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The escalating difficulty of raising Series A capital in recent years has forced many companies to have to raise multiple seed rounds. Terms like pre-seed, seed, post-seed, and seed extensions are commonplace lexicon in early stage financing.
Fortunately for companies going through the multiple seed round path, this phenomenon has coincided with a dramatic increase in small seed stage venture funds entering the market. The success of first generation micro-VC firms like Lowercase Capital, Felicis Ventures, and Baseline Ventures has helped pave the way for growth we’ve seen in the sector. We count roughly 300 US micro-VC firms today — a 2x+ increase from September 2014.
As is the case with companies that must navigate through the seed ecosystem prior to getting traditional A round financing, most micro-VC funds follow a similar path. Absent a long institutional investing track record or an objectively apparent revolutionary model, the road map for new micro-VC funds has been fairly consistent:
Raise a small proof of concept fund of $5MM-$20MM through individuals and family offices and then hope to show enough portfolio traction to enable a larger institutional investor backed fund 2–3 years later — the micro-VC version of a Series A round. Institutional backers are almost always necessary for scale and sustainability of venture firm.
To note, the proof of concept fund moving to institutional fund process in micro-VC isn’t new. Jeff Clavier’s (SoftTech) first fund was under $1MM and Chris Sacca’s first Lowercase fund was under $10MM (congrats to all those fortunate enough to have invested in that fund as it remains the best performing fund of all time).
From 2010–2015, the proof of concept to institutional backed fund exercise was fairly straightforward. Managers that had demonstrated strong early performance through mark-ups and had built decent relationships with institutional investors had little to moderate difficulty attracting institutional backers for their sophomore funds.
However, the market today is decidedly differed and most institutional investors have slammed on their handbrakes with respect to allocating to new micro-VC funds. A few primary reasons exist for this:
– The glut of funds in the market has driven the bar for institutional allocations much higher and the amount of portfolio traction/differentiation needed to get capital from a fund of funds or endowment is very high.
– Many institutional limited partners have made their bets within the micro-VC sector and are content in letting performance play out with existing managers.
– Limited proof points. After 2 years, managers have little more than a few markups and anecdotes to show as proof of concept. With the reset of venture valuations in full swing, previous valuation upticks are being heavily discounted by limited partners.
– Fear that smaller seed funds may face material portfolio attrition if downstream financing gets even more challenging (likely).
– Basic math. Venture investing has always been a power law industry where returns are skewed toward a limited number of companies and funds every year. As such, projecting that only 50–60 micro-VC funds will provide a meaningful risk adjusted return for investors doesn’t feel overly presumptive(as an aside, I’d posit that the top 10% of micro funds will provide much better dollar multiples than the top 10% of traditional venture firms).
So what does this all mean? For those that have recently or are planning start a new micro-VC franchise, I think it’s prudent to brace for a longer path to that “Series A” institutional fund.
This means that prospective managers are likely going to have to wait longer between funds to demonstrate meaningful traction points and/or be forced to raise another seed round/proof of concept fund. It also means several years with limited management fees.
Now all of this shouldn’t necessarily dissuade managers to start new venture franchises. I’ve stood firm in my position that some of the best venture franchises have just been formed (or have yet to be formed) and I have repeatedly been impressed by the individuals and culture that exist within the micro-VC market. It’s a culture that’s characterized by entrepreneurial spirit, hustle, unbelievable founder empathy, and diversity.
My message however is to emphasize the importance for managers to thoroughly examine motivations for starting a venture firm. The idea of being a venture capitalist is appealing, however forging a career in venture capital goes far beyond the simple act of investing in companies. It requires patience, passion, and for micro-VC funds, a true “love for the game” as economic opportunity cost is quite high in the early years.
Becoming a venture capitalist is still easier than it ever has. The road to staying one is a path that’ll be littered with more potholes and bumps than most expect and will require the same resolve and patience exhibited by the best entrepreneurs.
Time to roll up those sleeves and start building.