“Micro-VC firm”. “Emerging Managers”.
These are terms that invariably come up in any discussion about the current state of Venture Capital. And for good reason – Smaller, newer fund managers seem to be surfacing by the day and seem to be a key theme in the evolving world of Venture Capital.
Look, the 80’s and 90’s represented great times in Venture Capital. With innovations in mainframe computing leading the way, Dell, Sun, Apple, Microsoft, and Cisco all underwent wildly successful public offerings. Of course, the decade that followed this golden era was marked by two significant economic down cycles. Outside of Google and a few other edge cases, the exit market relative to dollars raised by Venture Capitalists was extremely unfavorable, resulting in an extremely poor pooled performance for the industry.
Although sweeping changes in Venture tend to be dawdling at best, the long-term underperformance from 2000-2010 served as a powerful change agent for the industry. The industry is clearly experiencing its first true “rinsing” cycle. In the hearts of entrepreneurs and LP’s alike, struggling legacy firms are giving way to Emerging managers. Coupled with the continuing LP concentration around a select group of industry bellwethers, LP capital allocation strategies today resemble a barbell; heavy on the ends, light in the middle.
On one end of the barbell are large, platform plays. These “brand name” firms are viewed by most to have the best probability for persistent market outperformance. As expected, these firms are able to raise larger funds, and more frequently. Last year, the top 10 firms accounted for ~65% of the total capital raise. Names such as Sequoia, Redpoint, Greylock, Accel, Benchmark, NEA, and Andreessen Horowitz populate this list.
On the other end of spectrum are Emerging managers, many of which can be characterized as “Micro-VC’s”, which I’ll cover in the following narrative.
First, what exactly is a Micro-VC? Perhaps overly simplified, a Micro-VC firm is a firm that raises funds of <$100MM from 3rd party capital sources, and whose initial investments are primarily at the seed stage. Most Micro-VC funds that have successfully closed are between $10MM-$50MM.
So why is this happening now? Aside from the broad-based underperformance within the industry, there are several specific reasons behind the Micro-VC boom:
1) Cost efficiency of startups – With the advent of cloud computing and lower component costs, it’s easier and cheaper to start a tech company than ever (by a factor of 5-10x from 10-12 years ago). This makes a $25MM Micro-VC fund eminently viable.
2) Dislocation of economics within legacy firms – Many legacy firms still maintain economic structures where “tenured” partners enjoy a disproportionate share of firm economics, regardless of recent involvement or attribution. For successful younger partners, this can be incredibly discouraging. As a result, many GP’s, who have entrepreneurial DNA’s to start, choose to raise their own funds.
3) Ex-pats from “walking dead” firms – With the Darwinian nature of Venture, many firms are staring at inevitable wind down scenarios, leaving a crop of investment professional free agents.
4) VC 2.0 – With the advent of tangible value add platforms such as Andreessen Horowitz and First Round, former entrepreneurs turned investors have become much more interesting for LP’s and founders alike by bringing significant recent operating mettle to the investing table.
5) LP behavior – Even with 12-15 year returns being compressed as a whole, Venture Capital still represents a very interesting investment opportunity. While an ideal investment allocation for LP’s would be to invest 100% of allocated capital across the top 10 firms in the US, it’s not a realistic proposition. Most top-tier funds follow an exclusive membership model, providing allocations only to LP’s whom they’ve shared a long history with and/or with LP’s that are able to commit hundreds of millions to the franchise. Rather than continue to invest in perceived stagnant legacy fund managers, many LP’s (particularly Fund of Funds and Family offices) are looking to identify the next great franchises, thus affording them the ability to be part of that exclusive membership with the next great franchise funds.
6) Math - As outlined in the now famous (infamous?) Kauffman report, the current exit environment, dominated by modest sized M&A transactions, provides smaller funds a lesser path of resistance to achieving great returns.
Micro-VC fund managers typically are ex-entrepreneurs turned investors or investors that have just left other Venture firms. Most Micro-VC fund managers have experience as both (particularly with multi-GP firms). Apologies in advance for the extreme west coast tilt (I’m based in SV), but a few examples include:
GP’s leaving firms to start their own shops:
Tim Connors (USVP to PivotNorth)
Aileen Lee (Kleiner Perkins to Cowboy Capital)
Peter Wagner & Gaurav Garg (Accel and Sequoia to Wing Ventures). Not really a Micro-firm given our definition, but I’ll include them as their $111MM raise places them close.
Greg Sands (Sutter Hill Ventures to Costanoa)
Sunil Dhaliwal (Battery Ventures to Amplify)
Ullas Naik (Globespan to Streamlined VC)
Beau Laskey (Steamboat to Knightship)
Mike Maples (Floodgate)
Manu Kumar (K9 Ventures)
Shinya Akamine (Core VC)
Aydin Senkut (Felicis Ventures)
So where is the market today? And what lies ahead for the Micro-VC firms? While still relatively nascent, a few notable themes have emerged.
- Notable brands are beginning to emerge: Many early entrants such as Floodgate, Baseline, Felicis, and Softtech are becoming respected brands who are able to generate great deal flow and have significant LP interest.
- New firms that are coming online are very focused: by sector (i.e. Data Collective, Ribbit Capital, Softtech, Streamlined), geography, and stage focus.
- More institutional LP Capital available: While the math still collides for most Pensions and Endowments (who need to write big checks but don’t typically want to be more than 15%-20% of a fund), many Fund of Funds are actively allocating to Micro-VC funds. Funds such as Knightsbridge, Greenspring, Trubridge, Cendana, Horsley Bridge, Venture Investment Associates, SAP, Weathergage, and Northern Trust all are active in exploring Micro-VC allocations.
- Everyone is fundraising: Fund formations are at breakneck speeds today. Based on discussions I’ve had, Cooley, Gunderson Dettmer, and Goodwin Proctor have been engaged to form well over 100 new Micro funds over the past 18 months.
So how will things play out?
Many lament that there are too many Micro-VC firms flooding the market and that pooled returns will be depressed. While the latter might be true, any capital that drives innovation is good in my book. Sure, the potential oversupply of capital at the seed stage may result in looser investment disciplines and higher valuations, thus making it even more difficult for firms to produce historical “venture” type of returns. That’s not really a problem. Venture is always going to be a concentrated returns game.
My guess is just like any other industry, expansion will be followed by contraction and consolidation. Of course it’ll take MUCH longer than most industries given the long tail of Venture. A more interesting question from my perspective is how many Micro-VC managers transition into traditional larger, life cycle firms?
Invariably, as specific managers become extremely successful, so will pressure from large institutional LP’s like pension funds, FoF, and endowments to take more capital? Will they? Who knows, but this will be one hell of a fun ride.