Jonathan Friedman
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A common rule of thumb among early stage VCs is to reserve 2–3x dollars for every $1 initially invested in a startup. This is in order to maintain ownership levels in selected portfolio companies and to support them through good times and bad.
Obviously, it’s not optimal to invest the same amount per company. Given the often binary returns within VC portfolios, there are usually companies that get more than 2–3x in reserves, and some end up with none.
So how do VCs view your company among their portfolio, and what does this mean for your startup?
Investment Ratings
In the public markets, timing is a core competency that makes or breaks returns. As such, analysts expend a lot of effort establishing buy/sell ratings for each company they cover. These include target price per share, and are updated periodically on each quarterly report and every time there are major announcements.
While VCs’ relationships with their portfolio founders are more personal and involved than those between analysts and the CFOs they cover, both groups frequently adjust expectations and targets for companies according to the latest updates they receive. Therefore, a similar buy/sell framework can be reapplied to represent VC reserves and liquidation strategy.
Accumulate
VCs assign an “Accumulate” rating to portfolio companies when they believe, at the current price, an investment in them will likely outperform other available investment options. The strategy in this case is to buy shares at the next round at some level above their pro-rata allocation.
For example, if a VC has conviction that a company is currently undervalued versus an upcoming inflection point, they may aim to proactively increase their ownership percentage via a round extension before the company gets offered externally led investments.
In more extreme cases involving fast-growing companies that have competitive follow-on rounds, VCs may even resort to buying secondary shares and offering convertible bridge loans, all resulting in increased ownership.
Cultivate
When VCs invest below their pro-rata right allocation in portfolio companies’ follow-on rounds, or when they don’t participate at all, this indicates a “Cultivate” rating.
Often, VCs continue nominally investing in their portfolio companies for positive signaling purposes. In these cases, the company can count on some level of investment support from their VC, as long as their price stays within the “Cultivate” range.
Harvest
Unlike public markets where investors can sell all their shares in a company at any time, private company shares are generally illiquid. Because of this, when a VC places a company in the “Harvest” category, the VC needs to develop an exit strategy out of this position.
You only get here in only two scenarios: Either you as the founder have done a great job creating value for your investor, and at your current price the VC is willing to begin selling shares, or, in the less rosy scenario, you are being viewed as a write down.
Write downs are triggered when a company runs out of money or has given up. As a founder who hasn’t reached product/market fit, you’ll know you’ve been placed in this bucket if you begin getting encouragement around ideas for mergers and acquihires that don’t represent venture scale exits.
On the flip side, when a portfolio company’s valuation grows to a level where it represents a significant proportion of a VC’s total portfolio value, it may make sense for the VC to begin taking some or all of their chips off the table via secondary offerings.
Investor Relations
Just like a public company whose investor relations don’t end after the IPO, your fundraising doesn’t end after securing your first round of investment.
Always remember you are being measured against all the other opportunities available to your investor, and if you want their financial support at or beyond your initial allocation, you need to continue to stand out and educate them as to why you continue to belong in the “Accumulate” bucket.
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