The Many Challenges Facing The MicroVC Model
Lately, I’ve been thinking there are some real threats to the microVC model (say, sub $50M funds). This isn’t to say some won’t do very well — and especially the recent news from Dan Primack in FORTUNE about the first Lowercase fund, which will soon be the stuff of legends and, scarily, isn’t done collecting returns just yet. So, Sacca took about $6-8M and turned it into well over $1B.
Could that happen again? It could, but the glut of small funds (full disclosure — I am part of this problem!) need to show returns to survive. And, therein lies the rub — returns. There are some things going on in the early-stages that threaten the return profile of funds, such as:
- Pro Rata Rights: This has been discussed at length over Twitter, on the blogs. Dave Lerner has a good summary here. Essentially, early investors who are granted pro rata rights often are asked to relinquish them at the next round of financing, especially when the very best institutional VCs follow into the company. In my experience, this can be about 18% dilution per round. If the model of a fund is driven by returns from the outlier (should a fund be lucky to have an outlier), the lack of strength in retaining pro rata can directly impact IRR and overall fund performance.
- Information Rights: LPs want their GPs to have information rights, but guess what, those rights don’t amount to much. Some companies will just share what’s minimally acceptable to report, such as top line numbers and bank balances. A relationship with the founder and company is required to obtain
- Seed Valuations Rising: MicroVCs have a business model, and often don’t have much ownership. So, if a manager has a $20M fund and is expected to return 4x, that requires more luck than skill, or pushes the manager to take lead positions in angel/seed rounds as the valuations rise. But, not everyone can truly lead these rounds.
- YC Alumni and YC Itself: A company can take $120k or so from YC, find product market fit, and go right to a large VC firm. I’ve seen it happen a few times. Amazing companies in those examples. Elsewhere, the strong network effect described by Elad Gil in his post allows this new and growing network to fund current students from alumni tithings, except here the investments are direct and can be quite meaningful. Going from seed to A to B for a YC founder or alum as an investor could show unrealized markups of 20x in about a year (I’ve seen this). The point here is — they have access before the micros.
- Crowdfunding: This has been written about often. A good source here is Matt Witheiler’s blog “Bits of Cents.” Briefly, founders can use crowdfunding platforms like Kickstarter to test demand, take a range of pre-orders, and then go right to a big VC if there’s a strong team, market, and evidence of consumer demand.
- AngelList Syndicates: This is a form of crowdfunding on AngelList, but worth mentioning separately here. Even raising $500k right now can take lots of time, and while it’s not totally easy, the money is everywhere. If an individual investor with a Syndicate wants to just put in $25k and has enough in the Syndicate to fill out the round, the founder may elect — in the interest of time — to just take the money, the one line item from AngelList, and go forward. Here, speed is the issue — instead of meeting a bunch of micros, just take the initial money and see what happens. (As an aside, we must also consider the forthcoming AngelList Platform Funds: Very soon, I believe, the next crop of investors will raise their funds entirely on AngelList’s Platform, where the software and infrastructure will help take care of administration, upkeep, and communication, as well as a mechanism by which to raise money from LPs.)
- Big VCs and Companies With An Appetite To Go Early: VCs are incubating companies. They’re doing seeds in great teams because they have bigger funds and money needs to be put to work. A great team will be funded. Oh, and big companies are playing, too.
- Expansion of Private Markets: Many institutional VC firms have to sit on investments for a decade or longer to return capital and see liquidity. Now, in an era of companies staying private longer, the earliest investors, for whatever shares they have left after being diluted, it’s not easy to sell those shares. Often in a private sale offering, the CEO and/or existing investors on the cap table need to sign off on the deal. Whereas a larger VC with a board seat and some influence on the company’s governance could guide the team to an IPO and liquidity, a microVC does not have that option.
- Cost Of Living In Bay Area: MicroVC funds aren’t really vehicles for managers to earn fees for income, and with the cost of living on the rise in the Bay Area, it’s not a rosy proposition to be a full-time microVC unless one has their own wealth independently (especially because any fees likely have to go to the GP commit in the fund). Before people say someone can invest early but not be in the Bay Area, I counter with the fact that when things are early, it’s critical investors get to meet founders face to face. There are exceptions, but being physically close is the best. Managers may be under pressure to raise bigger funds in order to make it in the Bay Area.
- Most Not Built To Scale: Many micro funds with some success are trying to scale, which is rational — to a point. Some are scaling very quickly, even before returns are realized, suggesting LPs are hungry for direct access, either as co-investors and/or as follow-on investors. Furthermore, many of the players in micro-VC aren’t truly qualified to take long-term board seats in companies for many years — oftentimes, if a company reaches Series A, the new investors will figure out a way to reconfigure the board. This limits the amount a hungry LP can scale with the particular fund.
- LPs Are Exhausted After So Many MicroVC Pitches: VCs get exhausted tracking all the seed startups — and that is exactly how all the traditional institutional LPs and family offices who invest in the venture category feel about all the microVC funds pitching them. To get a sense of how noisy it is, read this post by “Super LP” Chris Douvos, who has an artful way of describing the problem. The entrepreneurial streak in many makes this route the cool choice, but unless you’ve been down this road, it is much harder than one would realize.
The common thread here is to isolate groups, dynamics, or vehicles that have access to early-stage deals before micros can get in (or want to take the risk). There are some glimmers of hope for microVC, however. One, small funds can be more nimble, creative, and cobble together returns as it’s easier to return smaller funds. Two, the “Sacca Effect” will surely ripple not only among GPs (it may have already), but also LPs who will start to see the hidden potential of strategically placed micro funds. And, three, the microVC firms are getting bigger (some of them) and now leading rounds around $2-3M, which is new Series A. I go back and forth on this myself. Sometimes, I think investors can get trapped in seed, yet sometimes I think, this is where all the important relationships get formed.