A follow-on investment is made using venture capital financing or funding obtained shortly after an initial public offering (IPO). Typically, they are used by a new company to gain supplemental funding.
Follow-on investments offer smaller firms an opportunity to get in on the ground floor of a new business that could be potentially lucrative.
What Is a Follow-On Investment?
In venture capital, a new private company might need funding to scale its growth. It can often obtain significant Series A, B, or C funding from a larger investor. However, other investors may be interested in the company as well, but not be willing (or able) to match the large investments of the primary investors.
Follow-on investors can include smaller venture capital firms, angel investors, wealthy family members or friends, or other entrepreneurs. They will typically invest a smaller amount than the lead investor, but may still receive the same class of stock.
A follow-on public offering (FPO) aims to attract smaller firms in an effort to gain additional funds for growth following an initial public offering.
A follow-on public offering is based on the market value of the company’s shares, while an IPO is based upon the performance and health of the company. A follow-on public offering must be registered and a prospectus should be issued to regulators. In contrast, a venture capital follow-on investment does not require this.
Advantages of a Follow-On Investment
Investing in a private company as a follow-on has some significant advantages. First, follow-on investors can take advantage of investment documentation that has already been prepared and thoroughly reviewed by the primary investor. Thus, legal fees are kept to a minimum and the process is much quicker.
The legal team will typically just ensure that the deal doesn’t have any significant red flags and that terms are clear and consistent.
Secondly, investing as a follow-on provides some relief to the follow-on investor knowing that they are placing the same bet on the company as the lead investor. Finally, follow-on investors can develop strong relationships with lead investors, which can result in future investment deals down the road.
In a public company FPO, there are two types of follow-on investments. A diluted FPO results in an increase in the number of shares available to the public. Future earnings per share are then diluted by the increased number of shares. This can provide some disparity, as shareholders will receive less monetary reward per share that they hold.
A non-diluted FPO occurs when prior private shareholders decide to bring their interest in the company to the market. Instead of the company increasing shares, the private companies transfer their holdings directly to new holders. EPS remains unchanged.
Disadvantages of a Follow-On Investment
Follow-on investors are usually unable to get major shareholder rights, like board seats or observer rights, because their holdings generally do not meet the threshold determined in the initial agreements dictated by the lead investor.
They are also generally not able to change the terms first set out in the lead investor agreement. This means they likely won’t get inspection or information rights and will have no pro-rata participation rights.
Examples of Follow-On Investments
There are many examples of private follow-on investments. For instance,
Yieldstreet received a follow-on investment in the amount of $50 million dollars in November 2021. Yieldstreet is a multi-asset alternative investment platform that allows regular investors the opportunity to invest in assets such as art and the supply chain, opportunities that were previously only open to institutions and individuals with a high net worth. Yieldstreet plans to use the investment to improve its technology and increase its sales and marketing initiatives.
Another company, LifeRaft, a Canadian security intelligence company that enables businesses to monitor and identify security threats and business risks, received a follow-on investment from the Canadian Business Growth Fund in April 2021 that it used to further its working capital, product development, and sales initiatives.
From a public company perspective, Google issued an FPO in 2005 after its IPO was issued in 2004. The IPO valued its shares at $85, while the FPO was able to bring in $295 per share based on the market value at the time. Google used the additional funds for research and development, as well as sales and marketing activities.
Follow-on investments can be a terrific opportunity for smaller investors to get in on the bottom floor of a new company that has the potential for significant success. The investment will require fewer valuation hurdles and legal activities, as these will be performed by the lead investor.