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.
Worked in full in The Growth Equity Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
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.
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× |
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.
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× |
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.
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% |
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 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× |
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.
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% |
“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% |
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.
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.
This article is one calculation from The Growth Equity Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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