Steve Anderson is the founder of the pioneering “micro VC” Baseline Ventures. What is a micro VC? As the name implies, micro-VCs are smaller versions of more traditional venture firms (e.g., they raise less money and invest smaller amounts at an earlier stage in life cycle of the startup business). Mattermark writes about the category: “Most (around 80 percent) of the initial investments that micro VC firms make are in companies that are at the seed stage, whereas traditional VCs tend to focus on later or across multiple stages.”
Anderson raised his first $10 million fund in 2006 and most recently raised a $100 million fund in just four weeks. Before entering the venture capital business, Anderson worked at eBay, Microsoft, Kleiner Perkins, Starbucks and Digital Equipment Corporation. Baseline Ventures has invested in more than 75 businesses and generated more than 25 financial exits. Among the more famous Baseline Ventures investments are its early investments in Instagram and Twitter.
Venture capital is obviously itself a business and innovations like micro VC (e.g., Baseline), platform (e.g., a16z), compensation and governance (e.g., Benchmark) happen. As examples of this phenomenon, I recently wrote about two other innovators: Jessica Livingston who was a co-founder of Y Combinator and Chamath Palihapitiya who plans to transform his business into something that looks similar to Berkshire.
Here are the customary dozen quotations:
- “In 2006 I was starting to ruminate on the idea of founding a company. When I began to think about raising seed capital there were few alternatives to consider.” “The average exit over the last ten years on average has been $100 million. If I own 10% of a $100 million outcome that is real money for me and my co-founders. Why isn’t anyone [in venture capital] aligned for that sort of outcome?” There is an informative video on YouTube in which Chris Dixon and Anderson talk about how early in their careers they each wanted to finance their own businesses and found themselves faced with a requirement that they sell more than half of the equity in the business just at seed stage to get the cash they needed. In an email to me, Chris Dixon described the situation he encountered then in this way:
“When I started my first VC-backed company in 2004 there were 10-20 firms who might consider investing in consumer internet companies, and they were all bigger VC funds that were designed to invest in Series A or later. In our seed round we had to give up >50% of the company for 2.6M (plus the deal was tranched which added other challenges). It was pretty obvious that the market needed a new product. I ended up co-founding my own seed fund (Founder Collective) and investing in Baseline, Lowercase, and a few other people who saw the same opportunity.”
What most experienced founders want at seed stage is a lead professional investor who can add more than just capital to the business (for example, a range of startup experience and company building skills). What do I mean by professional investor? In my dozen things profile of Keith Rabois I quote him as saying: “There are fundamental differences between an angel, what I call an amateur investor and being a professional investor, a venture capitalist.” Professional investors are more than just wealthy and well-connected. They can add the benefits of their networks and business skills to the businesses they invest in. It is common to have non professional Angel investors in a seed round. But it is generally not optimal to have no professional investor involved in a seed round. I again agree with Keith Rabois: “If you have the option, raise money from one lead investor who has the right skill set, background, and temperament to help you.” Exclusively raising funds in the form of $25K to $50K checks from a long list of nonprofessional investors like florists and dentists is not optimal. Some seed round can become what Tom Tunguz recently described: “Party rounds symbolized the heyday of the startup seed market just last year. Called parties because of the number of investors who collaboratively financed seed rounds of startups, the lists became almost comically long as seed sizes ballooned and investor syndicates swelled with them.”
Fast forward to today from the period of time when Steve Anderson and Chris Dixon were both having a hard time raising funds for their startups without massive dilution and there are more seed stage venture capitalists (374 at last count) offering much more attractive terms, assistance and valuations to founders. The investment climate now in micro VC is robust according to data provided by my friends at PitchBook:
Data on angel and seed rounds more generally can be seen here:
- “You have to sell at least 20% of your company at every financing [if it’s a big venture fund involved since they need to put a lot of money to work to justify the deal].” Traditional venture capital firms can only sit on so many boards and help only so many startups at any given time. They have a high opportunity cost and in many cases can’t invest without taking a significant equity stake. It should be noted that not every business is right for venture capital. Many businesses should not raise venture capital at all and are better off trying to financially bootstrap. Fred Wilson has a post on how he invests in “media, food products, restaurants, music, local real estate, local businesses” which he explains in the form of an example: “…the investors put in $400k, get $100k back for four years in a row (which gets them their money back), but then the business declines and eventually goes out of business in its seventh year. The annual rate of return on the $400k turns out to be 14% and the total multiple is 1.3x.”
