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Although I spend most of my days closely tracking the emerging venture capital market, I almost fell of my chair when I came across a report from Prequin that noted that nearly 500 first time Micro-VC funds were currently in the market (the vast majority being US based).
If only half of these managers are successful in closing a fund, we’d still have 600+ active Micro-VC firms globally, with over 80% having been formed post-2009.
A couple of years ago, I projected a mass consolidation of the market by 2020. While still likely, it’s become evident that the number of active Micro-VC funds in 2020 will be far above the 50 or so I had projected.
Based on the responses from my tweet, it appears that many venture insiders were equally as shocked.
As a refresher, Micro-VC firms are venture firms that typically have the following characteristics:
- The super majority of fund investments are pre-Series A (somewhere within whatever is called seed today).
- Invest on behalf of 3rd party Limited Partners.
- Most commonly have fund sizes that are sub-$100MM.
From a general partner perspective, Micro-VC funds are typically raised by individuals from 1 of these 3 profiles (note in some cases, individuals/teams have a combination of the below).
1. Individuals spinning off from other firms
2. Former operators/entrepreneurs
3. Successful angel investors
Let’s examine some of the trends we’re seeing today:
Jump in “mini Micro-VC” firms
An important nuance when thinking about new Micro-VC firms is distinguishing the difference between a “first time fund” and a “first time manager”. A first time fund represents a firm with a Fund I offering, but has at least one partner that has worked at an institutional venture firm in the past. A first time manager is a new firm with a Fund I offering where none of the partners have had significant experience working at a venture firm (or if they did, it was in a pre-partner/principal role).
For most firms that fall into the first time manager bucket, attracting institutional or semi-institutional capital is an incredibly difficult endeavor. As such, these managers must primarily rely on High Net Worth individuals and small family offices in their network to back them. Given the small dollar sizes generally allocated by these types of Limited Partners, most of these managers raise funds in the sub-$15MM range.
I generally view these funds as “proof of concept” funds or “Fund 0”. The plan for these firms is to raise a small first fund and then scale fund size starting with the next fund after some execution is shown. A couple of years ago this plan happened regularly as scheduled, but with the sheer numbers of managers vying for investor capital and the difficulty of accurately projecting early fund performance, many Micro-VC managers will have to wait until their 3rd fund to raise significant capital — that is if they can get there (the execution bar for institutional investors is already high, and will just get higher). The tweet by Homebrew’s Hunter Walk accurately describes the above.
2/ Institutional investor sentiment
The foundation of venture firm sustainability is getting backed by a strong and diversified stable of institutional Limited Partners, typically in the form of foundations, endowments, large family offices, fund of funds, and in the case of bigger venture firms, pension funds. We recently hosted a dinner with 12 institutional LP’s who over the past several years had allocated to dozens of Micro-VC funds. Here are some of the takeaways from that dinner:
- Not surprisingly, everyone agreed that there are too many Micro-VC firms today. The exercise of finding that diamond in the rough is similar to trying to hit a bulls-eye on a dartboard that has shrunk 80% in size.
- Despite the low yield environment in other asset classes, LP’s have not adjusted their return expectations for venture capital. Micro-VC funds are still expected to yield a minimum 3X net multiple on invested capital, a number that is increasingly tougher to do with a rapidly diluting capital pool.
- For individuals rolling off venture firms to start Micro-VC firms, prior performance attribution must be crystal clear to be given any real credit.
- Expect a longer “dating” period as institutional investors aren’t willing to allocate unless they’ve built a significant trusted relationship with the manager. This is especially in light of some of the publicly discussed partnership issues that have surfaced with young firms over the past 18 months.
3/ Longer fundraising cycles
While edge cases exist of firms that raise funds very quickly (i.e. SaasTr fund), the general trend has been toward longer fundraising cycles.
As a quick exercise, I looked at a sample of 30 first time offerings over the past 2 years, and discovered the following:
For first time managers (no prior institutional venture experience), total time to first close was just under 6 months, with first close being less than 35% of targeted capital. For first time funds, first close was~4 months with the first close being closer to 50% of target capital.
Of course, we must account for the fact that there are certain months during the year (July/August/November/December) that tend to be slow allocation months, but it’s clear extended fundraising cycles and a higher degree of difficulty in reaching fund targets in the new normal. Additionally, a recent Prequin study noted that the average fundraising cycle for Micro-VC’s is over 13 months (with many reaching 18 months).
People often ask me whether the flood of Micro-VC’s represents a net positive event for the industry. While it depends on perspective (great for entrepreneurs, perhaps not as much for LP’s), I think it’s the best “innovation” that has occurred within venture industry since I started covering the industry in 1999. The truth is that the innovation economy is still quite nascent, and Micro-VC’s play a critical role in solving for the funding gap that developed about a decade ago when traditional venture investors started investing later in the life cycles of companies (along with a consolidation in active firms).
And although the number of seed rounds dropped in Q3 2016 to just over 800 seed deals from 1000+/quarter last year, founders should be encouraged to hear that new sources of capital aren’t likely to dry up anytime soon.