When VCs get together one of the topics that invariably surfaces is a discussion of the big one that got away.  Every VC has a story about the 100x investment they didn’t make for some reason or another.  Bessemer even has an “anti-portfolio” on their website with funny commentary about it.  We all know that dwelling on the past isn’t productive, but at the end of the day it is human nature to ponder the what-ifs.  It also is a type of braggadocio to say that you “passed on investing” in Facebook or Groupon, because that means you are in the flow of good opportunities.

However, there is a second scenario in the VC world that also lends itself to what-ifs, and believe me VCs are not talking about it at cocktail parties.

It goes a little bit like this: we make an investment, everything goes great, and then the company gets a commitment from a new investor at a high price.  In my experience this typically happens at a price that is at least twice as high as the price we were considering internally given our knowledge of the company.  It may even be a price that we contemplated selling at earlier.  What do you do?  Your options are either A.) sell your position in the round, B.) do nothing and let the new guy invest, or C.) match the price and do the round internally.

On the surface this seems like a good problem to have – afterall, worst case you get a mark-up.  But there is a problem.  You see, there are very few occasions that afford an early stage VC with an opportunity to both put a lot of money into a company and get a big multiple on it, so these internal rounds are important for fund returns.  If you can spot the big winners in your portfolio, and in this context I will say that big winner means any company that can exit at a value of four times the size of your fund (at a $130mm fund, $500mm is a big winner for me) then that Series B round is actually more important than the initial investment.  It is ultimately the difference between returning a high multiple on your fund and just paying back invested capital.  The tough part is that this follow-on decision is often made in a single day, and it can be the most critical decision you make in a 10 year partnership.  Imagine what would have happened if the early VCs in Facebook sold their stake at $250mm, or $500mm, instead of riding it to $50bn.  I guarantee there were some sellers at that price back then.

So here is my suggested answer to the problem:

First, be honest with yourself.  Charles Dickens had one of my favorite quotes, “All other swindlers on earth are nothing to the self swindlers.”  There are generally no greater optimists than VCs when it comes to upside in their portfolio.  Nonetheless, to get this decision right you have to distinguish between your best companies and your run of the mill companies, so put the eternal sunshine on hold.

Second, force rank your portfolio from best to worst.  My thesis is that while you may not know how well each company will do individually, it should be possible to tell how well they are doing relative to one another.  If necessary you can score each company on individual attributes like financial performance, quality of the team, and size of the addressable market as benchmarks.

Last, figure out which companies are in your top quartile. 

Every VC should expect that the top 25% of his or her deals are going to return the fund, and the rest are going to be low multiple returns.  The entrepreneurs reading this might find that characterization unfair, but I am actually being somewhat generous.  The industry figures show that the top 10% of companies that generate all the returns, not the top 25%.  I just find that the bright line between the good companies and the run of the mill generally emerges around the top quartile mark, and figuring out the top 10% is challenging.

After you have done this, if the company in mention falls into the top quarter of your portfolio than I suggest you go all in.  If it is not in the top quartile, than I suggest you pass, take the dilution, and move on.  I know very few firms that sell in this occasion because the risk of being wrong is greater than the reward from being right (as you can imagine from my Facebook example).  And if you are lucky enough to have a company outside of your top quartile that is worth many hundreds of millions of dollars than you are doing fine anyway. 

I hope this helps VCs going through the decision process.  After 10 years of going through follow-ons and studying my own “what-ifs”, I can see how the best deals continually exceeded my expectations about upside and growth.  It is Sigalow’s Law of Intertia – companies that are outperforming generally continue to outperform.  That has made these high priced follow-on rounds seem much less expensive in retrospect.