- On average I invest $500k.” If you raise a $100 million fund you can obviously make a lot of seed stage investments. There is not precise formula for how the funds are allocated in any given fund. How much a given seed stage venture capital firm saves for follow on investments varies from firm to firm and from year to year. Mattermark’s data says 20% of investments of micro VC investors are non-seed stage. In general, data from Tom Tunguz says there are less party rounds right now which is a good thing for founders and investors:
- “Ten years ago you needed $5 million to start [a business]. Today you need $70 and some coding skills.” One thing that is remarkable about raising funds at seed stage for a business today is now little cash it takes to fund the company relative to the past. Access to cloud services and modern software development methodology means you need less money and people to create a business than ever before. This lowering of capital requirements is good and bad: good in that it enables people to get ideas to market more effectively and quickly, but bad in that enables a lot of poseurs to flood the market. which often sends confusing signals. Too much money delivered too early into a market is not helpful if you are a founder trying to create a successful business. The best founders do better when there is less noise and more signal in the investing and business environments.
- “Generally speaking, most of my investments are pre product launch- they’re just an idea.” There is so much uncertainty and ignorance involved in seed stage investing that a focus on factors like the strength of the team becomes extra important since what an investor is trying to purchase at a bargain is optionality. Investable ideas at seed stage are not easy to find, but the ability to actually execute on those ideas and iterative to adapt at the environment evolves is even harder to find. Most businesses which take a seed stage investment fail. Jason Calacanis wrote this past week: “Startups before their A round — which is where I operate — are a high mortality business. Eight of 10 startups angels invest in, in my experience, are a donut (zero dollars returned).” Not everyone will have the same failure rate as Jason since everyone has a different propensity to take on bets with bigger potential upside, but a higher failure rate. As was stated above, there are no precise formulas in venture capital and investing and business conditions change over time. But there are certainly tendencies that experienced venture capitalists can use to their advantage. As a wise person once said, the past does not repeat itself precisely, but certain things tend to rhyme over the years.
- “Your goal is product market fit.” “My goal as an investor is to make sure there’s enough financing to give companies time to do that, a year to 18 months. The worst scenario is to try to raise more money when you haven’t achieved that goal.” “If you don’t have it, eventually you’ll run out of cash, say the experiment is wrong, and fold up your tent … A lot comes down to the entrepreneur. Do you keep doing this against all the feedback, or not? That’s why when I invest I want to leave enough room for pivoting or reexamining your goals. After that, most of the time entrepreneurs are realistic near the end and say this isn’t working. Those decisions aren’t that difficult. It gets more difficult in later stages when you’ve got millions of dollars in. Usually there, you try to sell the company.” Too much money can distract a young business from focusing on what is necessary to create a successful company. Businesses don’t just die from starvation- they can just as easily die from indigestion. And they often do. Ironically, many investors believe the best time to start a business is in lean times. The root cause of a business running out of cash is often that the business lost focus and diverted resources to activities not on the critical path toward success. Cash starvation or indigestion is often a symptom of bad decisions like premature scaling, trying to do too many things at once or pivoting too often.
- “With series A, B, C, or growth investments, you already know what you want to invest in.” Investing in a business before “product market fit” exists means decisions are relatively more instinct-based since the investor has less data. Anderson has even said in an interview that he tends to go with his gut on his seed investments. My blog posts on Eric Ries and Steve Blank set out their thoughts on finding product market fit. Andy Rachleff describes the process well: “Eric [Ries and I] believe in order to increase the likelihood of succeeding, a startup should start with a minimally viable product to test what he calls a value hypothesis. The value hypothesis should state the founder’s best guess as to what value will drive customers to adopt her product and indicate which customers the product is most relevant to, as well as what business model should be used to deliver the product. It’s highly unlikely that a founder’s initial hypothesis will prove correct, which is why an entrepreneur has to iterate on her hypothesis through a series of experiments before product/market fit is achieved. As a consumer company, you know you have proved your value hypothesis if your business grows organically at a rapid pace with no marketing spend. Only once the value hypothesis has been proven should an entrepreneur test her growth hypothesis. The growth hypothesis covers the best way to cost-effectively acquire customers. Unfortunately many founders mistakenly pursue their growth hypothesis before their value hypothesis.”
