My friend Fred recently authored a post titled The Expanding Birthrate of Web Startups, raising an issue that weighs on my mind daily: how to support seed stage investments throughout the investment life cycle. Here is an extract from his provocative and insightful piece:
The VCs I talk to who have been doing this for 25 years or longer aren’t so much worried about the “dipshit companies” (as if there were such a thing). They are worried about the entry of so many new investors with relatively small funds birthing so many companies. These veterans may not be as connected to the latest web startup, but they sure are connected to the realities of the venture capital business. They’ve lived through it and they know what is involved with getting a company all the way to profitability and exit.
The venture capital business is contracting. There are less VC funds than there were a few years ago. And there will be fewer in a few more years. And the birthrate of web startups is expanding. That is the challenge we all face.
So, if you are an entrepreneur you should be very focused on either getting to profitability or getting a VC firm or two with deep pockets into your company (or both). If you are a seed investor, don’t go quite so fast. Reserve some funds for follow on investments. And help your portfolio companies get to profitability or get a VC firm or two with deep pockets into your company.
I think this expanding birthrate is a great thing. Entrepreneurship is alive and well all around the world. Smart and scrappy entrepreneurs are imaging new products and services and building them. But we all should be careful to think about how we are going to fund all of this company creation. Not just the first part of it, but all of it.
One of the biggest issues I have as a small venture fund is how to reserve for follow-on investments. While some have strategies of making extremely large numbers of small investments and following on in none or very few, IA Ventures’ strategy is a much more traditional “lean hard into winners” approach (albeit with extreme domain focus); the dollars required to validate the technology and business model are (relatively) small, leading to quick and informed decisions concerning follow-on investment. When our capital and participation has helped de-risk a business to the point where it is appropriate to follow on and finance growth, we want to step up to do our pro rata and beyond. This makes the reserve policy question extremely important, especially when the resources at our disposal are small compared to a larger funds with whom I work every day such as True, First Round and Flybridge. In short, we can’t do it alone. And pure angel syndicates often suffer from a lack of leadership, which isn’t a problem until there is a problem. Who will step up and take the lead if the company needs more time to hit key milestones? It’s not merely an issue of deep pockets but of leadership, structure and experience. Fred articulated a concern that has been bubbling around in my mind, and I penned the following comment to his post:
fred, you’ve clearly raised a very powerful and important issue. mark (suster) and josh’s (stylman) comments both strongly resonate with me. to me the issue is one of the seed funding business model.
as mark accurately stated, there is a lot of (traditional) vc-bashing going on. while some of it is warranted, some of it is not. my fund, ia ventures, regularly partners with larger funds on seed deals, fears about signaling aside. i personally feel the signaling issue of larger funds investing in seed deals to be overblown, as in my experience high-quality firms make high-quality decisions that generally reflect the risks and rewards of the company.
while running a seed fund, we are focused on appropriate reserves to be able to follow on, but clearly acknowledge that other syndicate members (with deeper pockets) will need to participate if an inside round to buy more time is warranted. many other seed funds have chosen to invest small amounts in many deals and to avoid reserving for follow-ons. this is certainly one person’s valid business model but it isn’t mine. what happens to those syndicates where there aren’t deep-pocked funding sources at the table (and more time is needed for the company to hit key milestones) is a worry to me as well. angel syndicates are great and can add lots of value. i spent the better part of six years leading and participating in such syndicates. but as i’ve matured as a seed stage investor i’ve come to embrace larger fund partners as a constructive way of helping to address the follow-on/bridge problem as well as having another smart and engage set of partners as part of the syndicate.
i’ve written about ia ventures’ asset allocation model, and believe it to be a right and valid approach, at least for me. 20-25 deals, a mix of incubation, smaller “opportunistic” positions and larger “concentrated” (more classic VC-type) positions. this likely requires $20mm or so to minimally prosecute properly. however, additional value can be created by moving from $20-$40mm. would this money go into new deals? no - it would simply represent additional reserves from which to follow on. i firmly believe that the life cycle approach to investing is the right approach to maximize ROI, build strong and lasting entrepreneur relationships and to be “in the market” at the time maximum value is being created. but after so much de-risking has been done at the seed stage of the deal, wouldn’t it be great to have additional reserves to lean heavily into winners and to increase stakes when opportunities present themselves? indeed it would.
So to answer the question: Can Micro VC Go the Distance? Yes, but not by itself. It needs larger partners to help support growth further along the investment life cycle. It doesn’t need to be a we/they relationship between Micro VCs and larger VCs. It can, and should, be a collaborative and mutually beneficial relationship that ultimately inures to the benefit of the entrepreneur and the company. And that’s kind of the whole point.