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Although I’ve never raised a venture fund myself, I can claim having worked closely with managers on nearly 200 fund raises over the past 5+ years. These raises, coinciding with the incredible growth of new venture firms over the past 6 years, primarily relate to those in the Micro-VC sector (firms focused primarily on seed stage investing with fund sizes <$100MM).
Using data from Preqin, the table below shows the yearly activity of sub-$100MM US funds over the past 5.5 years. Note that the data includes sub-$100MM fundraises for all funds, not just initial funds (i.e. Fund III’s would be included if they fall within the parameters of <$100MM and US).
As the market has grown and evolved for new venture firms during this time, so has the temperature and characteristics of the emerging manager fundraising market.
Headwinds and tailwinds exist today for hopeful emerging ventures managers. Despite the low yield economy and obvious ubiquity of technology, new managers face an increasingly saturated field, a weak liquidity environment, general fears of an economic downturn, and recently the highlighting of poor behavior by peers. Overall, the degree of difficulty of raising a Micro-VC fund is unquestionably higher than it was a several years ago.
To provide some context on that statement, here are a few of my observations and thoughts about the current fundraising market:
The length of fundraising cycle isn’t getting any shorter. In 2014, the average fundraising cycle from start to final close for a Micro-VC manager was 12 months. Today, the average fundraising cycle is closer to 18 months, and managers raising their first ever institutional fund should budget 1.5–2 years to raise their fund.
There lies a large distinction for LP’s between new managers raising a first fund and experienced managers that have spun out from other venture firms. For first time managers with no prior institutional investing experience, the following should be expected:
- Absent a long relationship with institutional- grade capital providers, a fund size of $10MM-$25MM (perhaps slightly more if multiple partners) is likely. Aiming for a $50MM+ target is ambitious and is something we’ve only seen a few first time managers reach.
- An LP base that is likely to be made up entirely of family offices and High Net Worth individuals. With the growth in first time funds since 2012, institutional LP’s have significantly raised their bars for allocations, and are very unlikely to invest in in managers that don’t have prior strong and attributable track records.
- Higher emphasis on authentic differentiation. I’d like to underscore the word authentic as the differentiation must stronger than general marketing speak and should precisely and logically convey the firm’s advantage in sourcing and winning deals. Judgement and picking acumen are obviously incredibly important, but when fundraising as a first time manager, this is impossible to measure (as a side note, it’s difficult even with managers that have 10 years of experience as the attribution at large firms is notoriously opaque, and it’s tough to separate skill from luck).
Managers that are forced to raise funds of <$20MM (or “Nano-funds”) shouldn’t assume that a few portfolio mark-ups will translate to a larger 2nd fund with institutional backers. Today, LP’s are discounting mark-ups and many managers that were anticipating a big step-up in size from their first fund are encountering challenges. It’s not difficult to understand why either — the liquidity cycle for seed funds is very long and demonstrating real traction in the typical 2–3 year period between funds is inherently tough. As such, new Nano-fund managers likely will have to raise multiple smaller funds before institutional LP’s pony up. To help mitigate this a bit, GP’s should constantly be in fundraising mode, even between fundraising cycles and in truth, many LP’s require that they know GP’s for years before allocating.
Avoid making simple mistakes when setting a target fund size. Too often, I hear managers express something along the lines of, “I spoke to pension fund X or endowment Y, and they said the fund has to be $XXMM to be interesting to them, so that’s where I’m setting the target”. Of course, just because a LP expresses to you what their economic model requires, it doesn’t mean A) they are going to commit to you if you set that target B) it is the right target for your investment thesis, or C) that is even reasonable given where the market it your profile.
Keep in mind that you may not raise your full target in a single closing. Many first time funds hold 2–5 closes during a single fund raise (I’ve seen 6+ closes on several occasions!). In general, to avoid negative signaling for further closes, it’s prudent to have a first close that is a minimum of 35–40% of the stated target.
Starting a firm or raising a fund? When raising institutional capital, many managers make the mistake of pitching a fund but not enough time pitching (or thinking about) the long term vision of the firm. A primary driver for institutional investors investing in emerging funds is not only getting a good fund return now, but to reserve a seat at the table of what is hoped to be the next great venture franchise. Thinking about why your firm has an enduring advantage along with the plan for growth/scale needs to be a critical part of planning.
What about placement agents? Frankly, most placement agents won’t take on funds smaller than $100MM given sub-optimal economics (the time spent on raising a small fund is as long as and often longer than a large established fund). But even if a placement agent were willing, it doesn’t mean one should be used. The foundation for a trusted relationship between GPs and LPs is usually set during the fundraise itself — Outsourcing this is a mistake. Additionally, as a manager, being able to convey an inspiring message about your firm to LPs is indicative of how effective you will be in communicating with entrepreneurs.
LPs generally have little motivation in being first movers in a fund and solving for this is difficult. It’s much more comfortable for an LP to wait and observe the momentum of a given fundraise, see who else is participating, and know that enough capital will be raised to execute on a strategy. There are many LPs that won’t allocate to funds that are less than 60% already committed. In order to defend against this, I’ve seen many managers either offer economic incentives to early committers or manufacture scarcity/urgency through “creative” marketing of how much interest they actually have. While these techniques may work at times, I generally caution against them as they often create bad signaling and offer up the potential for loss of credibility.
Picking a partner. Effective partnerships can be attractive to LPs, as they offer bench strength, diversity of though, a path to scale, and a reduction in obvious risks associated with sole GP’s. However as history has suggested in venture, the dynamics of multiple partners in a fund can be tough to manage singularity of vision and values doesn’t exist. Keep in mind that the average marriage in the US is 8.2 years while the average seed fund will be 14+ years! Pick a partner wisely, and carefully. In general, I’d counsel managers not partner with someone unless they’ve worked with and/or invested with that individual for some period of significance.
At the risk of being painfully obvious, fundraising is really hard (and frustrating). But for those raising Micro funds today, some solace should be taken by the fact that despite a higher bar, there still exists substantial capital from active allocators. From where we sit, we are expecting the number of new sub-$100MM funds to equal or surpass last year’s total of 136.
Finally as I’ve expressed many times previously, while the idea of being a VC certainly can sound compelling, the work that goes into starting a firm and staying relevant is much, much more than just working with entrepreneurs and making investments.