Follow-on reserves and target ownership
Seed funds often reserve capital for follow-on investments in series A of select portfolio companies. This strategy balances opportunity cost with ownership share of winners and is based on the increase in conviction at Series A.
The opportunity cost of reserving capital for series A is the ability to invest in more potential winners at seed stage. Seed stage valuations are lower and so exit multiples are higher. If a fund intends to invest in the A round of all portfolio companies, it should invest the full fund at seed to get the lower stock price and higher share of ownership.
The reason to reserve capital for A rounds is that the conviction of which companies will be winners is higher at series A. The optimal portion of the fund to reserve for follow-ons depends on how much the certainty increases from seed to series A.
Conviction must increase more than proportional to the valuation step-up from seed to A for it to be worthwhile to have any reserves. Above that, the optimal portion of the fund to reserve depends on the difference in prediction certainty between the rounds. Large reserves signal that fund managers believe they are much better able, at series A, to discriminate between future winners and losers. A seed stage fund with very large reserves is essentially a series A fund.
Reserve Allocation Examples
Assuming a 3x valuation step-up from Seed to Series A:
2x increase in conviction: 0% reserves
4x increase in conviction: ~20% reserves
10x increase in conviction: ~67% reserves
Ownership Considerations
Some funds target minimum ownership percentages for two main reasons.
Influence: Large ownership can secure board seats, voting rights, and information access, potentially empowering the fund manager to act to improve company prospects.
Future Investment Rights: Ownership with pro rata gives the fund rights keep owning a significant share of the company in future rounds. This will have been valuable if (a) the investment remains promising and (b) conviction increases substantially. It will not have been important if future rounds are priced so that they are not highly oversubscribed or the fund manager keeps a friendly relationship with the founder.
Higher ownership has the opportunity cost of limiting diversification across additional deals. Unless a large ownership share substantially improves success probability for one of the reasons above, ownership percentage alone doesn't affect fund returns. Ownership should be decided deal-by-deal and result from portfolio allocation based on conviction. It should not be a blanket objective.
Pay-to-play and recycling
VC funds might reserve capital to maintain positions in future pay-to-play rounds. However, barring dire market conditions, pay-to-play rounds are unusual, they almost never occur for companies that go on to return a fund, and they tend to occur after the fund's deployment period.
Reserving capital earmarked specifically for pay-to-play rounds is unlikely to be worth the opportunity cost during a fund's deployment period for most seed funds in most sectors.
An exception to consider is to reserve from distributions capital returned from early exits. If the exits are early enough, the reserves can be recycled into later rounds with especially high conviction, including pay-to-play rounds.
Fund managers should evaluate their conviction with the same rigor in pay-to-play rounds as other follow-ons and avoid sunk cost bias.
Conclusion
In summary, reserve strategy and target ownership should align with the fund's ability to identify winners at later stages, balanced against the benefits of broader seed-stage investments.