Planning reserves for follow-on investments before making initial investments protects your ability to support your best companies and to maintain ownership where it matters most.
11 min read · Level 5
The investors who regret their reserve policy most are usually those who had none: they found their best company and could only watch as later investors bought what they could not. I think setting aside capital before the first cheque is one of the most practical disciplines in private investing, because the hardest time to create reserves is after the winners have become obvious.
Reserves are capital set aside at the start for future follow-on investments. Without them, an investor who backs a company that does well cannot participate in its later rounds.
An angel plans to invest 200,000 over three years in early-stage companies.
Approach A: 10 initial cheques of 20,000, no reserves Approach B: 7 initial cheques of 20,000 (140,000), 60,000 reserved
With Approach A, when two companies raise strong rounds, the angel has no money left to follow on. With Approach B, the angel can put 30,000 into each of the two strongest companies.
Funds use a reserve ratio - reserves as a share of total investable capital. A fund of 50,000,000 might plan 50% reserves:
Initial investments 25,000,000 Follow-on reserves 25,000,000
The right ratio depends on strategy. Very early investors whose companies raise many later rounds often reserve more; investors writing larger cheques at later stages may reserve less.
Reserves should not be committed to any specific company in advance. Their value comes from being deployed selectively into the companies that turn out to deserve them.
Because early-stage outcomes are concentrated. A small number of companies produce most returns, and those are exactly the companies raising larger rounds at higher prices. An investor without reserves is diluted most in their best investments.
It also helps avoid pressure to support weak companies. Reserves planned for selective use make it easier to say no to rounds that do not pass the fresh money test.
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.
Two angels, same first cheques in the same winning company. Each invested 20,000 for 1% at seed. The company raises three more rounds, each selling 20%.
Angel without reserves: 1% x 0.8 x 0.8 x 0.8 = 0.512% Angel with reserves who kept 1% through each round: 1%
At a 200,000,000 sale, the first angel receives 1,024,000. The second receives 2,000,000, having invested additional capital in the rounds. Whether that additional capital was a good use depends on the prices paid, but only the second angel had the choice.
Deploying all capital into initial investments and leaving nothing to support the companies that turn out to perform best.
Decide what share of your total budget to hold for follow-ons, based on your stage and strategy.
Reduce the number or size of first investments to protect reserves.
Use them only in companies that pass the fresh money test, not proportionally across the portfolio.
Hold them in a form you can use when rounds happen.
Before starting an angel portfolio or planning a fund's investment strategy.
Do not hold reserves so large that you make too few initial investments to diversify. Early-stage portfolios need enough companies to have a chance of including a winner.
Venture funds commonly disclose planned reserve ratios to their limited partners, and industry commentary from fund managers and LPs frequently discusses reserves in the range of roughly a third to a half or more of fund capital for early-stage strategies, with wide variation by stage and approach.
Reserve planning is standard practice for professional early-stage investors, and individual angels benefit from the same discipline.
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