We discussed recently the question whether small venture capital funds could become viable businesses. We provided a few specific steps that fund managers might consider to maximize their potential for success.
In this article, we turn to the critical issue of investments to be made by the manager of a “micro” VC fund. Good luck can certainly lead to a great fund (and the opportunity to raise larger amounts of capital in subsequent investment funds); there clearly are some investors (or dart throwers) who in the past few years invested early in what became decacorns (including Uber and Airbnb) and are managing larger pools of capital as a result. But luck is not a solid basis for growing a sustainable venture capital business. To the contrary, we share in this article certain observed patterns among successful micro VC managers.
We begin at the beginning: there is an overarching need to develop an enormous pipeline of potential companies for investment. In our experience, seasoned managers are extremely disciplined when deploying capital and typically invest capital in only one to four out of every one hundred early-stage companies that are under review. A micro VC fund manager could anticipate making initial investments in twenty-five businesses in one fund, thus implying a pipeline of 1000 to 2500 companies to be screened during the five-year commitment period.
Those micro VC managers seeking to grow a real business therefore need to have viable strategies and systems in place to generate this volume of deal flow. One threshold question may be the size of the internal organization; we most frequently see two or more investment professionals for micro VC funds (there are occasionally successful venture funds with only one person, but that individual must be enormously talented to succeed).
We have seen talented managers who have developed a specific geographic, thematic, or sector-based investing niche. The deeper a fund manager focuses on a certain industry segment, the more established the reputation and knowledge in that specific sector and, therefore, the greater the access to potential investments. For example, Urban Innovation Fund has succeeded by focusing exclusively on startups developing solutions related to urban life. Others have developed deep domain knowledge in fintech, ag tech, or life sciences companies. Expertise may come from a manager’s education or work experiences before becoming a fund manager. Some micro VC managers might even target one specific networking or pitch event, such as Y Combinator’s semi-annual “Demo Day.”
Focusing on a specific sector or geographic region may provide better access to resources and experts in that market or industry segment. This practice might also limit the amount of expenses devoted to travel; a heavy travel budget can quickly cut into a manager’s limited management fees.
A micro VC manager may consider developing a well-networked group of investment advisors who have significant operations experience or specific expertise in investment sectors or themes. Friends and colleagues with industry knowledge may be willing to serve as advisors and consultants. They can be compensated with a carried interest linked to companies where their expertise has driven real value, instead of a salary that crimps the management fee stream.
Assuming that a robust deal pipeline can be constructed of high quality businesses, the micro VC fund manager then needs to put capital to work. This may be a challenge too; many startup businesses have financing rounds that are oversubscribed and have the luxury of picking their investors. In our experience, thoughtful managers of smaller funds need to make compelling cases in competitive situations.
Successful micro VC managers recognize the reality of the competition. They do thorough diligence, but on an expedited basis, and offer to fund quickly. They are easy to deal with on documentation as well, executing standard SAFEs and convertible notes without substantive negotiation. These investors also have capital in reserve for follow-on investments (and may have the ability to raise co-investment fund capital for particular investments).
In our experience, these micro VC fund managers also offer to contribute resources beyond the financing. Such managers offer to devote attention, energy, and resources to assist the founders of a startup business, and they are proactive in thinking how to drive value. The specifics vary based on the startup’s needs but may include customer introductions and internal recruitment.
Ambitious micro VC managers also look to team with larger venture capital funds. That may be valuable to the larger fund (when startup companies are looking to diversify their investor base). As with generating deal flow, the successfully executed strategy with larger, more established funds results from hard work by the micro VC fund manager who can prove that value is being created through the business relationship.
We recognize the significant challenges and hurdles but believe that a robust pipeline is critical to generating investment opportunities that put the micro VC fund manager in a position to succeed.
By Murray A. Indick and Ryan Conner, Morrison & Foerster