Micro-VC, strictly by the numbers

Follow me @samirkaji for my random, sometimes relevant thoughts on the world of early stage venture and start-ups.

In my last post, I described the icy fundraising market as it relates to emerging venture fund managers that are seeking capital for the first time. While I recognized that the post was particularly discouraging for aspiring venture fund managers, I also noted the several friendly tailwinds that may result in thawing of the fundraising market in the quarters ahead.

To step away from the editorial, I want to use this post to drill down further into current data of the Micro-VC landscape. Quick note: I’ll use the term Micro-VC interchangeable with seed stage funds, and am using the hard parameter to define both as funds that are only sub-$100MM in size (While there may be a few exceptions, I have a difficult time believing firms raising funds greater than $100MM are truly long term seed focused).

The chart below provides an illustration of the aggregate number of sub-$100MM seed stage funds that have been raised per year from 2009–2018. Note that this data captures only sub-$100MM funds that are fully closed, but includes all funds irrespective to fund roman numeral.

Aggregate Micro-VC funds and commitments closed by year

By way of the chart below, it is evident that the average Micro-VC fund size has stayed relatively flat (albeit a definitive bump in 2017; 2018 is too early to be statistically significant).

This may be surprising for many, and looking deeper, the average fund size metric doesn’t tell the entire story. While average fund size is fairly flat, it’s necessary to add a dimension and consider standard deviation. In 2012, the standard deviation of fund size for Micro-VC’s was <26 while the standard deviation in 2017 was 32 (it’s been rising every year). This can be most likely attributed to two major drivers:

1) The continued increase in fund sizes for follow-on funds as managers that have shown favorable metrics of early performance have increased fund sizes, sometimes dramatically, to both increase initial ownership and fund deeper into portfolio companies capital stack (often through a Series B). Of course, larger fund sizes also create migration to investing later in the seed stack as portfolio construction dynamics unequivocally shift with rising fund sizes.

2) New fund managers without ostensible track records must settle for raising smaller proof of concept funds (“fund zero’s”) in order to demonstrate execution needed for institutional capital.

Further evidencing point #1 is the table below that illustrates that median fund size increase from Fund I to Fund 3 is >2.0X.

Next, let’s examine what really matters at the end of the day — return performance.

The return performance of seed stage venture funds is shown in the chart below. The normal caveat for venture performance is that sample sizes, while often statistically significant, are small relative to the population.

As expected, the return characteristics of Micro-VC funds closely mirror the broader venture market, as there is a wide delta between top and bottom quartile performance. As originally hypothesized in the Kauffman Study of 2012, and since been repeated by nearly every small fund manager, the numbers for top performing small funds continue to stack up positively to the returns of much broader venture fund market which include all fund sizes.

While I think this will continue to be the case, expectations should be tempered for the current environment as seed stage funds that started in 2009–2012 (or before) enjoyed a much more favorable valuation and competitive environment.

Additionally, IRR’s for seed funds are often significantly buoyed in early years during strong economic times when the step up in valuations in Series A/B rounds creates robust mark-ups. A significant and prolonged market reset poses a serious threat for seed funds, particularly smaller ones that don’t have funding capacity to maintain pro-rata positions.

As we continue to track this sector very closely, we’re eager to see how the next few quarters play out in a seed fund space that continues to evolve and grow daily.

Thanks to @hanayang for the charts and @pitchbook for the data.