Micro VC funds have been the rage as of late. What's next?

The following is a guest post by Samir Kaji (@samirkaji), Managing Director at First Republic Bank (@firstrepublic). 

Micro VC market

Just over a year ago, I posted a blog post about the state of the “Micro-VC” market.

As a refresher, Micro-VC firms are venture firms that typically have the following characteristics:

  1. Primarily initially invest at the seed stage.
  2. Invest on behalf of 3rd party Limited Partners.
  3. Most commonly have fund sizes that are sub-$50MM.

I’m not a huge fan of the Micro-VC moniker but will use it here for lack of a better term.  At any rate, I’ve dedicated much of the last three years closely observing this end of the Venture Capital barbell, and it’s been fascinating study. While I anticipated major growth in this area of the market in 2011, I definitely underestimated the velocity and magnitude.  In hindsight, it’s easy to see the why such mass proliferation has occurred.

  1. Viability of small fund sizes given current capital efficiency of start-ups.
  2. Low barriers of entry for Micro-VC funds entering the market.  Unlike larger funds who rely on institutional capital (Pensions/Endowments), Micro-VC funds can be raised if a manager has a deep rolodex of High Net Worth individuals and Family offices.
  3. Funding gap between Angel funding and traditional Venture Capital.
  4. Renewed LP interest into Venture Capital sparked by the bull market within tech  (note that $16B was raised by VC in 1H 2014, or 1.25X of what was raised in all of 2010).

According to CB insights, there are approximately 135 Micro-VC firms that are actively investing today. I’d estimate there are an additional 40-50 freshman funds that are in active fundraise mode. In my seat at First Republic, I’ve been fortunate enough to have met over 125 Micro-VC managers over the past 24 months.

Here are a few trends that I’ve observed within the Micro-VC market:

Continued maturation of the industry; Successful 1st generation Micro-VC’s are raising significantly larger fund vehicles:

The challenge for many seed stage funds is managing fund sizes that typically aren’t large enough to take full advantage of pro-rata follow on rights (and sometimes super pro-rata grants), an important element when optimizing for fund performance. Many top 1st generation Micro-VC’s have significant increased fund sizes over the past 1-2 fund cycles to enable full pro-rata participation with appropriate opportunities. Felicis ($96MM), SoftTech ($85MM), Floodgate ($76MM), and Data Collective ($125MM+) are recent examples of this.  I’m expecting other top Micro-VC managers continue creeping toward $75MM-$100MM funds in the coming years.

Blurred lines within seed fundraising:

In the past, a clear line of demarcation was present between Seed rounds and Series A rounds.   This is simply no longer the case. In today’s world, Seed financing has many dimensions and stages – The team at Bullpen Capital was 100% correct when they stated that seed is a process vs. a singular event. To note, I’ve seen companies raise three seed rounds prior to taking on traditional Venture Capital.  I’ve also observed a “Seed” round completed at $4.0MM that did not include any traditional Venture investors. Today, late stage seed rounds often resemble smaller A rounds from the perspective of company development, valuation, and dollars committed. The truth is that many of institutional seed investors are investing later in the seed process, a trend easily attributable to the continued democratization of the seed financing market and companies achieving more traction with less capital (while enjoying more non-institutional sources of capital at the early/mid seed level).  Investing at the late seed level also serves as an important mitigant against follow-on financing risk for Micro-VC’s.

Increasingly difficult fundraising market:

Yes, 2014 will be a banner year for funds raised. As noted above however, the market for Micro-VC funds has exploded (note the graphic!). Unsurprisingly, this has created significant confusion and pause for Limited Partners of all types, who now experience huge signal to noise issues. Many managers appear identical making it tougher and tougher for LP’s to discern tangible differentiation.

Using public data, I ran a randomized study of of a group of 1st time managers (n=23) commencing with March of 2013. The median time from fundraise launch (admittedly a bit squishy) to final or projected final close is currently 14.6 months, almost 1.5X of what I observed in 2012-2013. While edge cases like Maiden Lane and Upside Partnership certainly exist, the vast majority of first time managers are experiencing significantly tougher fundraising treks and substantial competition for LP capital.

Furthermore, many early adopter institutional LP’s (i.e. Fund of Funds, small endowments, Foundations) have already placed their Micro-VC manager bets and have become increasingly reticent to onboard new names. The exception, unsurprisingly are appears managers that have emerged from well-regarded traditional Venture firms with referencable track records.

Increased emphasis on true and quantifiable value-add:

As you’d expect, all Venture investors purport to be value creators for their portfolio companies. A positive byproduct of the competitive landscape is that the importance of demonstrated value add.  For seed-stage managers to consistently gain curated dealflow access  (truly seeing the most promising deals within thesis) and winning them without writing premium valuations, managers must demonstrate clear and quantifiable value add within their targeted sectors. This includes recruiting, potential customer introductions, mastery of business sector and models, and trusted relationships with top-tier traditional VC firms for follow on investment.  Additionally, Micro-VC’s who are able to lead a round have a huge competitive advantage over Micro-VC’s who require syndicates. Examples of creating differentiation include firms like Rothenberg Ventures which employs a distinct community based millennial based approach to the market and Upside Partnership which employs a structure that provides carry to portfolio companies.

