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What do Admob, CafePress, Aardvark, Polyvore, and Xoopit have in common?  If you said that they were all backed by great VC’s like Sequoia, August, Benchmark, and Accel, you would be correct.  But did you know that they are also all backed by the same seed stage investor as well?

What these companies all have in common is that they are all portfolio companies of Harrison Metal Capital. With 3 exits in 2009 (Admob, Xoopit, and GeoAPI) Harrison Metal is one of the hottest of an emerging category of investors that some call “Micro VC’s”.  Harrison Metal isn’t alone in their success - there is Maples Investments (SolarWinds, ngmoco, Chegg), Founder Collective (Hunch, 20x200, Milo), and probably another dozen or so firms like these that have emerged over the past 5 years.

What these firms all have in common is a fund strategy and size that is both different from and complimentary to traditional VC’s.  Their investment strategy and sub $50M funds are well suited for the increased capital efficiency of certain sectors and the fact that larger VC’s have difficulty deploying capital in $1M chunks. It’s also a very attractive option for entrepreneurs in that it preserves option value. Mike Maples puts is best:

“Smaller up-front investments create a greater range of exit strategies where everyone wins. For example, if a business raises a small amount of initial capital, then exceeds its early milestones and decides to swing for the fences, it can then raise a larger sum at a higher price, while preserving ownership. If the business is not ready for rapid growth, it preserves the option for an exit at around $50 million, while still delivering a high return for investors.  This dual-track model is less available to companies that raise large amounts of money early.”

It should be noted that most of these fund aren’t shooting for mid-sized wins.  But their size allows them to do quite well with mid-sized wins, and it is well suited for consumer internet investments where it’s often very difficult to predict whether a company has the chance to be big enough to produce “venture returns”.

I think these firms are excellent investments (looking from an LP perspective).  Their strategies fit the times and inefficiencies in the market.  They also do wonders for their local entrepreneurial ecosystems by allowing more companies to get shots on goal and providing the help that sophisticated investors can bring.  They are continuing the work that great angel investment pioneers like Ron Conway who helped (and continues to help) great companies emerge.

As an investor at Spark, which currently invests out of a $360M fund, I am very excited about these guys.  Even though we also do seed stage investments, it’s great to be able to call on sophisticated seed investors that can partner with us and add serious value to companies on hiring, product marketing, and strategy.  These funds also bring a lot of excellent deal flow, and give companies great counsel on how to approach VC’ and how to hit the milestones that matter earlier.  This increases the pool of great companies that we have a chance to invest in and gives us greater leverage on the seed investments that we pursue.

UPDATE: Notch up one more exit for Harrison Metal - Google acquired Aardvark for $50M.

VC’s often ask entrepreneurs of early stage companies questions that they can’t realistically answer.  For example:

1. What’s the cost of customer acquisition? (most entrepreneurs have no clue.  Plus, even with early data, this answer can change radically with scale)

2. What will the product look like in 5 years? (Who knows?  Product evolution is rarely linear.  You may be going after a completely different problem in 2 years)

3. What’s the competitive landscape? (who knows what players will emerge?  Who knows what Google/MSFT/Apple will do to suck the air out of your industry?)

4. How will this business scale to millions of users?

As I type this, I’m almost laughing at myself. I think entrepreneurs are understandably annoyed when they get peppered with questions they can’t possibly have the answer for.

My advice is this: Answer the questions beneath the question. What I think VC’s are really trying to answer are the following:

1. Is this an attractive industry and how do you win? Hopefully, you’ve targeted a VC that has a clue about your industry, but our knowledge is usually not nearly as deep as it could be.  Help us understand the trends, customer challenges, and business levers that matter.

