Follow-on Investment

What is a follow-on investment?

Follow-on investment (a subsequent investment) is a further investment by an investor in a company in which it already holds a stake, usually as part of a later funding round. The investor thereby increases its commitment and limits or avoids dilution: without its own participation in the round, its percentage stake falls, because new shares are issued to others. The term does not describe a type of investor but a transaction that any existing shareholder can carry out. Follow-on financing and, in fund parlance, topping up are synonymous.

Follow-on investments concern above all venture capital funds, which hold back part of their capital for this purpose, but also business angels, family offices and the investment units of corporate groups. The legal basis is usually the subscription right (pre-emptive rights), which allows existing shareholders to take up new shares in proportion to their holding and is regulated in the articles of association and the shareholders' agreement. Like any investment, a follow-on investment is carried out through a capital increase, and to bridge the gap between two rounds often also through a convertible loan.

In the private equity business, the term describes additional equity that a fund injects into a company in which it usually holds a majority stake. Triggers include acquisitions as part of a buy-and-build strategy or strengthening the balance sheet.

Reserves for follow-on investments

Funds plan follow-on investments from the start. Of the capital available for investments, only part is used for initial investments. The rest remains as a reserve for later rounds of the fund's own portfolio companies, that is, the companies in which the fund already holds a stake. As a rough rule of thumb, funds hold back 40 to 60%, depending on stage and strategy. Early-stage funds tend to need higher reserves, because their companies still have several rounds ahead of them.

The reserve is not distributed evenly. Funds concentrate it on the companies that develop best and forgo a further investment in others. Fund agreements also often limit the share of the fund's volume that may go to a single company. After the end of the investment period, the first years of the fund's term, they permit only investments in existing holdings. Whether a fund can top up therefore does not depend on its assessment of the company alone.

Pro rata rights and allocation

Subscription right in the amount of the existing percentage

The pro rata right (from Latin pro rata, proportionally) allows an existing investor to take up so many shares in a new round that its ownership percentage stays the same.

Formula: Pro rata amount = existing ownership percentage × volume of the new round

Without participation: new percentage = existing percentage × valuation before the round divided by valuation after the round

Limits and super pro rata

Shareholders' agreements often restrict the right to significant investors above a minimum holding, so that not every tiny shareholder can claim an allocation. New lead investors often demand a minimum share of the round. If the round is oversubscribed, the allocation between subscription rights and the share of new investors is negotiated; existing investors then frequently waive part of their subscription right. Conversely, some investors want a stake beyond their percentage (super pro rata), which reduces the space for new investors.

Signalling effect of a follow-on investment

New investors watch closely how the existing investors behave. If they top up, this counts as confirmation, because they know the company from the inside through the advisory board and reporting. If a large existing investor declines even though it has sufficient funds, new investors ask for the reasons. This can make a round considerably harder.

Declining does not always have to do with the company. Possible reasons are an exhausted reserve, the end of the investment period, concentration limits in the fund agreement, a strategy that excludes later stages, or a conflict of interest with another holding. The management should know these reasons early and be able to substantiate them in order to explain them to new investors.

Internal rounds and pay-to-play

If no new lead investor can be found, the existing investors sometimes finance a round alone, often as a bridge until the next external round (bridge round). Such an internal round secures liquidity but provides no valuation by an independent third party. If the existing investors set the price themselves, particular attention must be paid to a comprehensible price-setting process towards shareholders who do not participate.

A pay-to-play provision ties rights to participation in follow-on rounds: anyone who does not exercise their subscription right loses, for example, their liquidation preference or their anti-dilution protection, or their shares are assigned to a subordinated class. Such a provision does not create an obligation to invest, but it sets a clear economic incentive.

Worked example: calculating the pro rata amount and the fund reserve

A seed fund holds 12% of a company before the Series A. The Series A amounts to EUR 8 million at a pre-money valuation of EUR 24 million. The fund has EUR 60 million for investments, of which EUR 30 million is for initial investments in 20 companies and EUR 30 million as a reserve.

