The number of micro venture capital firms — funds that raise money from limited partners to invest small amounts of money in many very early stage companies — have grown dramatically, from fewer than 50 in 2011 to about 250 today. This rapid growth has occurred because micro VCs fill an important gap in the market for financing early stage companies.
What’s Behind the Growth of Micro VC?
Increasingly, startups need less money initially than traditional venture capitalists can provide economically. The amount of money it takes the typical startup company to achieve product market fit has fallen dramatically, from about $3 million in 2004 to about $500,000 in 2014. Traditional venture capitalists cannot make $250,000 to $500,000 investments in large numbers of companies, given the size of their funds and their labor-intensive due diligence processes.
The decrease in the amount of capital necessary to achieve product-market fit has also meant an increase in the number of businesses experimenting with minimum viable products and business models. At the earliest stage in company development, investors cannot easily differentiate winners from losers. Identifying an Uber or Airbnb from the population of companies raising initial capital at this stage is nearly impossible.
To avoid missing a unicorn, investors need to make a large number of small bets across a wide range of companies, something that traditional venture capital firms are not well equipped to do. Such investments require a philosophical shift from identifying winners to massive diversification. It also requires investors to take a different approach to conducting due diligence, investing before many questions about downstream activities can be answered. Finally it requires the use of data and software to select ventures, set valuations and manage investments.
Existing alternatives to micro VCs — individual angels, angel groups, and family offices — aren’t well suited to fill this funding gap. Individual angels are difficult for entrepreneurs to find. They rarely have websites advertising their investment activity, and often have limited geographic breadth. Moreover, each one has limited financial capacity, and only some have the knowledge necessary to set terms. As a result, entrepreneurs are often challenged to find individual angels who can lead a $250,000 to $500,000 round or even to find enough of them to fill a round.
Family offices are also inappropriate. Family offices are typically extensions of the people responsible for generating the family wealth. Such individuals do not have enough time to evaluate a large number of start-ups. Moreover, they often have strong opinions about business opportunities, founders and approaches to management, which make them too “hands on” to make a large number of widely diversified, small dollar, bets in numerous companies.
Angel groups are not a solution either. They are not “agile enough capital” for this stage of company development. Groups are not good at making fast decisions about investments in very early stage companies when substantial uncertainty surrounds their future. Not only is it simply much slower to organize meetings and phone calls with a group of 25 angels than to organize those same activities with a single partner of a micro VC, but different people will each seek different information to evaluate a venture’s unknown future. That tendency creates an information generation burden on company founders and slows the fund raising process.
Like most financial market innovations, micro venture capitalists have emerged to fill a gap in the early stage funding market place that has opened up as the cost of achieving product market fit at startups has fallen. That change necessitated a different type of venture capitalist than the traditional VC.
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