June 22, 2021

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Meaning of Follow-on Investment for Private Equity Fund and Explanations

Meaning of Follow-on Investment for Private Equity Fund and Explanations
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Private Equity companies may require more funds to continue the business. This can happen after a series of funds was provided by a Venture Capital firm. Several reasons may cause a private entity to need more funds. To achieve this, the VC may carry out follow-on Investment. What is it? And what two reasons can lead to it?

Definition — What is Follow-on Investment?

1. It is an additional investment sourced by a Venture Capital firm from its incumbent investors to finance a private equity company.
2. It can be defined as subsequent funding by investors who made previous investments in a startup. It arises at a later stage investment and not an initial investment.

Key Explanations

Additional Investment. Follow-on funding is an additional investment. Here the VC had earlier agreed to provide capital to the startup with an equity fund. And the venture capital firm has fully provided the fund to the company. However, as years go by, the private equity firm may require more funds. This is when follow-on or additional investment is provided.

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Incumbent investors. These are the investors or limited partners of a VC firm. They already provided a series of funds to the entity. But here, the private limited company requires more funds. The general partners of the VC will call up more capital from these investors. Nobody will want to do a follow-up investment on a business that isn’t growing up. The company’s board will need to prove that it deserves more fundings.

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Venture Capital firm. A VC is an intermediary between the incumbent investors and the private equity company. It is responsible for calling up more investment from the investors. It also helps manage the entity on behalf of the investors. Therefore, a general partner of a VC will sit at the board meeting of the investee company.

Series of funds. A private equity fund may be provided through a series of funding rounds. You will hear words like series A, B, C, D, and so on. The series of funds make up a single fund the VC promises the startup. At the end of this, the company may require more fundings for a particular reason. This will lead to follow-on Investment.

Why Startups may require follow-on Investment?

Here, two reasons are discussed:

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Eroded capital. Startups may not make a profit at the initial stage. In most cases, many small companies make losses for some years before earning profits. The losses incurred will erode the capital of the startup. Therefore, funds available to meet the present obligations of the company may not be enough. For this reason, the private equity company may need more capital. If the firm has a promising future, the VC firm can call up a follow-on investment.

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Growth and Expansion. The startup may need to expand to other countries within the same region or other regions. In such a case, more funding may be required if the total equity fund provided previously does not include funding of expansion.

Conclusion

In a nutshell, follow-on investment arises when a private equity company needs additional capital. The venture capital firm will call up investment from incumbent investors. The capital provided may be used to sponsor expansion or to fill up the eroded capital of a promising company.

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