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June 29, 2010

For better or worse, Micro-VC’s and Super Angels seem to be the new intriguing sub-segment within Venture Capital.  Funds like First Round CapitalFloodgate, Lowercase, Founder Collective, IA Venture PartnersHarrison Metal, and Felicis and individuals like Ron Conway, Keith Rabois and others show up multiple times a day on TechCrunch and seem to be behind every high profile investment in the internet world. 

How did this happen?  Are these groups just a new fad or is a fundamental and long lasting change happening in the early-stage financing eco-system?  

Here’s a quick primer on this new category of early-stage investor. 

Why Have These Firms Emerged?

  • Capital efficiency. The startup value equation has changed.  Not only is capex increasingly becoming opex, but the plumbing of internet businesses allows for much easier distribution, monetization, and product development.
  • Compensation for risk. Angel capital has always been present.  And some angels have done very well.  But more so than ever before, the value created in the seed round is increasingly being rewarded because companies can launch products, gain traction, and prove micro-level metrics.  Founders and seed investors can now get greater credit for this value creation from the funding marketplace. 
  • Potential for better incentive alignment.  The scale and strategy of these funds provide the potential for much better alignment between the interests of the investor and entrepreneur and even between the investor and their LP’s.  More on the former below. 

Why Micro-VC’s Might be Attractive to Entrepreneurs

  • Flexibility in follow-on financing options. Chris Dixon probably said is best here. Another quick way to think about it:  If you are an A+ company, why wouldn’t you rather have your pick of lots of series A investors who can compete and give you a market driven valuation, terms, and value-add for your hard work?  If you are an A- company, it behooves you to not have one VC hold you captive for the A when a multitude of factors might make them exhibit a less than stellar signal to the outside market. 
  • Outcome flexibility.  Micro-VC’s aren’t playing small-ball, but the model does allow for success in both venture-scale companies as well as capital efficient wins that exit at a more modest scale.  Owning 50% of a $50M outcome is pretty darn good for any entrepreneur.  It’s nice to have an investor who is aligned with you enough to be happy with that exit if it is the best risk-adjusted outcome for a given company.  
  • Willingness to lead.  On the opposite end, it’s challenging to raise money from angels because it requires many meetings with different individuals who might not be comfortable leading a round and setting terms. Micro-VC’s take this leadership role, and often help corral other value-added angels in the round.
  • Access to Great People.  Some of the first and best known Micro-VC’s are simply top notch individuals.  These folks truly understand the challenges of entrepreneurs and can provide practical and hands-on help.  They also come across as much more founder-friendly and accessible than some large VC’s that have lost touch with the current generation of internet founders.  
  • Side Note: This is why some very strong entrepreneurs are turning to this segment for seed stage.  It’s interesting that it isn’t just first time founders that are going this route.  It’s also folks who could credibly raise large A rounds from great VC’s or even self-fund their companies at the early stage. 

Why Micro-VC’s Might NOT be Attractive to Entrepreneurs

  • Limited Capacity: Micro-VC’s have some of the advantages above simply because their funds are limited in size.  Sometimes, a company that is knocking the cover off the ball will want to avoid fundraising altogether (a distraction even for the best companies) and just raise money from insiders to accelerate growth.  Or, if a company is falling behind, it’s nice to know that existing investors can help a company get to a major milestone, rather than try to raise money outside at worse terms. 
  • Brand and Sustainability:  Micro-VC’s are the new, shiny thing today, but the reality is that some of the luster is due more to perception than performance.  It’s still quite early for this segment, and there are still some real questions about the durability of the model.  It may very well be that the great hot firm of today may not be around in 10 years.  There is some significant value for an entrepreneur to have the backing of an excellent firm that has been resilient through multiple economic cycles.  It’s also nice to know that your backer won’t be distracted at some point by the challenge of fundraising themselves, something that many will have to deal with as they become more institutionalized. 

Unknowns About the Model

  • Follow On Investment Strategy.  Best practices haven’t yet emerged, and strategies are all over the board. There is a trade-off between capitalizing on pro-rata rights aggressively and falling into the very same signaling problems of larger VC’s.  There is some talk about working with LP’s to monetize these options for later rounds, but most of those are yet to materialize. 
  • Time/capacity.  The great thing about Micro-VC’s is that the best ones are internet operators.  Guys who can help with product, customer acquisition, strategy, and fundraising.  The bad thing is that the Micro-VC strategy by definition means a higher pace of investments than the typical 2-deal-per-year pace of VC’s.  So something has to give.  You see some teams stretch as their funds grow, others that find a more scaleable way to help companies, and others that have a very finite active period with the companies. 
  • How much is too much? How many players can the market sustain? How many until the dynamic goes from cooperative to cut-throat competitive? How much is too much capital per partner to really be micro?  All open questions that have not yet been tested by the market.  Some VC’s claim that there is a super seed bubble.  Others disagree completely. 
  • Longevity.  How well will this model scale as more partners are added?  Will the founding principals get disinterested or stale in the market over time? Are these folks interested in building firms with lasting value, or funds that will come and go at the whim of the high-profile founder?  Or will these funds just evolve into the large VC funds of the future?  All unknown. 

Whew!  That was a mouthful. Stay tuned for more depth on some or all of these issues in the upcoming weeks. 

Full disclosure, I was previously a Venture Capitalist myself and am a co-founder of NextView, a seed stage investment firm focused on internet enabled innovation.  I tried to present a balanced view of this segment, but obviously I’m voting with my feet.  

  • Author robchogo
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