I recently attended a book launch session by Spencer Ante, an editor at Businessweek who is the author of a new book entitled Creative Capital and presents the story of Georges “General” Doriot and the birth of venture capital. Doriot is considered the father of VC, founding and running the first successful venture capital firm, American Research and Development which went on to finance and nurture over a hundred startups. Many of the founders of the most successful venture firms, such as Bill Elfers of Greylock, Eugene Kleiner of Kleiner Perkins and Don Valentine of Sequoia, trace their roots to Doriot.
It was quite fascinating to me to hear Spencer talk of the history and strategies followed some 50 years ago. How the industry was formed on investing tiny amounts of capital, intensely nurturing those startups and bringing the right mix of talent in to scale the business up, and the returns brought about by investing early at low valuations and high corresponding multiples at exit.
One of the questions asked of Spencer was how the General would see today’s VC industry as compared to that of when he started. He commented that there has not been much innovation in venture capital in the past two decades. Many in the industry have enjoyed “sitting on their laurels” while returns to LPs have declined. The sheer size funds have grown to and number of firms seems too large to be able to deploy all their capital across the best startups. With the exit markets the way they are, too many billion dollar sized exits are needed to make these funds return capital. That’s not going to happen anytime soon.
At the end, he expressed that if he were going into VC today, he would be aiming to raise a micro-cap venture fund, investing $500K sized amounts at the earliest stage, injecting the right mix of DNA to help it be successful and being flexible in today’s exit market- exactly what my vision was for Nueva Ventures when I started it 5 years ago.
As a serial entrepreneur, I experienced firsthand in raising capital the large disconnect between the amount of capital standard VC wants to invest and what is really needed to prove out certain business models while maintaining flexibility in today’s exit market. I felt the VC industry had not scaled well and a new model – or perhaps more of a return to the way the industry started out – was necessary to overcome the challenges of today’s market conditions.
So what is a micro-cap fund and how are we different?
I’d say there are a few things that destinctly characterize a micro-cap fund and why as an entrepreneur you’d want to consider taking money from one versus standard VC:
1) A micro-cap fund makes $250k-$1M sized investments in a startup. They offer a far more efficient fundraising path than pooling angel capital and they are usually managed by full time partners whose job it is to work with their entrepreneurs much as General Doriot did in mentoring his companies. Standard VC has effectively abandoned this sized investing because the economics of their fund sizes and demands on time are such that it cannot work for them.
As an entrepreneur, I would say your job is to eliminate risk as efficiently as possible. If you eliminate risk with less capital, you can conserve more upside. Today’s cost of technology, outsourcing options and distribution channels offer a more efficient path to prove out a business model before ramping it. Why not take the least amount necessary, albeit maintaining a prudent amount of runway, to prove out the business and then be in a great position to raise larger ramp capital at a better valuation once that milestone is achieved? Such a path also preserves your exit options. If you take $10M from a standard VC, it might be hard to convince them later to sell the business for $50M (making them say a 2x return on investment) while you may really think that is the right strategic move to make at the time. A micro-cap fund could make a 10x return on such an exit and would be more inclined to seriously consider it.
Furthermore, taking more capital than you need can actually decrease your chances of success. It encourages hiring more people and building large overhead, raising your burn to such a level that makes it hard to rapidly change course if things are not working as planned (and they won’t!). It can make you over develop your product and lengthen time to launch iterations since you feel obliged to get it all right before launch, avoiding getting critical market feedback early and often.
2) Micro-cap funds can make smaller sized investments because of the way they are structured. They typically have $10-25M of capital under management per partner, compared with $50M for standard VC. While the focus in both cases is on homerun potential startups, the micro-cap fund gets in earlier and has higher return multiple potential. The ones who make the most money are usually the first ones in – e.g., Andy Bechtolsheim’s legendary $100K seed funding in Google worth $1B at exit. The exit economics and lower fund sizes are such that doing smaller investments earlier can move the needle on a micro-cap fund’s overall return.
Now come the economics of the fund: why would a fund manager choose to manage $50M versus $10-20M? It comes down to fees – it is more lucrative to be guaranteed to earn a 2.5% management fee on $50M than on $10M, especially if you are not delivering ROI and earning a carried interest which kicks in only after returning all of the original capital of the fund! It’s also a lot nicer to have a fancy pants office with an army of administrative and analyst support staff, and the perks – attending fancy conferences, travel, etc.
Making a small fund work means deliberate and frugal choices about how to run the fund – just like the entrepreneurs we back. I don’t have an administrative assistant and book meetings myself (I find this more efficient actually), I use a lot of low cost technology to support a highly streamlined operation, I do the accounting myself as a former CFO and I do the detailed diligence myself while once in a while consulting with experts in my network who are happy to help out for free. I really don’t need much of an office because most of my time is spent up and down the valley meeting with entrepreneurs and our portfolio companies at their offices – I get to see firsthand how they operate and if they are up to bootstrapping. I know that I have a greater part of my compensation directly tied to delivering return to my investors, totally aligned with their incentives, and can live with that and look forward to a decent carried interest return eventually if I do my job well and luck is also on my side.
Many VCs forget that ROI for a venture fund results when there is a large numerator and as small a denominator as possible. That means getting into a startup very early on in its formative stage at a low valuation, backing entrepreneurs who can prove out the business model with less capital and being able to make returns on what may amount to lower exit values than has been traditionally the case. An entrepreneur should not be bragging about how much venture capital they raised. It just makes it that much harder to generate ROI.
3) Most micro-cap funds practice the same sort of “hands on” value add as a standard VC. While there are many best of class angels who do the same, often it’s hard to get that same professional attention and help as you go through the trials and tribulations of starting and managing a new business. In our case, we want to be part of your Board, we’re dedicated to being there when times are tough and choices unclear, we help you find talent and resources.
The one key difference is that an early stage investor, closer to seed financing, is going to face a higher rate of failure. We take that into account in terms of how we can allocate our time efficiently across a portfolio and the expected rate of attrition freeing up time. A micro-cap fund has to do more investments, we think 2x as many as a standard VC, because of expected attrition. This has to be carefully managed such that at the end of the day we follow industry norms about how many companies we can be involved with. Standard industry rule of thumb is no more than 8 board seats per manager. Sometimes I feel that even 8 may be too many given the intensity of involvement at the early stage of the start-up’s life. Working back from that number, translating it into how many investments each manager can therefore make and how much capital that means is needed is the way we calibrate our fund size.
This gets us to a key issue – why the VC industry has not scaled well. I believe that the fee driven approach to raising ever larger funds has moved most if not all standard VC up to doing later stage investing or to encouraging putting far too much capital in at the early stage, a “capital deployment strategy” per say rather than a prudence strategy of de-risking a business. This has created the gap that exists today in raising capital between $500K – $2M. Too big for most angels and too small for standard VC.
I’ve been in the entrepreneur shoes and I’ve been tempted quite a few times and have taken the larger capital offered by the “capital deployment strategy” – the rationale being if I’m going to be diluted only a little more, why not take the larger capital amount. My experience has been that taking that larger amount resulted in ramping our burn, making us far less able to iterate and change our strategy and product quickly, and put us on a path to having to exit at a huge number. My most successful startups (both from experience as an entrepreneur and investor) have been those that took the least amount of capital and focused on proving out the business model first.
[...] other key difference between NZ’s super angels and the microcap type funds covered in Business Week is that the NZ firms are true angels – they’re playing [...]
Keep in mind that although most of a fund consists of other investor’s capital, the partners in the fund most often do have a significant part of their own wealth tied up in the fund. That is certainly the case for us at Nueva Ventures and so we treat it no differently than our own money!