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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. 

I’ve both given and received the feedback that a product or pitch isn’t “different enough”.

It’s challenging feedback to receive because it’s completely open ended.  You doesn’t necessarily know what it would mean to be different, but you know it when you see it.

It can be very very subtle elements that make a product different.  When someone first hears about Tumblr or Posterous, the response is probably something like “how is that really any different from Wordpress or Blogger?”.  But the minute you use the product, something clicks and you realize that you are dealing with something different.

Difference also has many imitators.  Groupon’s unsubscribe page has a very different sort of “sorry to see you go” message (I think it reflects on the creativity of the team and culture of the company too).  But even that concept has been ripped off (as well as many other elements of their business). 

Another simple example is VC firm websites.  First Round Capital was very different when they introduced a real-time feed as the core of their site.  As for the imitators… it’s not bad to adopt best practices, it’s just not unique.  Interestingly, amidst the many VC websites moving towards highlighting real-time streams and lots of multi-media, a16z was unveiled and is completely different.  

The problem with difference is that’s it’s hard to manufacture.  It must be authentic, or it’s just cheap.  My partners and I have been thinking about how to position NextView differently.  One friend calls us “sexy guys doing sexy deals” (: And although that’s very flattering (or maybe not), I’m not sure that sentiment reflects our personalities. 

So today, I’m thinking about a story I read in the book “Different” written by one of the more popular profs at HBS. In this vignette, the author recalls a time in High School when the students were tasked with the assignment of taking a day and doing whatever they wanted (within reason) to express who they really were.

Most people came to school wearing crazy clothes, or doing weird activities that highlighted their favorite hobbies.  They were acting unconventionally, but almost all in a strangely similar way. 

But the person that stood out the most did none of these.  He didn’t do anything flashy or outlandish, but did something incredibly sincere and also truly different.

What did he do?  You have to read the book :) 

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 Capital, Floodgate, Lowercase, Founder Collective, IA Venture Partners, Harrison 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.  

One of the things I have the privilege to do outside of work is serve on the board of an Christian church in Brookline called Highrock. The church was founded less than 2 years ago, and it’s been a pleasure watching this “startup” develop.

I’ve also been able to see the operations of a few other non profits over the years. Many are well run by unbelievably talented and inspirational people. But there are a few best practices I’ve seen that I think could be very helpful, especially for startup non-profits. These seem like common sense (especially for folks who have worked in well managed businesses), but it’s easy for all of us to let basic principles slip.

1. Be Very Careful About Hiring Your Friends. 

 Starting anything is an intimidating endeavor, and it’s hard to do it alone. When building an early team, it’s very tempting to draw from your friends, especially since they are likely to share similar passions and have social chemistry with you. As a general rule however, I think it’s very very dangerous to work with or hire friends. Working with friends makes it very difficult to be objective and to give and receive feedback. It’s comfortable when things go well, but much more complicated when things go wrong (and all startups face major obstacles along the way). I think that team building should always be about determining what are the most important jobs to be done, and finding the best people possible to get those jobs done. In a world of limited resources, team decisions are very precious and hard to reverse, so before hiring a friend, be very sure you’ve determined objectively that he/she is the best person for for the job.

2. Establish a Culture and Process Around Performance and Accountability

Starting a non-profit often feels like a thankless job.  One of love and sacrifice.  As a result, I think leaders are often reluctant to institute basic management processes around performance and accountability.  I think this is a mistake.  Most workers do best with some level of structure around strategic priorities, measurable objectives, and specific feedback.  These practices not only result in higher performance, but usually in a more harmonious team.  A couple very simple things that I recommend:

a. Establish mid-term priorities for each person (6 months - 1 year).  Limit these priorities to fewer than 5. Make it crystal clear how these priorities tie to the top priorities for the non-profit as a whole. 

b. Create measurable goals as much as possible.  Measurable goals create accountability, and allows you to track progress along the way.  I find that people tend to get uncomfortable when there is a number tied to their work.  But that’s the point.  I wouldn’t be religious about “hitting numbers”, but I would make sure to track progress towards goals and have an ongoing discussion about why the person is tracking ahead or behind.

c. Establish weekly 1:1’s.  Pretty standard practice in companies.  Meet with team members 1:1 to troubleshoot, provide feedback, and make sure that everyday activities are building up to the mid-term priorities.  It also gives a team member air time to give you feedback on your leadership and the direction of the enterprise. 

d. Give feedback. It’s important to be very straightforward about both exceptional and sub-par performance.  The structures above probably give you enough opportunity for rapid feedback, but if not, carve out some time to do this.  There are lots of different ways to do this (and a lot of ways to waste time doing this). Doing a drawn out annual review is probably a mistake, but figure out what works well for your team and don’t avoid difficult conversations.  The earlier and more direct the feedback, the better. 

