This is a build off my last post which was a primer on the Micro VC market.
Often, I hear investors talk about companies that are “venture scale”. These are usually the kinds of companies that have the potential to drive meaningful returns for a top VC fund. Because of the high risk of early stage companies, the performance of large funds are driven by discontinuous returns (ie: the home runs).
As a result, I think that most early stage VC’s tend to look at a similar profile of investment – big market, proven teams, potential for an outcome in the hundreds of millions or more, but realistically low probability that that outcome will be achieved.
In comparison, Micro-VC economics allow them to do quite well in investments in companies that exit at a much more “modest” scale, assuming the company is not over-capitalized. But this leads to an interesting question: Are Micro-VC’s pursuing the same companies as traditional VC’s, just at an earlier stage? Or are they pursuing a fundamentally different profile of company?
Strategy 1: Pre VC Companies
I think the majority of micro-VC’s and Super Angels are pursuing this approach. They do indeed preserve optionality for a modest outcome, but their hope in the vast majority of investments is that the company can emerge as a “Thunder Lizard”.
The strength of this strategy is that the micro-VC’s can get access to great investments because of the reasons discussed in my post and by others. Seed investors are able to get in earlier, and thus, their initial cost basis is lower. Their mortality on investments remains high, and they are counting on big winners to drive the bulk of returns.
The downside of this is that micro-VC’s have financial and strategic reasons not to defend their ownership over time. Thus, initial cost basis is not the only consideration. One should factor in the impact of dilution over time, the risk of being lower on the cap table in subsequent rounds, etc.
The assumption for a micro-VC is that they will accept the downside of these risks because they believe they will get better access to great companies and minimize the risk of pouring good money after bad. Plus, they can still enjoy a fund returning exit even if they do get diluted over time into single-digit ownership.
Strategy 2: Capital Efficient Wins
The other strategy is to invest in companies that are not likely to ever get to venture scale. However, these companies might require relatively little capital to get to profitability and/or to get to a scale that makes it a must-buy for multiple acquirers.
The strength of this strategy is that this is a completely under-served market. I always contend that the #2 reason VC’s pass is because companies can’t get “big enough”, even if they believe that the company is likely to do quite well and generate a return on their investment.
How big is big enough? My rule of thumb is that it’s roughly the same size as the fund one is pitching to, since they are all targeting >15% ownership and I’d consider a return of >15% of a fund “meaningful”.
The vast majority of top tier funds have fund sizes in excess of $100M. Therefore, there is a dearth of really excellent investors that will invest in companies that are 80% likely to be sub $100M exits, even if the probability of a money-making outcome is very high. This presents an opportunity for an investor to target this class of company where there is less competition, and possibly many companies that can generate great risk-adjusted returns.
The downside of this strategy is that it’s unclear how much risk there is in these sorts of businesses. Can one make a living investing in early stage companies and have a high enough hit rate that you don’t need a Thunder Lizard to drive excellent returns? Also, because there is a shortage of investors in this space, there is a dearth of co-investment partners and follow-on investors for these companies, leaving the investor (and the entrepreneurs) exposed to significant financing risk.
By the way, I think there is an interesting potential angle for firms that act as small-scale growth equity investors in capital efficient wins. One or two groups come to mind, but I think there are relatively few out there specifically pursuing this strategy.
What’s the Answer?
As with many elements of the micro-VC model, it’s too soon to tell what path will lead to the greatest success over time. If a Micro-VC is investing in all venture scale companies, I think LP’s might feel like they already have access to these companies through large VC’s (albeit at a higher cost basis). But if a Micro-VC is investing mostly in capital efficient wins, it might be hard to convince their investors that this market will behave differently from traditional venture which relies on the massive hits to drive returns.
My personal view is “all of the above”.
Investing in companies that are fundamentally different from the companies VC’s look at could be a very good strategy. It’s much less competitive and underserved. The investor just needs to make sure that the risk/reward dynamics are favorable and also know where to go for follow-on capital.
But most companies are not clearly venture or non-venture scale. Great companies of the future often look like dinky toys to most. The micro-VC model is great for this, because it allows the investor to participate when there is an uncertainly of outcomes and make the decision of venture-scale vs. capital-efficient win with more data and the ability to make good money in either outcome.
One recent example that comes to mind is Tapulous which was acquired by Disney a week ago. There are very good reasons why a company like this could achieve venture scale, but others might reasonably say “it’s a small iphone app company” (despite its 35M+ users). Great super angels like Jeff Clavier invested in the seed round and did quite well. I suspect the company could have raised venture money, but accepting Disney’s offer was probably a very good outcome that both the entrepreneurs and investors are very happy about.