This is an important topic as more VC-backed startups return to their investors to ask for more money. The markets have been tough. The NASDAQ has corrected. And, a lot of public tech stocks are down 50% to 60%. So, needless to say, it’s a very tough market out there.
As a founder, one of the easiest, fastest, most convenient places to get more capital is from an existing investor. But, what some founders don’t realize is that these VCs are funding out of their reserves. So let’s break break down the mechanics of the VC fund reserves.
For most VC funds there are no hard and fast rules. But most maintain 30% to 40% of the fund in a reserve. That means the remaining 60% to 70% is going to new capital, new companies. The reserve funds typically are used to support portfolio companies.
How are the VC fund reserves used?
There are two compelling reasons VC fund will dip into its reserve fund:
- To support companies doing well. It’s usually really good dollar-cost average even if it’s a higher valuation in the future. Typically, the company is raising more and more money at higher and higher valuations. If you’re a VC maintaining your pro-rata ownership percentage, you want to keep getting as much capital into those companies as possible.
- To fund companies needing to hit a milestone. The other reason to use those reserves is to fund a company that isn’t struggling or dying but needs to hit either a funding milestone (they need a few more customers or need to get a product out the door) or needs a bridge to an exit. If a company needs three to four months of capital to get bought, which means the VC makes some money and gets their capital back, that’s a pretty good reason to invest more money into a company.
Asking a VC for more capital
The next time you ask for more capital, there will be a lot more scrutiny, especially if your company isn’t performing very well. That’s why it’s critical to treat this ask almost like a new investment. You are likely going to have to pitch the partnership again, although you may not run through a full VC due diligence process again. You should realize you will be using one of your chips.
It may be, especially if it’s a bridge situation, the last time you can ask the VC for more capital. After this, you’ll be on your own. It’s very hard to continue to fund a company three or four times, especially if good things are not happening and new capital isn’t coming into the company. VC fund reserves are very precious.
There may even be a little competition among the partners to see who gets to support their companies via the reserve funds. They don’t want to see one of their investments falter or get shut off at the spigot if they believe in it.
Prepare carefully before asking for more funding
So, the best way to ask for more capital is to be prepared. Recognize that your partner’s reputation is on the line when you pitch, so make a compelling case that either the company is excelling, or you can see a milestone, or you can see an exit very clearly. That is the only way you will get a piece of your VC fund’s reserve. If you have any other questions on startup funding, please contact us.