2. Is this a good entrepreneur? The entire fundraising process is an evaluation of the entrepreneur.  We want to know how resourceful you are, how self aware you are, whether great people will work for you, and whether you can withstand the challenges of a startup.  A lot of the questions I ask are meant to understand how an entrepreneur thinks and will respond to the challenges of the entrepreneurial process.  In a way, I’m also asking myself “if I were interviewing for a job with this person, would these answers give me confidence to work for them?”  Also, I’m trying to figure out whether this entrepreneur is trustworthy and listens to feedback.  It’s great when entrepreneurs realize that I’m hung up on a particular problem about their business and comes back later with a potential solution and plan to test it.  It’s not great when an entrepreneur tells me about a customer they are about to sign and the diligence shows that they’ve only spoken to the company once.

3. Does this entrepreneur understand the business she is getting into? Even if startups have a lot of uncertainty, there is a big difference between entrepreneurs who understand their business and those that don’t.  Experienced consumer internet executives rarely say: “we will acquire customers through word of mouth and Web 2.0 techniques.”  Instead, they have very specific thoughts about distribution partners, specific social media outlets they can tap, how to market effectively through SEM and SEO, etc.  I want to back an entrepreneur who demonstrates intimate knowledge of the industry she is focused on, even if she has never worked in that industry before.  History is littered with previously successful entrepreneurs who failed because they went after a market they did not understand.

4. Will this entrepreneur spend my money wisely? This isn’t just about being cheap.  It’s about investing in the right areas at the right time in the right amounts.  I want every dollar spent to reduce as much risk as possible or increase as much upside as possible (or both).  This usually comes back to #2 and #3.  Good entrepreneurs may say something like this:

“I know I can’t get scale in this business by selling directly.  I need channel partners.  But I DON’T know what customer segments I should be targeting first. So, I will spend a little money to test my product with a bunch of customers before spending a lot of time and money marketing the product and securing a big channel partner.”

Bad entrepreneurs will spend millions of dollars building a product and millions more marketing a product before realizing that no one really wants it.  Shockingly, this happens a lot more than people think.

5. Do I believe in the proposed product? This is very hard to figure out.  Usually, this is answered by a combination of a) customer feedback or b) gut.  Customer feedback means lots of people are using the product (aka traction), or we have called a bunch of potential customers and done technical due diligence and the feedback is positive. Gut means that we have a strong point of view of how the market will evolve and what solutions will be important, and your product meets that vision.

The threshold for this question isn’t as high as the others if I’m satisfied by the answers to questions 1-4.  If that’s the case, then it’s in the bucket of “this is a good entrepreneur going after a big opportunity, and I believe he will use my funding wisely to figure it out”.  For true early stage companies, I think this is the most an investor can realistically ask for.

When I joined the venture business, I was told that the job is a lot harder than it looks.  You need to find great companies to invest in, work hard to make them successful, and work even harder to try to make the most of the ones that aren’t going so great.

But what I found to be much harder than I expected was the process of choosing companies, and having deep conviction about those choices in the midst of vast uncertainty.  It’s also difficult to exhibit clear judgement when you learn more about a company and uncover things you didn’t expect to find.  It’s an intangible quality that I’m going to call investor mojo.  As one of my colleagues Santo wrote in an old blog post:

“If I did not foolishly think I knew everything and would be right most of the time, I could not be in this business. It is hard to be often wrong - historically only 1 or 2 in 10 companies provide meaningful returns - and live with it.”

I didn’t have an appreciation for this because I used to hear about new companies all the time, and always had an opinion.  In fact, I never had a hard time saying “that company sounds really interesting” or “that investment sound really dumb”.  If you look at the comments section after any new investment announcement on Techcrunch, you see a lot of similar comments from folks from all walks to life.

But there is a world of difference between making a passing judgement and really committing your time and money to a company.  Maybe it’s just me, but it’s a completely different exercise when you decide that you are going to love a deal and pound on the table to make the investment happen.

By “pounding the table” I don’t mean that every investment decision is contentious.  But the truth in early stage investing is that almost all companies have a few fatal flaws.  Maybe it’s an inexperienced founder, a product with no traction, or something else entirely.  For almost any new investment announcement, there is bound to be a sizeable population of folks who say “wow, that was one dumb deal.” I’m as guilty as anyone.

