Going from a proof of concept fund to an “institutional” venture fund

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Over the past several years, we’ve spent considerable time studying and writing about the rapidly evolving emerging manager venture landscape.

As illustrated by the chart below (data courtesy of Pitchbook , combined with our own data tracking), the propagation of new firms has intensified in the last two years and since the beginning of 2017, more than 50% of total funds raised have been fund 1 offerings.

With the barriers of entry being low for the smallest venture funds, many new entrants are managers that bring minimal prior professional investing experience. As such, a significant portion of new offerings are in the sub-$25MM range and are primarily backed by high net worth individuals and smaller single family offices. When examining this segment more closely, over 50% of first time funds (post 2016) in the sub-$25MM segment raised funds that were under $15MM at final close (funds in this size range are often referred to as proof of concept or nano-funds).

With the economic and operational challenges these size funds inherently present to GPs (notably fee stream and reserve capital), the business plan for managers starting these funds is fairly typical — execute a given thesis effectively and transition from a proof of concept fund to larger subsequent funds that are backed primarily by institutional LPs.

This path to institutionalization was one that many first and second generation (pre-2014) Micro VCs successfully navigated. In this past, this leap was perhaps a bit easier to make given fewer managers in market, active emerging manager mandates by LPs, and greater emphasis placed on portfolio mark-ups. Attracting institutional LP capital is almost always a necessary component for scale and durability (please note in the context of this post that I’m referring to institutional capital as allocations that are at least 5–10% of a fund, and not pilot checks that some institutional LPs deploy for relationship building or optionality).

Before we get into the current market and the considerations going forward to become institutional, we believe there are three broad emerging manager segments:

Late seed/Series A ($75MM+)

- Post-seed/Series A round lead investor

- 2–3 partners

- LP base that is largely institutional (70%+)

- Scaling in fund size often planned for subsequent funds

Institutional Seed ($25MM-$75MM)

- Lead rounds across seed spectrum (pre-seed — post-seed)

- 1–3 partners

- LP base mix of institutional investors and non-institutional (With the former being a larger component for funds at the top end of this range)

Co-invest seed ($0–25MM)

- Typically act as co-investor (versus lead) in majority of deals

- “Proof of concept” funds (particular with funds <$15MM)

- LP base primarily High Net Worth and Family Office

The chart below illustrates the number of first time funds raised over the last few years, segmented by size.

A few quick observations:

- Clear escalation in the number of $0–25MM funds, thus increasing the size of the top end of the funnel for firms that are or will be soon looking to toward institutional capital.

- The chart doesn’t capture the fact that many first time funds in the $0–25MM segment were unable to institutionalize in their 2nd Fund, and will be seeking to do so with Fund III. This adds to the backlog of firms looking to move down the aforementioned funnel.

- Mark-ups for early funds are simply not carrying the same level of weight as they did prior to 2015, particularly for funds that do not routinely act as lead investor.

- With the maturation of the emerging VC landscape, the number of institutional LPs actively building emerging manager portfolios has dwindled, with many LPs eschewing newer managers in favor of backing existing portfolio emerging manager investments, or choosing to go downstream toward new Series A entrants (typically led by experienced investors that have spun out of legacy firms with attributable track records).

- While impossible to predict with any accuracy, it stands to reason that a market disruption will occur in a way that affects limited partner appetite into illiquid asset categories. Family office and high net worth capital often disappears during times of economic distress.

With that being said, we expect that a large contingent of “non-institutional” managers will be able to successfully traverse the path toward becoming institutional. While fund performance will be the ultimate litmus test, there are some considerations that those in this segment should consider.

Investment model

As referenced earlier, while early portfolio mark-ups are helpful and evidence portfolio quality to a degree, it’s not the most important measure for sophisticated LPs. This is especially true today where the axiom that a rising tide lifts all boats rings true.

Currently, the majority of proof of concept seed funds we see do not lead deals, and rather serve as helpful co-investors to another lead (as mentioned in a previous post, the average institutional seed round has over 5 seed fund participants!).

For institutional LPs, this makes for a tough assessment of manager investment judgement as it’s difficult to determine A) the degree of company and business model diligence versus syndicate diligence and B) whether the firm will able to scale checks in hotly contested opportunities as fund size grows. Typically, many small funds can access interesting deals at $100K-$350K as a function of strong co-investor relationships and a moderate degree of complimentary value add. Writing a check that represents half of a round or more requires either non-consensus conviction investing, or extremely definable value add that allows for winning in the most competitive deals. Both of these are difficult to evidence if the core strategy is co-investing with small checks (there are exceptions to this in cases where there is a VERY definitive and clear sourcing advantage)

This question of whether a manager can scale effectively becomes even more relevant if you ascribe to the notion that as many seed funds grow and capital continues to concentrate into fewer companies, we will presumably shift into a sharper elbowed seed environment (today it is decidedly much more about collaboration and “co-opetition”). As such, these questions should be answerable prior to truly attracting institutional capital.

Operating model

One of the key traits of a well-run institutional firm is a robust operating model. Developing this well in advance of raising institutional capital is important. Here are some questions that should be addressed early:

- How strong is the firm’s operating infrastructure (audit/tax, accounting, banking, insurance, and legal)? Resist the urge to go quickly out of convenience and time limitations. Instead be deliberate in this process with a lean toward fit and ability to scale.

- What is the firm’s distinct differentiation/advantage? This must be clear, and structured. While anecdotes certainly have a place in the sales process, the firm’s differentiated founder value add should be as “productized” as possible to ensure consistency of service model.

- Are the firm’s core values and mission clear?

- Is the team construction (or anticipated construction) conducive to long term scale?

- Have the appropriate processes and systems been implemented to ensure consistency around sourcing, portfolio construction, and portfolio company management? This needn’t be overly prescriptive, but a complete absence of structure erodes confidence that the firm has the DNA to be a consistent alpha performer.

- Is it clear how investment decisions are made, from initial meeting to close?

The next few years should be interesting in determining the shape and scale of the venture landscape. Thinking through what it means to become a durable firm is something that should be done prior to the first fundraising meeting.