• Valuation after the round: EUR 24 million + EUR 8 million = EUR 32 million
• Share without follow-on investment: 12% × 24/32 = 9%
• Pro rata amount: 12% × EUR 8 million = EUR 0.96 million
• Share with follow-on investment: 9% + EUR 0.96 million divided by EUR 32 million (3%) = 12%
• Calculated reserve per company: EUR 30 million divided by 20 = EUR 1.5 million
• If each of the five strongest companies needs EUR 4.5 million for Series A and Series B together so that the fund holds its percentage, this ties up 5 × EUR 4.5 million = EUR 22.5 million of the reserve
• For the remaining 15 companies, EUR 30 million minus EUR 22.5 million = EUR 7.5 million remains, on average EUR 0.5 million per company

The reserve therefore only covers a selection. Declining a follow-on investment can thus be a decision about the allocation of the reserve and does not have to contain a judgement on the individual company.

Distinction: follow-on investment, subscription right and follow-on offering

• Pre-emptive rights: the right to take up new shares in proportion to the holding. The follow-on investment is the exercise of this right or a holding beyond it.
• Co-investor: any investor that joins a round on the terms of the lead investor. An existing investor making a follow-on investment is at the same time a co-investor in the new round.
• Secondary sale: the purchase of existing shares from other shareholders. The money goes to the seller, not to the company.
• Bridge round: bridge financing between two rounds, which is often carried by existing investors and is thus a special form of follow-on investment.
• Follow-on offering: the issue of further shares by a company that is already listed. It shares only the name with a shareholder's follow-on investment in a funding round.

Common mistakes

• Assuming they will top up. Whether existing investors have reserved funds should be asked early. Many business angels and some funds can no longer take part in larger rounds.
• Subscription rights for everyone. If every shareholder is granted full subscription rights in early rounds, there is no room for new investors in later rounds.
• Declining not explained. If there is no documented reason when a large existing investor declines, a warning signal remains with new investors.
• Allocation not calculated. Without an overview of all subscription rights, a new lead investor is promised a share that is no longer available once the rights are exercised.
• Internal round without a comprehensible price. If the existing investors set the price alone, conflicts with shareholders who do not participate are likely.
• Pay-to-play overlooked. Shareholders who do not know the consequences of not participating lose rights they had counted on.

Frequently asked questions

Is an investor obliged to take part in follow-on rounds?

No. The subscription right is a right, not an obligation. A pay-to-play provision can tie non-participation to the loss of rights but does not oblige anyone to invest.

How can a company tell whether a fund can still top up?

From the vintage year, the stage of the investment period and the remaining reserve. The management is best advised to ask the fund directly about these details before the round; many funds provide information on them.

Do business angels top up in later rounds?

Rarely in full. The amounts of later rounds usually exceed their means, so an angel investor at most takes part with smaller amounts and is otherwise diluted.

How is the amount for a follow-on investment calculated?

Existing ownership percentage times the volume of the new round. An investor with 5% needs EUR 500,000 in a round of EUR 10 million to keep its share. If it does not take part at a pre-money valuation of EUR 30 million, its share falls to 5% × 30/40 = 3.75%.

What is the effect if the largest existing investor does not top up?

Usually aggravating. New investors then examine more closely why the best-informed shareholder is not investing. Verifiable reasons that do not lie in the company mitigate this effect.

The Roemer Capital view

Before we approach new investors for a Series A to C, we clarify the intentions of the existing shareholders. We ask whether they want to exercise their subscription right, what funds they have earmarked for it and whether there are reasons against taking part. This gives the volume that is actually open to new investors.

These details feed into the round planning and into the financial model with base, cautious and optimistic cases. If a large existing investor does not want to top up, we prepare a factual explanation with the management that can be given to new investors early and with supporting evidence.