Semi-Lazy Sunday Afternoon Musings On Reserves Management

Each weekend, I like to write a short post about a topic I’ve been learning in fund management. The topic for this weekend was originally slated to be “reserves.” However, now the world is very different and we are all readjusting to a terrible reality. I hope this is obvious, but clearly the immediate priority is our public health, social distancing, and staying away from other people as much as possible. Beyond this, for those with means, we should be thinking about local merchants, friends who may lose jobs, and even worse — the economy is going to unravel in a way none of us have ever seen before.

And with that gloomy introduction, let’s tackle what “reserves” mean for an investment fund. I’m going to write this in a way that’s targeted to founders and CEOs who seek to raise capital, rather than my customary approach to write to fund managers on this topic. So, here goes… Say you’re the CEO/founder of a startup, and you’ve taken venture capital from an institutional venture fund, they’ve likely raised a lot of money and have institutional investors. In order to manage investments over a long period of time, the most experienced and sophisticated funds will set aside “reserves” for each investment. Some funds reserve at a 1:1 ratio, and some reserve 2:1, and so forth — a 2:1 reserve model means that if they invest $5M in your Series A and take a board seat, they’ve set aside 2s that or $10M for follow-on investments. Now, it’s easy to think that $10M is entirely for you — it is not. It is at first a mechanism to force a partnership to play a longer-game, to make decisions about investments over a longer horizon, and to pace the speed of fund deployment.

There are generally three types of reserves: (1) for offense, to plow into companies where there’s a breakout and/or high conviction; (2) supporting, to keep future rounds humming without signal risk and/or to maintain pro-rata ownership percentages; and (3) defensive, to apply in bridge rounds, or pay-to-play rounds where either the market or newer investors for investors to protect an initial investment.

The topic of Reserves Management is now, as the world has changed, a major topic of discussion among investors, especially lead investors on cap tables. There is no doubt in my mind that even great companies right now will have their business operations and bottom lines altered by the shift in the economy. We’ll make it out of this, but that will likely not be any sooner than 2021, at the earliest. And VCs who are in lead positions will have to begin to make tough decisions about where exactly to allocate the reserves they’ve been setting aside. Say a company isn’t performing and/or doesn’t have a strong relationship with their lead — hard to see how reserves get deployed here. On the other hand, say a company is lean, low burn, and showing a path to sustenance over the next 12 months — their investors may lean in to bridge the company and get rewarded with more ownership in a rough economy.

Investors will not tweet about this publicly because it is part of the sausage-making of how a venture capital fund works, but you can surely bet that they will be having these discussions. Most firms will use some quarterly or bi-annual “Monte Carlo Simulation” to both approximate winners, leaders in a portfolio, and struggling companies, and as part of that go into “Reserves Management” (make sure to read this post by Fred Wilson, please) where the individual investors will be asked to forecast which of their own portfolio companies will need what over the next year. Some will get what they want for Company X, but not for Company Y. There will be lots of internal debate about where to allocate funds. The broader public always sees the very first investment by a VC firm into a company, but they often don’t realize it’s the 2nd and 3rd check decisions that are most crucial and hostly contested internally,

If I was a startup CEO and I knew this, I would plan to approach my board about this some time in April or early May. This week may be hard. And I would have a broader discussion about capital planning for the next 12-18 months and I would try to learn about how my lead investors were thinking about reserves. Existing relationships now inherently have more value. VC firms have been built to allocate the capital of their limited partners. So for any CEO going down this path, it would be wise to get smart on reserves and have this conversation earlier rather than later. Best of luck out there and I hope everyone’s families and friends are doing OK.