Follow-on capital usually has a better expected result in companies with strong evidence, even at higher prices, than in struggling companies at lower prices - though the right choice always depends on the specific evidence.
11 min read · Level 5
I think early-stage investors should treat a falling price as a question rather than an opportunity. Sometimes it is an opportunity. More often it is the market, and the founders, telling you something about the company's prospects that a lower average cost cannot change.
Two ways to use the same follow-on capital:
Concentrating investing more in companies performing well, often at higher prices Averaging down investing more in struggling companies at lower prices
Averaging down can look attractive because the price is lower. In early-stage investing, a lower price usually reflects weaker prospects, and the chance of a total loss is higher.
An illustrative comparison for a 50,000 follow-on, using probabilities chosen for teaching rather than real data:
Option Outcome if good Probability Outcome if bad Probability Expected value Winner at higher price 150,000 (3x) 60% 25,000 (0.5x) 40% 100,000 Struggler at lower price 250,000 (5x) 20% 0 80% 50,000
Winner: 60% x 150,000 + 40% x 25,000 = 90,000 + 10,000 = 100,000 Struggler: 20% x 250,000 + 80% x 0 = 50,000
The struggling company offers a bigger possible multiple, but its expected value is half that of the winner in this example. The real probabilities are always uncertain; the point is to estimate them honestly rather than being drawn by a low price or a large upside.
Because early-stage outcomes follow a power law. The companies already showing strength are more likely to be among the few that produce large returns, so capital added to them tends to work harder.
Averaging down also mixes emotion with analysis. Adding to a struggling company can feel like reducing the average cost of an investment, but the average cost does not change the company's prospects.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
An angel's follow-on decisions over five years.
Follow-ons into companies with strong evidence 4 investments, 120,000 Follow-ons into struggling companies 3 investments, 90,000
Result: strong-evidence follow-ons returned 360,000 in total struggling-company follow-ons returned 30,000 in total
The angel's review showed that the struggling companies' lower prices had not compensated for their much higher failure rate. They changed their policy to follow on only when company-level evidence was improving, regardless of price.
Investing more in a struggling company because the price is lower or to reduce the average cost of the original investment.
For each follow-on option, write plausible good and bad outcomes and rough probabilities.
Multiply each outcome by its probability and add them.
Ask whether a low price reflects a bargain or weaker prospects.
Check whether your concentrating or averaging-down decisions produced better results.
When deciding how to allocate limited follow-on capital across several companies.
Do not treat every struggling company as hopeless. Sometimes a company has fixed its problems and a lower price is genuinely attractive; the evidence must decide.
Venture fund managers commonly describe allocating most of their reserves to a minority of portfolio companies showing the strongest performance, and publicly available fund strategy discussions often emphasise concentrating follow-on capital in companies with strong evidence rather than supporting all companies equally.
Follow-on capital tends to be most effective where evidence is strongest, even when prices are higher.
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