The Micro VC Game

This post by Chris Douvos makes a lot of sense.  I have never met Chris but someday I hope I will.  Fund of Funds investors are starting to open up.  I am glad they are.  If you don’t know what fund of funds are that’s okay.  They are integral to the funding universe.

All kinds of entities accumulate huge pools of capital.  Think, government pension funds, company pension funds, endowments and centralized places where money is collected and sits.

Those entities need to get a rate of return on their capital.  For example, the state of Illinois public pension funds assume they will get a 7% return on capital.  Of course, in a 0% interest rate environment, they are returning a lot less than that which hurts their bottom line and eventually will cost taxpayers big.  The entities outsource a lot of their capital allocation to fund of funds.  They bust up their centralized pool into smaller bites which makes it easier to deploy.

Most of the capital goes into stocks, bonds and less risky assets.  But, some of it finds it’s way into venture.  I am of the opinion that venture is the only way to really earn a high return given the state of the current financial marketplace.  Stocks are at all time highs.  How much higher can they go?  Interest rates are at 0%.  What happens to the value of real estate and private equity when they go up?  What happens to the price of notes and bonds when rates go up?

Venture capital is the place to get the best return given risk/reward.

Where do you get the most bang for the buck in venture capital?  Seed and Series A.

This is why fund size is important.  If you run a VC fund that is a multi billion dollar fund-it’s hard to write a seed check.  Most funds that invest in seed are less than $200M in size.  We are raising a micro VC right now.  The size of the fund will be small.  There are a lot of reasons for that.

However, Chris accurately points out that the alimentary canal for investments is pretty full.  A lot of companies are getting funded at the top of the funnel, but there are not a lot of exits.  This has impacted the returns on the fund of funds.  That means their customers aren’t getting return either.  The downside to investing in assets like real estate, private equity and venture is the liquidity that you give up.

Here is where things might have to change.  At the seed investment, investors need to have a frank conversation with entrepreneurs.  What kind of company do they want to build?  Sometimes, it’s smart to go for the home run.  Every entrepreneur is conditioned to say, “I am going to build a billion dollar company.”  But, how often does it happen?

We read a lot today about billion dollar companies. They are less rare than they used to be but they are still statistically pretty rare.

In many cases, it might be better for the entrepreneur to think about building a company that will have an exit value of $50M to $100M.  That’s not sexy.  But, it’s a different kind of company than a billion dollar company.  Often, you can build that type of company faster-and get acquired by another company faster-which returns capital to your employees and investors. Getting acquired from a fund manager perspective is nice because I can return capital to investors.  When I return capital to fund of funds, they get to return capital to their investors.  Everyone is happy.

The one downside to that line of thinking is risk.  It’s risky to try and do a startup.  If you are going to go for it, you must be all in.  At the outset, it’s impossible to know if you have a billion dollar company or not.  As an entrepreneur, the best thing you can do is build something that creates value which people are willing to pay for.  Let valuations run their course.  The founder loses a lot of valuation control after the seed round.

As an investor, I have to make sure I don’t let emotions cause me to make bad decisions.  Sometimes, there are opportunities to take cash off the table.  You have to seriously consider it if that opportunity arises.  No matter what I think at the outset of an investment, by the next round things could change.  Each round of investment is a time for me to re-evaluate everything.  As companies mature, new opportunities might avail themselves.  All of a sudden, the business can be a billion dollar company.  I don’t want to be the person that holds them back.