A lot of new Micro-VC firms have been formed over the past couple of years. A lot. For some, it may seem like anyone that has a good story and a PowerPoint can raise a fund.
Having lived through the process vicariously through dozens of new managers, I can tell you that raising institutional capital can be very tough for first time managers. And in many ways, despite the bull market we’re in, it’s much tougher to raise institutional capital today than it was 3-4 years ago.
Some institutional LP’s have placed their bets within the Micro-VC sector and are in wait and see mode while others struggle to differentiate between the constant inflow of new manager slide decks.
To get into the heads of institutional LP’s around Micro-VC, I took some time over the past few weeks talking to several about how they analyze new (and often unproven) venture managers.
For ease of readability, I’m narrating the collective thoughts of the institutional LP’s I talked to in the first person.
One of the things I’m going to be very interested in is understanding what inspired you to start your own firm/fund. As an institutional investor, I’m looking to invest in your franchise and not a single fund. As such, I want to know that you have been thoughtful around why this is the direction you’re taking your career.
In a bull market like today where the velocity of capital is high, it’s sometimes difficult for us to differentiate between managers that have true conviction to build a great long-term franchise versus part time hobbyists who are cashing in on the current wave. Make sure it’s a question that you ask yourself before pitching.
On what is important to us?
1/Founder endorsements – Assuming I get this far in my diligence, I want to hear that the entrepreneurs you’ve backed are your biggest cheerleaders. While I want founders to say great things about your character and acumen, I’d really like to hear tangible examples. It could be how an entrepreneur went to bat to protect your pro-rata or how you were their first call when they started a new company.
2/Hustle factor – Pure and simple, Micro-VC investors need to convince me that they have the same hustle as the entrepreneurs they invest in. I want to feel that you’re going to run through walls to make the firm and all of its constituents successful. With the level of competition for the best entrepreneurs, we’re going to lean heavily to those firms whose core philosophy is built around outworking the competition and being resourceful.
3/Differentiation – The most interesting funds to us are ones those feature managers who are true non-derivative thinkers.
In today’s noisy market, we see often see managers that believe they are differentiated, but in reality represent no more than a derivative of other more established or branded firms in the market. Differentiation must be authentic and needs to paint a compelling picture on how you’ll see, win, and help the best companies/deals.
4/Network – Obvious, but it’s worth mentioning as your network speaks to what deals you will see and most importantly, how you will be able to help your portfolio companies succeed. Capital today is a commodity – You’re network is not.
Additionally, with most Micro-VC investors being only able to lead a single round (if at all), having robust relationships with follow on capital sources is critical. For example, if you place calls into top-tier lifecycle investors like Sequoia and Benchmark, do they place priority on your referrals (or even pick up your calls)? The litmus test comes down to the follow-on rates of your portfolio versus other managers (also of importance is the quality of VC’s that are leading follow-on financings for your companies).
At the end of the day“`, everyone raising a fund has a network. What we’re most interested in is the signal strength of those networks.
What are the main red flags for us?
1/Conflicting information when back channeling and contacting references – If you tell us “X”, and we consistently hear “Y” in the market, any trust that we’ve established is broken. Don’t worry; it’s ok if you’ve had some missteps in the past or have missed on some great deals. Just don’t tell us something is true if it’s not. It’s a small industry and we’re going to do our diligence to confirm that what you’re telling me is true.
2/ An overly constructed thesis – As mentioned above, demonstrating some level of differentiation is important. And it seems like this message has been heard loud and clear in the market based on what we’re now seeing. So loud in fact that we too often see narratives that are either overly engineered or simply fabricated in an effort to stand out from others. This is one of the easiest things to sniff out, and immediately puts in question your thought process and plan.
3/Misrepresented track record – We know that the attribution game is tricky, particularly if you’ve spent time at a big, political partnership in the past. That being said, assume anything you place in your track record will be scrutinized and checked. For example, a first time manager recently trumpeted proprietary deal access and intuition by outlining 2 companies he invested into that are currently part of the billion-dollar club. Impressive on the surface, but what he failed to mention was that both of these investments were small personal investments that were done when both companies had already reached ten figure valuations.
Track record is one of the most important things we look at – Don’t leave things out that will help us favorably evaluate you, but use judgement and audit yourself. If it doesn’t feel consistent with what you’re selling, than it probably shouldn’t be included.
4/Loss rate inferior to average – For Micro-VC’s, the bread and butter is investing in seed stage companies. Relative to your peers, if your portfolio attrition rate due to companies not raising another round of financing is higher, it raises questions. Of course, we want you to take risk and understand the vast majority of your investments will be in 0-1X bucket, but too many losses early may speak against your ability to pick viable investments and could point to lack of signal strength with follow-on funders. This isn’t a deal killer if the rest of the portfolio looks great, but from a pure investment standpoint, it presents concerns around where you play within the risk curve.
5/Single hit track record – It’s well understood that venture is a hits driven business. However, if your numbers are heavily concentrated into a single investment, it makes it tough to determine whether you’re truly a good investor or you just got lucky and hit the lottery. Yes, both skill and luck are necessary in venture investing, but it’s a much easier for us to project out your potential success if your return distribution shows some granularity.
6/Personality – At the end of the day, we’re investing in people. We’re investing in people that we trust can execute on a strategy and provide us great returns, but people we can root for. Coming across as arrogant or defensive will do you no favors. We’re looking to be long-term partners through good – and bad. And if you’re not coming across well to us, how can we believe you’ll come off well to entrepreneurs?
7/Selling fund size as a differentiator – Raising a small fund doesn’t guarantee great returns and candidly that narrative is well dated given competition and the rise of seed stage valuations. While it’s possible to build a nice 2-3X net return fund without the benefit of a billion dollar exit, it’s still very challenging. Many managers underestimate the difficulty of producing a top returning Micro-fund.
Trends we expect (or hope) to see
More spin outs of people leaving existing firms
Continued rise in numbers of Micro-VC firms in 2015, but an inevitable drop in active firms within 2-3 years
More Micro-VC’s cashing out in secondary transactions within the “private IPO” market
2016 – The year that we start seeing downrounds?