What a pro rata cheque actually costs, and the band where it loses money
A pro rata cheque is ownership times round size, and companies that are worth more sell less. Defending cuts the multiple at every exit value there is.
Exercising pro rata is supposed to cost more than the original cheque, because the
company is now worth more. On ordinary growth parameters it costs half the
original cheque in the first follow-on round and three quarters in the second.
The sentence everyone repeats is the wrong half of an identity.
A pro rata cheque is your ownership times the round size, and round size is dilution
times post-money. Valuations rise, but companies that are worth more sell less of themselves, and
the two effects largely cancel. Getting this backwards leads a fund to reserve for a cost it will
not incur, and to skip the calculation that actually matters — the exit range in which
defending your ownership destroys value.
The arithmetic, on ordinary parameters
A 600 fund with 15 core positions and an equal reserve alongside every initial dollar. That
implies a 20 initial cheque, and at 15% entry ownership an implied entry post-money of 133.3. Two
follow-on rounds: a 2.5× step-up selling 20%, then a 2.0× step-up selling 15%.
Post-money
Share sold
Round size
Your pro rata
As a multiple of the initial cheque
Entry
133.3
15%
—
—
—
Round C
333.3
20%
66.7
10.0
0.50×
Round D
666.7
15%
100.0
15.0
0.75×
Both rounds defended
—
—
—
25.0
1.25×
A 600 fund, 15 positions, a 1:1 reserve, a 20 initial cheque for 15% of the company.
Defending through both rounds costs 1.25× the initial cheque, not
more than the cheque in each. Notice what that does to the reserve: 20 was set aside for this
name and the defence needs 25. A 1:1 reserve does not stretch to defending the winner, let alone
to leaning in on it.
When would the usual sentence be true?
It is a one-line inversion. The pro rata exceeds the initial cheque when the cumulative
step-up exceeds one over the dilution.
If the round sells...
...the pro rata exceeds the initial cheque only above a cumulative step-up of
10%
10.0×
15%
6.7×
20%
5.0×
25%
4.0×
30%
3.3×
This deal’s cumulative step-up at round D is 5.0×.
At a twenty per cent round the company would have to be worth five times its entry
valuation before the sentence became true. Growth rounds step up one and a half to three times,
and later rounds sell less rather than more. The claim describes an outlier and is repeated as
the norm.
What defending does to the position
Now the decision itself. Same company, same 1,500 exit, two policies: never follow on, or
defend both rounds.
Never follows on
Defends both rounds
Ownership at exit
10.2%
15.0%
Capital invested
20
45
Proceeds at a 1,500 exit
153.0
225.0
Profit
133.0
180.0
Multiple on invested capital
7.65×
5.00×
Internal rate of return
40.4%
40.8%
Same company, same exit, two reserve policies.
Defending adds 47 of profit and cuts the multiple from 7.65× to 5.00×, while the
internal rate of return barely moves. That is not a quirk of these inputs. Follow-on dollars are
bought at a higher price than the initial cheque by construction, so they must return a
lower multiple, so the blended multiple must fall — at every exit value there is.
Which makes reserves a decision about what is being optimised. They buy profit dollars and
the size of a distribution. They do not buy multiple. A fund whose first line to investors is a
multiple is reporting the number its own reserve policy works against, and it is worth knowing
that before the reserve memo rather than after the annual meeting.
The band where defending loses money outright
The follow-on dollars buy 4.8% of extra ownership for 25. Divide one by the other and there is
an exit value below which they come back worth less than they cost.
Exit value
Multiple on the follow-on dollars
Undefended multiple
Defended multiple
Reading
400
0.77×
2.04×
1.33×
the follow-on dollars lost money
521
1.00×
2.66×
1.74×
the follow-on dollars lost money
750
1.44×
3.83×
2.50×
1,000
1.92×
5.10×
3.33×
1,500
2.88×
7.65×
5.00×
2,500
4.80×
12.75×
8.33×
Below 521 the follow-on dollars come back worth less than they cost.
521. Below that exit the follow-on dollars lose money — and at that
exit the original cheque is still returning 2.66× and the company is worth 3.9× what you
paid for it. That is not a failure. It is the ordinary good-but-not-great outcome a growth fund
produces most often, and defending ownership through it converts a solid winner into a worse
one.
Does a 1:1 reserve even bind?
Two statements are both true and point in opposite directions. The reserve is too tight for
the name that wins. It is also half unused across the book, because most positions never raise
again.
Positions
Pro rata each
Total
Never raise again
5
—
—
Raise once more
7
10
70
Raise twice more
3
25
75
Pure-defence need
15
—
145
Reserve pool
—
—
300
Utilisation
—
—
48.3%
Most positions never come back. The name that wins needs more than was set aside for it.
And the claim at the centre of every reserve memo
“Reserves shape a fund’s returns as much as picking winners does.” Test it
like for like. Two funds, the same size, the same company set, no follow-on selection skill on
either side. One reserves 1:1 and defends; the other reserves nothing and writes the same cheque
into twice as many names.
Names
Ownership each
Ownership-units
No reserve — same cheque into twice as many names
30
10.2%
3.06
1:1 reserve, defended
15
15.0%
2.25
Gap
—
—
36%
Same fund size, same company set, no follow-on selection skill on either side.
The no-reserve fund ends up owning 36% more of the identical company set, after dilution. The
1:1 fund can close that gap only by deploying its idle reserve — and at the same price per
unit of ownership, closing it costs 1.02× what it has left. Break-even,
almost exactly.
Which means the claim is not a parallel claim at all. It is the same claim wearing
different clothes. A reserve buys nothing on its own: at the same price per unit of ownership it
merely rebuys what concentration gave away. Everything it is worth is the quality of the
follow-on decision — and the follow-on decision is picking winners, done later and at a
higher price.
The measurement that makes a reserve policy honest
Compare the multiple your initial cheques returned with the multiple your follow-on dollars
returned, across the whole book, adjusted for the shorter hold. If the second is not clearly
higher, the reserve policy took value out of the fund. And since follow-ons are structurally
bought at higher prices, that is the result to expect unless the record shows otherwise.
Three numbers are worth computing before the next reserve memo: the actual pro rata cost as
a multiple of the initial cheque, the exit below which follow-on dollars lose money, and the
share of the reserve pure defence will consume across the book. None of them takes more than a
spreadsheet afternoon, and all three are usually assumed.
The workbook behind this article
Every figure above is a live formula in the companion file for
The Growth Equity Investor, which also holds the round-by-round build, the exit-by-exit band, the reserve utilisation across the book and the like-for-like against a no-reserve fund. It is free, and it needs no account and
no email address.
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The IRR at which a closed-ended fund merely tiesA drawdown fund advertising 13.25 per cent ties an evergreen netting 8.64. On committed rather than called capital, 78.7 per cent of the edge vanishes.
The month a remediation trigger has to be armed byMonth 8, on a one-year window and a 14-week hiring lead time. The date is 12W − L/4.33 and holds for any portfolio size — the book only changes the euros.
Two routes to the same NAVFive findings in one quarter-end close, and not one of them was a modelling error. Every one was a control that did not exist.
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Why refining a due diligence rubric makes it weakerThree of twelve managers carry a terminal flaw and the average approves all three. Splitting eight domains into sixteen makes it easier to hide, not harder.
If this book helped — or didn’t — a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.