But being a great VC is about proving all the doubters wrong.  Actually, that’s true about being an investor in every asset class.  Outsized returns comes from doing things differently from the herd.  As Warren buffet famously said:

“We simply attempt to be fearful when others are greedy and greedy when others are fearful”.

What he didn’t say is that doing this also exposes you to the risk of looking stupid.  Unless of course, you are Warren Buffet and you just bought a railroad.

I’ve often heard that there is a shortage of seed-stage investment capital in the Boston area, especially in the consumer realm.  Nabeel Hyatt, founder of Conduit Labs put it pretty succinctly:

“This is in IMHO *the* biggest impediment to a stronger startup culture. There is no ecosystem of consumer angels in Boston, at all.”

There are quite a few large venture firms in our region, but not as many who will a) write a bunch of $50K-$250K checks to help a very early stage company get going or b) can invest in deals that might not have venture scale potential but is still a sound business.  Some venture capital firms are active in this sector, but for a number of reasons, can’t fill the void completely.

I was trying to do some research on this market, and found that it’s actually pretty hard to figure out who could provide angel funding in this town.  So here is a list of the folks that I know are active at this stage (with a bias for my sector of focus).

Professional Seed Investors

These are folks who’s primary goal as a business is to fund seed-stage companies.  This does not include large VC firms (ie: any fund with $’s / investing partner > $30M).

• TechStars Boston
• Founder’s Collective - no website yet.  But investors in a number of early stage companies in New York, Boston, and SF.  It’s run by Eric Paley and David Frankel
• CueBall
• LeadDog Ventures
• Bantam Group
• Launch Capital

It seems that there is clearly a dearth of players in this sector.  The groups above have wildly divergent strategies and typical check sizes.  I think the more groups like this that are successful in the Boston ecosystem, the better.

Angel Networks

These are networks of high net worth individuals that pool their resources and deal flow.  There are often coordinators for the networks, or set events when these angels come together to evaluate opportunities.  A lot of folks have discussed the pro’s and con’s of these networks, so I won’t get into that here.  Xconomy has a nice summary of these groups here.  I’ve heard that quite a few of the members of these angel groups also invest individually.

Individual Angels

If I were raising angel money, I’d try to tap value-added individuals first.  It’s a lot of work, but I think getting someone with relevant experience to commit money and time to your new company is very helpful.  As a venture investor, we love investing with value-added individuals. I also find that companies that have these sorts of individuals involved tend to make better progress before raising an institutional round.  This is an incomplete list, so please add more folks in the comments.  If anyone here would rather not be on this list, please feel free to email me directly at rob at sparkcapital dot com and I will remove you.

• Bill Sahlman - well known HBS professor and angel investor.  I don’t think his list of investments is typically published, so I won’t disclose them. But anyone who has taken his class knows that he has invested with Jeff Parker for years.
• Shikhar Ghosh and Guli Arshad - former entrepreneurs and executives.  Investors in companies like Skyhook Wireless and BzzAgent.
• Dave Balter - CEO of BzzAgent.  Investor in a few companies, also an active advisor to quite a few others.  Involved in Perk Street Financial and I believe Runkeeper.
• Steve Kane - Founder and CEO of 3 successful startups. Investor in companies including Pangea Media and Conduit Labs.
• Andy Payne - Successful entrepreneur and OpenMarket co-founder.  Investor in companies including fansnap and care.com and Shareaholic.
• Dharmesh Shah - CTO and Co-founder of HubSpot.  Investor in companies including Visible Measures and OneForty.
• Brian Shin - CEO of Visible Measures.  Investor in Shareaholic and Hubspot.
• David Cancel - Founder of Compete.  Investor in Shareaholic and involved in a bunch of other companies like Geezeo, Visible Measures, and FlipKey.
• Stephen Kaufer - CEO and founder of Tripadvisor. His personal investments are not widely publicized, but I’ve seen a few companies that he has invested in personally and he is listed as an investor at weddingbook.
• Scott Griffith - I have no idea if he is investing personally, but I know that he has helped companies as an advisor, including runmyerrand which recently received further angel funding.
• Don Dodge - Fomrer Microsoft executive and serial entrepreneur.  His personal investments aren’t that public, but he is an investor in CitySquares.
• Ed Roberts - Chair of MIT Entrepreneurship Center.  Investor in Shareaholic and Visible Measures.
• Bill Warner - Founder of Avid Technologies, investor in Posterous.
• Jean Hammond - Member of a few angel groups and founder of GoldenSeeds. Investor in JAM Technologies and Zipcar.

