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How many companies does a venture reserve pool actually defend?

A 50 per cent reserve on a $100m fund backs forty companies and can hold its position in 2.71 of them. Defending all forty would cost 14.76 times the pool.

Julian R. Sterling · from The Venture Capital Associate

A venture fund that reserves half its capital for follow-ons, backs forty companies and intends to defend its ownership can do so in 2.71 of them. Not twenty. Not ten. Two and a half.

The convention — roughly half the fund held back for follow-ons — is stated in every guide and almost never divided by the cost of a follow-on. Once it is, three things that sound like strategy turn out to be arithmetic.

What holding a position costs

A $100m fund charging 2% for 10 years has $80.00m to invest. At a $1.00m cheque into a $10.00m post-money seed, the fund owns 10% of each company. Then every round sells 20% of the company, and the early ones top up the option pool as well.

Let the position ride and 10% becomes 3.70 per cent by the Series D. Defend it every round and it holds at 9.03 per cent — the residue being the option pool, which no pro-rata right covers. That defence has a price, and the price is not evenly spread.

One company. Each round sells 20 per cent; the first two carry a 5 per cent option top-up.

Round	Post-money	Round size	Pro-rata cheque	Share of the total
Series A	$30.00m	$6.00m	$600,000	4.1%
Series B	$80.00m	$16.00m	$1,520,000	10.3%
Series C	$200.00m	$40.00m	$3,610,000	24.5%
Series D	$500.00m	$100.00m	$9,025,000	61.2%
Holding the position to the end			$14,755,000	100.0%

Holding one position to the Series D costs $14,755,000, and 61 per cent of it falls in the last round alone. This is why reserve pools run dry late rather than early: the cheque that hurts is the one written when the company is already working, and it is 15 times the first one.

Divide the pool by the cheque

The reserve pool is $40.00m. One full defence costs $14,755,000. The pool therefore covers 2.71 companies out of 40 — 6.8 per cent of the portfolio.

Turn it around: defending every company would cost $590.20m, which is 14.76 times the pool and 5.9 times the entire fund. “We follow our winners” is a policy. “We maintain our ownership” is not available at any reserve ratio a fund could raise.

The same reserve, spent four ways

Same fund, same companies, same outcomes. Only the reserve policy changes.

Strategy	Companies followed	Ownership reached	Fund TVPI
Never follow on	0.00	3.70%	1.53×
Spread the pool evenly over 12	12.00	6.26%	1.90×
Concentrate, best first (2.71 companies)	2.71	9.03%	2.47×
Everything into the fund-returner	1.00	9.03%	2.45×

Spreading the pool over twelve companies buys a partial defence in each: the budget covers the Series A and B in full, 34 per cent of the Series C, and nothing of the Series D. Ownership lands at 6.26 per cent instead of 9.03.

Concentration beats spreading by 0.57 turns of TVPI on the same pool. And a reserve dollar deployed into the best companies returns 3.35, against 1.00 for a dollar left unused — it comes back at cost, having earned nothing. That difference, 2.35 per dollar, is what sitting on unused reserves costs.

Note also the last row. Putting the entire pool into the one company that actually returns the fund is not the best answer: it leaves $25,245,000 unspent, and unspent capital earns nothing. It comes to 2.45× against 2.47×. The optimum is not the boldest strategy; it is the one that runs the pool to zero on the best available companies.

And the convention itself

If half the fund is held back, half the fund is not invested in finding a winner in the first place. Fewer reserves buys more shots. Run the whole thing across reserve ratios, assuming perfect selection — every follow-on lands on a company that deserved it:

Perfect selection assumed — every follow-on lands on a company that deserved it. This is the case most favourable to reserving, and it still peaks early.

Reserve ratio	0%	10%	20%	25%	30%	40%	50%	60%	75%
Companies backed	80	72	64	60	56	48	40	32	20
Companies defended	0.00	0.54	1.08	1.36	1.63	2.17	2.71	3.25	4.07
Fund TVPI	2.26×	2.61×	2.97×	3.14×	3.11×	2.79×	2.47×	2.05×	1.34×

The peak is at 25%, not 50%. On this fund the convention costs 0.67 turns of TVPI, or about $67,090,725 of value on $100,000,000 of commitments.

And this is the result under perfect selection — the assumption most favourable to reserving, because every reserve dollar is presumed to find the right company. Even then the curve peaks early and falls. Under realistic selection it peaks earlier still.

What to do with this

For a general partner setting a reserve policy: state it as a number of companies, not a percentage of the fund. “Fifty per cent reserved” tells a limited partner nothing. “Enough to hold our position in 2.7 of forty, or in 6 if we stop at the Series C” is a strategy someone can disagree with.

For anyone underwriting a manager: ask what a full defence costs in their own portfolio, and divide. If the answer is more than three or four companies, either their cheques are small relative to the rounds they follow, or they are not really defending.

For anyone building the sheet: make the reserve ratio an input and the number of companies an output. The moment those two are linked, the convention stops being a convention and becomes a curve with a peak on it.

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