The stages typically correspond to important milestones in the life of the company (e.g., the development of a prototype, the first production, etc.). The capital invested at each time period must be adequate to bring the firm to the next development stage.
With follow-on funding, the venture capital investor can decide on the optimal investment sum for the next stage or—in case of an inappropriate development—cut off the project from new financing.
Follow-on funding may mitigate the moral hazard behavior of the entrepreneurs, as it gives them incentives to work hard to achieve the goals and thus, obtain the next financing tranche. However, follow-on funding may create other problems, such as short-termism by the companies.
The number of follow-on funding rounds and the money obtained per round depend not only on firm characteristics, such as the development stage, asset tangibility, R&D intensity, but also on external conditions in the venture capital industry.