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Follow-On Investing and the Dilution Bogeyman

 

Many of our angel partners are surprised to learn the Willamette Angel Fund typically avoids follow-on rounds. Investors use the term ‘follow-on” to describe subsequent investments into a company you previously invested in. When the subject comes up, many investors can’t believe we don’t participate in investment rounds after our initial seed investment, in order to protect ourselves against ownership dilution in these later fund-raising rounds. But… is dilution anything more than a bogeyman? Research shows the danger is overblown and investing in follow-on rounds may actually hurt returns.

Dilution occurs when a company issues and sells new shares of stock, thereby reducing the ownership percentage of pre-existing shareholders. For example, imagine a company with 50 shares of stock — each share represents 2% of the company. If the company issues and sells 50 new shares, an original share now only represents 1% of the company. The pre-existing investors’ ownership just got diluted. To avoid this, pre-existing investors participate in follow-on investment rounds, buying some of the new shares to maintain their “pro-rata” overall ownership in the venture.

Given the financial importance of this issue, academic research has investigated the relationship between follow-on investing and overall investor returns. A 2007 study by Wiltbank and Boeker found investors who participated in follow-on rounds saw lower return multiples and waited longer for returns to occur. On average, follow-on investors experienced returns of 1.4x on their investments in 3.9 years, whereas investors who avoided follow-on rounds enjoyed returns of 3.6x in 3.3 years. Why does this occur? One explanation might be investors are not as rational as they might think. The sunk-cost fallacy is powerful, and investors may pile money into failing investments in an effort to prop those investments up and avoid admitting defeat. A second explanation, as found in a 2014 study by Wiltbank et al, might be the decreasing marginal returns of subsequent investments. This study divided companies into two categories: “burners” raised a lot of investor capital to fund growth, and “earners” funded growth organically using company revenues. On average, the burners raised $25,000,000 and returned $58,000,000 in 7 years; the earners raised $95,000 and returned $24,000,000 in 13 years. Although earners had to wait an extra 5 years, the sheer scale of the returns compensated for lost time. Investors in both burners and earners realized similar profits, but investors in burners had to spend 263 times as much.

Faced with this data, why do rational, sophisticated investors continue to participate in follow-on rounds? There may be a few explanations. First, there’s the sunk-cost fallacy mentioned above. Second, there may also be a fear of missing out if an investor sees a new round of financing being enthusiastically greeted by their peers. Third, if the extra investment allows companies to avoid bankruptcy or be acquired sooner, investors may be better off preventing a total loss or realizing a faster gain. For example, venture capital funds are evaluated on their internal rate of return, which is extremely sensitive to the timing of cash flows. For VCs, spending more to realize faster exits makes sense. Finally, perhaps investors are simply giving in to peer pressure. “One and done” investors are often seen as adding less value to companies. Raising money is difficult and companies concerned with having to raise more in the future prefer investors who are known for repeat investing. As a result, investors who avoid follow-on rounds may not be introduced to as many investment opportunities.

In the uncertain world of angel investing, it is clear a logical, grounded approach is needed when it comes to follow-on investing. In the right situation, it may be appropriate — but as a general rule, the data just doesn’t support it.

References:
2007 Study – Wiltbank, R. and Boeker, W. Returns to Angel Investors in Groups (2007).
2014 Article – Wiltbank, R., et al., Investment and returns in successful entrepreneurial sell-outs. Journal of Business Venturing Insights (2015), http://dx.doi.org/10.1016/j.jbvi.2015.02.002i.


Nathan Foos

Nathan Foos is an MBA/JD candidate at Willamette University, and is an alumnus of the WU College of Liberal Arts where he studied history, mathematics, and economics. With a strong interest in the provision of capital to growing firms, Nathan has actively engaged in the experiential course offerings at AGSM, including the O’Neill Student Investment Fund and the Willamette Angel Fund. In particular, Nathan enjoys angel investing because he can engage on a personal level with investee companies, obtain real-world insight into a plethora of industries, and learn from the mistakes and successes of hundreds of startups.

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