Smaller, Earlier VCs Should Invest Differently

“Status quo — you know — is latin for ‘the mess we’re in.’”
— Ronald Reagan

Like any industry, VC can be resistant to change and disruption, and we’ve now begun to see a myriad array of new strategies in this growing asset class: accelerators & their follow-on funds, geo- or thesis- focused strategies, “index” portfolios and miniature versions of traditional firms abound. If you read much about this space, you’ve probably already read a bit about “the rise of micro-VC.” Most of these smaller firms focus on earlier-stages than their larger counterparts, as they generally need to make smaller investments.

We are one of those “micro-VC” firms. We invest earlier than most (entirely in the <$3M rounds we call “seed” stage) and we are smaller than most ($12M AUM). But we are proud to be in the Micro-VC category. Why? Wouldn’t it be great to have larger fees and invest in larger deals? Yes, but that’s not where the best money is actually earned. Earlier investing brings huge rewards — the earlier you invest, the higher the gross return and IRR. But with great returns come great risk… and a great responsibility to reduce that risk to a reasonable level.

So… how should Micro-VCs reduce that risk while at the same time enjoying those wonderful gross returns and IRR? Well, we argue that if you take a step back from what’s already the norm (i.e. traditional or later stage VC) and think through building up the ideal strategy, it’s unlikely that the same strategies will pan out consistently for Micro-VCs.

Overly simplified, the optimal portfolio strategy for a traditional, large VC firm is relatively straightforward. Number of companies? Enough for some diversification within your partners’ bandwidth to take board seats. Size of investment? Large enough to properly capitalize the company for major growth, make the transaction costs and a board seat worthwhile, take desired ownership in the company, and return the fund with one successful outcome. The investment tactics and decisions are relatively understood — load up capital behind the best performing companies, valuations aren’t as important as large outcomes, dilution and control are critical to monitor and gross cash returns are king. Industry expertise, a broad, powerful network, financing acumen and a seeming ability to select the right founder/market/product are how these firms differentiate and optimize results. There are legendary firms and investors that have proven this strategy and regularly write about their best practices.

How do smaller, earlier funds go about earning that high return while managing risk? The first thing that should be clear is that the same strategies that work for larger, later funds won’t work consistently for micro-VCs. Too many variables have changed, and the risk-reward ratio has dramatically shifted. Unfortunately, the larger funds’ success has created countless attempts to mimic their styles without the underlying infrastructure and resources. The effect is similar to me watching Steph Curry drive through a series of defenders to layup a basketball, then going out with my friends and attempting the same. It could work, but I’m much more likely to end up flat on my face with a sprained ankle than anything as beautiful and rewarding as I saw on TV.

Me (imagined)
Me (reality)

Over the course of this multiple-part blog series, I will attempt to counter some of the large-fund mentality that has trickled into micro-VC strategies. In order, I’ll cover:

  1. Portfolio variance
  2. Dilution doesn’t matter
  3. Valuations do matter

All of these aspects need to be managed much more differently in smaller, earlier funds than in traditional, large VC. I’ll invite plenty of feedback and debate, I know that there won’t be consensus on these topics, and I’ll be relatively general with my conclusions so as to avoid needing to find agreement on specifics. Even if I’m only modestly successful at challenging some conventions, I hope to shift some opinions and strategies. Otherwise the sustainability of micro-VCs could be threatened as cycles come and go, and the vast majority of funds demonstrate too inconsistent and unrewarding of returns to their LP bases.

Next Week: How Smaller, Earlier VCs should factor in portfolio variance to their fund strategy

A big “thank you” to fellow M25 director, Mike Asem, for his assistance crafting this series, providing feedback and help in editing.


About the Author

Victor Gutwein is the managing director of M25 Group, a VC firm he founded in 2015. Victor is a Kauffman Fellow (Class 22) and an active member and co-chair of the Consumer group at Hyde Park Angels. Previously he has worked in corporate strategy on a variety new businesses in retail & ecommerce. Victor has a passionate history with startups, including a vending machine business and kick scooter company, along with being on the board of the University of Chicago’s first student-run venture fund.

Victor lives with his wife on the South Side of Chicago and loves staying active with backpacking, running, biking and most water sports. If he can’t convince you to workout with him though, he’ll usually succeed in getting you to try out a Euro-style board game (like Settlers of Catan) with his friends.

Twitter: @lalayak

About M25

M25 Group is one of the most active venture capital firms focused solely on early-stage investments in the Midwest. Their objective, analytical approach has helped support their thesis and craft what is known as an ‘index fund of Midwest startups.’ M25 has already invested in over forty companies since their inception in 2015, and continues to invest in over twenty companies each year. Their collaborative, forward-thinking approach and diverse array of investments across industries and business models throughout the region has quickly established them as a key node in the Midwest startup ecosystem.