- “It’s all about networks. I spend time with entrepreneurs, I meet them mostly through other entrepreneurs.” Success begets success. Cumulative advantage is a underappreciated factor that drives the success of any business. For a venture capitalist, investing at the seed stage is a hustle game. By that I means not only the ways in which these investors help portfolio companies but also the ways in which they acquire deal flow and contacts. Reaching out and helping people in advance pays big dividends. Everyone has mentors on how to do things and mine was a wonderful fellow named Keith Grinstein. Pound for pound Keith was the greatest networker I have ever seen. No one even comes close. To illustrate how good he was at networking, when he passed away far too young most everyone at the funeral considered him their best friend.
- “You will know if you like [venture capital] well before you know if you are any good at it. “It takes five, six, seven, eight years… the cycles of feedback are long, which is difficult.” Becoming a great venture capitalist can take as long as seven to ten years to get right. Sometimes you make a mistake as an investor and don’t pay the price for many years. The long learning curve in venture capital is not only hard but impossible to eliminate unfortunately. Every venture capitalist is to some extent paying the equivalent of tuition every time they invest in a business. Investments made early in the career of a venture capitalist tend to be more “tuition heavy” than the investments they make later in their career.
- “There is a robust seed market now.” “Returns dictate everything. If the asset class has the financial returns, more money is going to come.” There are roughly 375 micro VC firms in the United States. The jury is still out on the right number of micro VCs since the category is so new and surely that number will vary over time as conditions change. A significant constraint on industry size is the overall level of financial exits for portfolio companies. When micro VCs collectively put X dollars of capital to work they must eventually generate enough financial exits for their investors or they will not invest enough to keep the category healthy. In other words, venture capital in the medium and long-term is top-down constrained by the aggregate level of financial exits for portfolio companies.Venture capital has been and is likely to always be a cyclical business. In the seed investing category, the presence of angel investors clouds the picture even further. It is impossible to quantify with any degree of certainty how many Angels are making seed investments at any point in time or their financial returns. People try to quantify the financial returns on Angel investing but there is huge survivor bias and lots of storytelling involved. One relatively recent guess is: “about 300,000 people have made an angel investment in the last two years.” Another guess: “A total of 29,500 entrepreneurial ventures received angel funding in Q1 of 2015.”
- “[Accelerators were created] for people who don’t have their own networks or can’t grow their networks. How often do you show up to one place and see 80 companies? Of course with that scenario you’ll pay a higher price because more people are looking. That’s fine. Entrepreneurs have more transparency today than ever before, they can choose the types of investors they want to work with.” It’s great that investors and founders today have so many choices, including participating in accelerators. The more transparent the choices are for founders the better off everyone is. My recent post on Jessica Livingston discusses the benefits of accelerators for founders.
- “In this business you will have a long list of things you could have done. If I miss something, I try to learn from that.” Every venture capitalist has investments that they pass on which represent missed opportunities. That is the nature of the business. The important thing is not whether you make mistakes (because you always will to some extent) but whether you learn from your mistakes. I have heard Bill Gurley and Bruce Dunleive of Benchmark Capital say more than once over the years: “Good judgment comes from experience, which comes from bad judgment.” Absent the direct lesson that comes from making a mistake yourself, reading about other people who do things and fail or succeed can also be helpful, especially if it allows you to avoid “peeing on the electric fence” yourself.
YouTube interview: https://www.youtube.com/watch?v=Z0AWCLGk8ow
Angel Capital Association: http://www.angelcapitalassociation.org/faqs/
Tom Tunguz: http://tomtunguz.com/party-in-seed-rounds/
Center for Venture Research https://paulcollege.unh.edu/sites/paulcollege.unh.edu/files/webform/Q1Q2%202015%20Analysis%20Report%20FINAL.pdf