Growth-Stage Companies Increasingly Must Embrace the ‘Micro Fund’ Ecosystem | by Marc Patterson | Apr, 2022

“Micro-VC managers tend to benefit from being early movers, as they are able to set the tone, gain higher ownership and develop strong engagement and relationships before the Series A groups get involved.”

— StepStone

Separating the Investing World into Two Camps — Private Equity and Venture Capital — is no Longer Sufficient

The investment landscape is continually changing. Too many times I see investors and growth-stage companies separate the investment world into two segments: venture capital funds and private equity funds. While these are certainly important categories, the investment world is far more complex. In today’s investment landscape, these two categories need to be further organized into important sub-categories. For growth companies that are still in the earlier stage (Seed and Series A), potentially the most important evolution in the investment industry over the last decade has been the virtual explosion in the Micro Fund category.

This category of investor practically did not even exist a decade and a half ago, but now drives a significant amount of investment volume — both in venture capital and private equity. To be clear, Micro Funds are being created to invest in almost every stage of company growth. However, for this article, I am focusing primarily on Micro Funds in the Venture Capital space.

‘Traditional’ Venture Capital Funds Often do not Even Invest in ‘Traditional’ Venture Anymore

What many growth-stage companies need to understand is that venture capital funds tend to have a growth evolution — just like a company. Over time, if a venture capital group is successful, the size of subsequent funds will often increase. As the size of the fund increases, the checks written to companies also increases. As the check size increases, the fund tends to invest in companies further along in their maturation. Over time, there tends to be an evolution away from earlier-stage, theoretically higher-risk companies, to more mature companies that have more fully-developed product lines, and a history of revenue.

That is why, over the last decade or so, many of the more high-profile venture capital funds have migrated to larger funds, and later-stage growth companies. There is nothing inherently wrong with this development. This is just natural evolution. However, it has left a rather sizable gap in funding for earlier stage companies. Many companies that are still in the Seed and Series A phase of development naturally reach out to the more popular names in venture capital — only to hear that they are ‘too early’.

Well, that is a playbook from ten years ago, not from today. Today, an entire new crop of venture capital funds now dominate the Seed and Series A stage. These are commonly known as Micro Funds. This phenomenon was recently described in a piece by StepStone: “the traditional VC financing continuum has broadened over the past several years. Compared with a decade ago, early-stage technology companies are raising nearly three times as many rounds prior to a Series A. The idea of a single financing round has been replaced, and Seed itself is no longer one category. Institutional Seed has displaced angel investors, with Micro-VC funds emerging as a new venture subcategory to accommodate these new rounds of pre-Seed, post-Seed and smaller series.”

The Funding Gap has Created Opportunity for the Next Generation of Professional Early-stage Investors

As mentioned above, many of the traditional venture capital funds have moved out of the Seed space. While that has caused some confusion for early-stage companies, it has also created a large opportunity. Smaller, more nimble, more hands-on venture funds have increasingly entered the space. Without competition from the larger players, the space is wide open. As detailed in the article, “This opens the window and provides an opportunity for Micro-VC managers that are raising smaller funds and often seek a more hands-on approach with their investments. They invest earlier than Series A–focused managers where it becomes more competitive. Micro-VC managers tend to benefit from being early movers, as they are able to set the tone, gain higher ownership and develop strong engagement and relationships before the Series A groups get involved.”

However, investors and growth-stage companies should not make the mistake of thinking that Micro Funds are not on par professionally with larger funds. Just the opposite. Over the last ten years, there has been a significant uptick in the capability and expertise of the Micro Fund world. Historically, Micro Funds were often part-time endeavors for successful entrepreneurs or wealthy investors that wanted to play in the space. While that does still exist, the bulk of Micro Funds today do not fit this description. From the article, “Emerging managers are also known as “first-time funds;” however, these funds are often led by investors who are either spinning out of brand-name VC firms or entrepreneurs with strong track records of investing and creating companies. Micro-VC managers are made up of a subset of individuals and groups that are innovative and have a clear vision of market opportunities. The multifaceted approach has led to far-reaching opportunities to pursue strategies that have historically been overlooked or are still emerging.”

Is ‘Spray and Pray’ Dead?

A hotly-debated philosophy has begun to work its way into early-stage investing. The early-stage venture capital model was frequently derided as the ‘Spray and Pray Strategy’. Spray as much much money into as many companies that you can, and Pray that at least a few of them hit. Historically, there is some truth (and validity) to that model. However, most active venture capital funds today regard this model as largely dead. Many argue that the inherent risks of early-stage investing have evolved, along with the market. This philosophy was detailed in the article “The perception that investing in unproven, high-loss strategies is a binary proposition is a misconception when considering the evolving VC landscape with Seed and Early Stage being far more versatile. The historical lottery approach to constructing a VC portfolio has since evolved and been replaced with a more thoughtful, measured and risk-adverse approach. This methodology has best been afforded to scaled platform investors that possess the informational, resource and relationship advantages to assist with sourcing and diligence. In the 1990s, the typical venture fund had a loss ratio of more than 50%, but since then, this figure has decreased considerably to roughly 20%, according to Cambridge Associates data.” Some in the industry would say that Micro Funds are well placed to capitalize on these changes.

Both Growth Stage Companies AND Investors Need to Understand the Players in this Space

Whether or not you agree that the risks of early-stage investing have changed, it is difficult to argue against the idea that the landscape has been completely altered over the last decade. The number of smaller, nimbler, more hands-on funds has exploded. Yes, a portion of this can be attributed to the wide-open capital markets environment of the last decade. Any serious and extended market downturn would flush a number of these new players out. However, we should not be too quick to dismiss the sustainability of this smaller fund ecosystem.

So why is all of this important? First, Micro Funds are an investment class that must be understood. Even if you are not particularly interested in investing at this stage, at the very least you need to know and understand the motivations of the players. Why? Because they will most likely already be on the cap table and have the ear of the CEO of growth-stage companies you are looking to invest in. Better to get to know them earlier rather than later.

Second, as an early-stage and growth-stage CEO, it is an absolute MUST that you understand this space. The good news for CEOs is that the Micro Fund world has exploded in size. That means that capital earmarked for an early-stage investment — like your own — is abundant. The bad news is that the funds are small, and relatively unknown. That means that while the capital is abundant, figuring out ways to access that capital is still a big challenge. Better start getting familiar with the space now.

© Copyright 2022. Marc Patterson/Bennu Partners. All Rights Reserved.

“The Alpha Algorithm for Micro-VC Managers” by StepStone, 1.13.2022