund declined. A clear explanation helps distinguish a capital constraint from a change in the investment view; non-participation alone does not establish either.

As reserves narrow, the same capital constraint can affect several decisions. Record where the fund would have invested more if capacity allowed. That keeps the investment assessment separate from the budget available to act on it.

Options to review against the fund’s terms

Recycling may allow eligible exit proceeds to be reinvested rather than distributed. It depends on the partnership agreement, applicable limits, any required approvals and the timing of actual proceeds. Wilson describes a cap of roughly a quarter to a third of fund size at his firm; that is an example, not a standard permission.

Other possibilities include a separate special-purpose vehicle, where appropriate approvals and conflict arrangements allow it, or deliberate non-participation. An additional vehicle requires its own capital and time. Accepting dilution may be the right decision. No one ordering fits every fund.

Compare the remaining options explicitly: expected round timing, proposed allocation, ownership effects and the opportunity cost of each check. Keep room to revise the plan as new information arrives.

Keep the reserve plan current

Wilson describes his firm modelling the financing needs of its portfolio companies and holding enough reserve to fund them with high confidence, revisited continuously rather than set once at construction. The specific technique matters less than the cadence: the reserve is a live position that has to be re-checked against a portfolio that keeps changing, not a number chosen in year one and consulted in year five.

The original percentage is only a starting point. A useful reserve review connects the money left with the decisions still ahead.

Where this shows up in the platform

Two places. The fund view tracks reserve deployment against the reserve planned, so the first two states above are visible as they develop rather than after the fact. And when the Scenario Engine evaluates a specific follow-on, reserves are one of the constraints it can name as binding, which is the same condition arriving at the level of a single decision.

A binding reserve constraint on a company the evidence otherwise supports is the clearest form this problem takes: the module is saying the case is there and the capacity is not.

Sources

• ReservesFred Wilson, AVC, January 2017Names under-reserving as a characteristic emerging-manager failure, and describes the modelling discipline used to avoid it.