3. Be Diligent and Conservative about Budgeting and Planning

All startups are capital constrained and non-profits even more so.  Funding sources may be fickle with very limited long term visibility.  This would be a hard operating environment for anyone, but to make matters worse, managing an effective budget often does not match the skill-set of the founders.  My recommendation in this case is to establish some sort of an advisory board and make sure there someone with real P&L experience commits to helping the team with budgeting and planning. This person is not supposed to be a bookeeper, but someone to talk to about major purchases/hires, income forecasting, cash management, establishing a sound budgeting process, etc.  Don’t let your board members treat their participation as a token good deed of the quarter.  Give them assignments, and make budgeting and planning a major responsibility for at least one of your board members.  

A lot of folks start their fundraising efforts by targeting their first choice prospect and working down the list.  It’s instinctively the most natural thing to do. 

But unless you are a really good fundraiser and know that the process will be a slam dunk, I think this is exactly the wrong approach. 

Practice makes perfect, and fundraising is no different.

Fundraising unfortunately is as much about how well you tell your story as it is about the content.  And most people only get better at telling their story the more times they do it.

You also can iterate along the way and figure out how to best communicate yourself in a way that is enticing to your audience.  This also requires market testing and can’t be done in a vacuum. 

Instead, I’d recommend actually starting the fundraising process by targeting folks in the middle of your prospect list, or even guys who you know will give you real feedback but are long shots.  It hurts to hear no early on, but it’s important to practice and battle test your pitch when there is little on the line. 

I wouldn’t do this too much, or your story will get stale in the market.  But I think you definitely shouldn’t walk into a meeting with your favorite VC and give your pitch for the first time.  Get your story straight, know the questions you are likely to get and prepare for them, and even create some heat around the investment by getting one or two others excited first.

Quick post today that came to me on the subway.  During my time in Venture Capital, I was surprised to see how many “rules” there are that have become gospel in the industry.  At the same time, I was surprised how little convincing evidence there was behind these rules aside from common industry wisdom. 

But markets and businesses all change, and venture capital is no different. Rules change, and players that fail to adapt become obsolete.  I remember when guys like Union Square Ventures and First Round Capital starting breaking some typical VC rules, I heard folks at other firms voice a bunch of criticisms that seem pretty silly in retrospect. 

The funny thing is that when everyone plays by the same rules, it creates market opportunities for those who can figure out how to defy the rules and do so intelligently.  It’s just supply and demand.  

Below are a couple “rules” that I think are worth breaking:

1. “We only invest in consumer companies that have a live product and traction”. 

Ok, this is actually a relatively new rule brought on by the capital efficiency of internet businesses.  But I think investors have swung a bit too far in this direction.  This rule basically means that you will only invest in a) things that are really on fire and you have to pay way up for and/or b) things that have traction but have no obvious business model. It’s a strategy that has worked for some.  But I think that this tends to disqualify some really ambitious products that just can’t be launched without meaningful investment.  Also, “traction” doesn’t just mean a lot of users. I’m usually much more impressed with a company with few users but really interesting unit-level metrics vs. something of more scale that could just be a flash in the pan. Finally, I think that some of the risk of investing in something pre-product is reduced by backing a team with a really good product process suited to the discovery phase of the business.  Oh, and a good early stage investor should be perfectly comfortable and helpful in implementing this process. 

I like how one angel investor described their focus on Venturehacks: “Strong preference for pre-product teams led by product-minded folks”. Refreshing. 

2. We only invest in companies going after billion dollar opportunities. 

I’ve blogged about this one before. I have two thoughts here.  First, at the early stage, investors honestly have no clue about whether a company has billion dollar potential.  What look like dinky toys to some can turn out to be monster companies, especially when the company is inventing markets, not capturing share of existing markets.

Second, the fact that most VC’s are going after companies of this scale (which they need to given their fund sizes) it says to me that there is a funding inefficiency for companies that can exit comfortably and capital efficiently at sub $100M levels.  By the way, this is where the bulk of M&A activity happens.

In my view, because of my first point, quite a few companies that may seem to be mid-sized exits might actually turn out to be venture scale.  Also, there may be some really interesting market segments out there that no investor is spending time in because it doesn’t meet this threshold (but perhaps reliably churns out mid-sized exits with reasonable risk).  

And by the way, since when was a $50M exit considered “small”? That’s pretty darn good for an entrepreneur, and will free them up to make a huge swing next time.