While it’s been an active few years, It’ll be interesting to see how this market continues to evolve in the coming years.

I predict that fewer than 50 institutional Seed firms will active in 2020. Why?

  • The concentrated return profile of Venture Capital makes it virtually impossible to envision a scenario where more than 50 firms produce the necessary returns to earn alpha returns, particularly when an inevitable market cycle shift is factored in.
  • Unstable LP bases. While most traditional Venture funds have LP bases that include deep-pocketed institutional investors, many smaller and/or newer Micro-VC firms have LP bases that are composed mainly of HNW individuals and small family offices. These type of LP’s tend to be bull market investors and extremely unpredictable with regard to follow-on fund allocations.  That said, I will disclose that there is a signficant subset of Micro-VC firms that enjoy strong, stable, institutional LP bases.
  • Many of the top 1st/2nd generation will look and feel more like small traditional Venture shops from the lens of investment model, firm infrastructure, and fund size.

__________

PicSamir Kaji is a Managing Director at First Republic Bank, where he leads a team managing Venture Capital and Start-up Company relationships. He has spent over fifteen years working within the venture capital industry. During this period, he has assisted and/or advised over 600 companies and 300 venture capital firms. Prior to joining First Republic, Samir spent thirteen years at Silicon Valley Bank, where he completed over 400 debt transactions, totaling over $4.0 billion in committed capital. Since 2008, Samir has led teams focused on providing services to venture capital firms and directly led engagements with several of the leading venture capital firms in the industry. Samir also has been an active angel investor in both venture capital funds and early stage companies. Samir is a graduate of San Jose State University, where he earned his Bachelor’s degree in Finance, as well as Santa Clara’s Leavey School of Business, where he earned his M.B.A., with a concentration in Finance.

  • Phil Haslett

    Umm, this is AWESOME. Great work Samir! Exciting to see data supporting the “there are so many Micro-VC funds now” chatter.

    Agree with consolidation. Why did you pick 2020? Are most of these funds raising 10-year funds or 7-year funds?

    I ascribe one other (potentially negative) reason for the uptick in Micro-VC: crowdfunding platforms. It’s just much easier to raise money from angels right now, which means the number of funded companies eligible for seed financing has risen dramatically. However the mid- and late-stage investment amounts have not risen in-step. I initially blamed the “Series A Crunch” on the crowdfunding phenomenon (more companies fighting for the same amount of Series A capital), but it seems that increased formal seed financing may be playing a part now too.

  • samir kaji

    Thanks Phil! Most of these funds are traditional 10 year funds. When I chose the year 2020, I was really focusing on firms that will be “active”, (i.e. doing new deals). By then, we’ll be past the investment cycles of Micro-VC firms that raise over the next 1-2 years (and perhaps cannot raise Fund 2). Additionally, many firms that raised Fund I successfully from 2012-2013 will likely will be able to raise Sophomore funds in 2014-2015 as a function of the strong #’s we’re seeing with this bull market, but may not be able to raise Fund III, at which point they will no longer be considered active in 2020. Their still will be several hundred firms that exist in Micro-VC in 2020, but we’ll see a lot of “walking dead”. We just don’t know who those will be yet – and I’m still very bullish that the winners will produce serious alpha returns.

  • Phil Haslett

    Makes sense. On average how big were the management teams for the Micro-VCs? Could you give an estimate on $AUM-per-investment professional? Given all the talk about larger VCs being overpaid, I think this would be quite an eye-opener for entrepreneurs.

  • samir kaji

    It’s a very good question – Rarely see 1 investment professional manage much more than $40MM-$50MM in capital and in many cases, I see $20MM-$30MM per partner. Taking overhead expenses (Rent/perhaps 1 other staff member), the pay is certainly enough to make a good living, but nothing like the 1st decade of the 2000′s when a ton of firms became AUM plays. Now a single GP managing 2-3 Funds of $40MM or more, then things look different. Just candidly haven’t seen many of those.

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  • http://www.yvcblog.com/ Jonathan Friedman

    Great essay, will need to check out more on your blog!
    One thing you did not cover is the trend of seed fund managers planning to raise seed co-investment or opportunity funds, mentioned by Mark Suster:
    http://www.bothsidesofthetable.com/2014/07/22/the-changing-structure-of-the-vc-industry/
    Do you predict we’ll be seeing more of these type of “opportunity funds”?

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  • samir kaji

    I did see the post from Mark S, which was a great overview of the overall Venture landscape. Yes, I have been seeing a ton of Special Purpose Vehicle (SPV’s) and/or separate vehicles for portfolio follow on purposes. These will continue, but expect this to be a very small part of the market from a $ perspective.

  • Church Lewis

    Very interesting and important topic. What is the average or median pre-money valuation of MicroVC first round investments?
    What is the average or median pre-money valuation of MicroVC follow-on investments?