Anyone else I’m missing?  Please add them in a comment.  And of course, I’m always in the market to hear about early stage investment opportunities and get to know local angels better.

VC’s pass on new investment opportunities more than 99% of the time.  My guess is that the clear #1 reason why we pass is because of the team.  This could mean a bunch of different things (eg. no confidence the team can execute well, personality clash, etc).  But I don’t think there will be much dispute that this is the main driver behind a “no” decision.

The #2 reason is NOT as obvious.  “Bad Product” or “Unattractive Market” are definitely up there.  But I will contend that the second most popular reason VC’s pass is because the company “can’t get big enough”.

This is something I hear all the time among VC’s and I know it must drive entrepreneurs crazy, because no one thinks that they are giving their time and energy into an idea that is not “big enough”.

What does big enough mean?

There has been a lot written about this so I won’t rehash the math.  But the basic idea is that startups have a high mortality rate.  And so the relatively small % of winners need to be significant enough to drive an impactful return for the fund.

Although a lot of posts speculate that VC’s block good outcomes because of this, I doubt that it’s as prevalent as it seems.  What is prevalent is that VC’s think very hard about whether the potential of the business is big enough relative to the time and capital investment required.  We also think very hard about whether the founder is interested in shooting for a big outcome.  If not, it’s a tough fit for a venture capital investment.

Why many entrepreneurs should accept this reality (and why some investors should take advantage of it)

The reality is that most businesses probably can’t get to the kind of scale that VC’s require.  Moreover, it’s damaging to the business to do unnatural things to try to get to that scale.  You may grow your team too quickly, forgo revenue for reach, hire expensive executives, etc.

These aren’t bad things, but they aren’t right for all businesses.  I think there are a lot of very rational businesses out there that can probably get to profitability and modest revenue and create a lot of personal wealth for those involved.  Building these businesses can look quite different from building a venture funded company, and the funding strategy ought to be different as well.  Funding may not come from the highest profile VC’s (at any round in the company’s life) but from wealthy individuals with deep domain knowledge in your sector, professional investors with a different set of economics and strategy, or good old fashioned cash flow.

I would say that I think there is a dearth of investors for this sort of company, and I think there is probably an opportunity in this sector of the market. I also don’t think such an investor is necessarily dooming themselves to mediocre returns in small companies.  If they invest in the right markets, I think 1 or 2 out of 10 companies might surprise them and actually yield traditional venture returns.

Why entrepreneurs shouldn’t lose hope in VC’s

Despite the reality that most businesses can’t get to venture scale, an entrepreneur may be absolutely convinced that their company is an exception.  If this is the case, don’t lose faith in VC’s!  If you think about a lot of very successful companies, many of them probably looked “too small for venture” in their very early days:

“Pez dispensers and collectables online?  Tiny market!”

“Free calls online?  How will Skype ever make money?  Too small!”

“A coffee shop with a goofy name and a mermaid logo?  Too competitive, can’t scale.”

The goal then, is to find an investor that shares your vision for how you can get big (and is willing to endure criticism from others who don’t see the same opportunity).  Sometimes, these investors just have a conviction about where markets will go.  Or they just have a love for what you do and unique ideas about how to win through better execution.  This takes some time to figure out, but it is getting easier as VC’s are becoming more transparent about their investments, themes, and thoughts on market evolution.

I also think that these are the VC’s who tend to be the leaders in the industry rather than the followers.  The first investors in category creating companies tend to look like idiots for a while before the company goes from “not big enough” to the clear leader in an emerging new sector.  Then the lemmings follow.