How Micro-VCs Invest (And How They Compare To Traditional VCs)

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This is a build off my last post which was a primer on the Micro VC market.  

Often, I hear investors talk about companies that are “venture scale”.  These are usually the kinds of companies that have the potential to drive meaningful returns for a top VC fund.

 Because of the high risk of early stage companies, the performance of large funds are driven by discontinuous returns (ie: the home runs). 

As a result, I think that most early stage VC’s tend to look at a similar profile of investment – big market, proven teams, potential for an outcome in the hundreds of millions or more, but realistically low probability that that outcome will be achieved. 

In comparison, Micro-VC economics allow them to do quite well in investments in companies that exit at a much more “modest” scale, assuming the company is not over-capitalised.  But this leads to an interesting question:  

Are Micro-VC’s pursuing the same companies as traditional VC’s, just at an earlier stage?  Or are they pursuing a fundamentally different profile of company?

Here’s the deal on micro-VC vs traditional VC investments >
Rob Go is a former senior associate for Spark Capital. Now he’s an entrepreneur working on a secret project. This post was originally published on his personal blog and is re-published here with permission.

Strategy 1: Pre-VC Companies

The downside

The downside of this is that micro-VC's have financial and strategic reasons not to defend their ownership over time. Thus, initial cost basis is not the only consideration. One should factor in the impact of dilution over time, the risk of being lower on the cap table in subsequent rounds, etc.

The assumption for a micro-VC is that they will accept the downside of these risks because they believe they will get better access to great companies and minimize the risk of pouring good money after bad. Plus, they can still enjoy a fund returning exit even if they do get diluted over time into single-digit ownership.

Strategy 2: Capital Efficient Wins

The downside

The downside of this strategy is that it's unclear how much risk there is in these sorts of businesses. Can one make a living investing in early stage companies and have a high enough hit rate that you don't need a Thunder Lizard to drive excellent returns? Also, because there is a shortage of investors in this space, there is a dearth of co-investment partners and follow-on investors for these companies, leaving the investor (and the entrepreneurs) exposed to significant financing risk.

By the way, I think there is an interesting potential angle for firms that act as small-scale growth equity investors in capital efficient wins. One or two groups come to mind, but I think there are relatively few out there specifically pursuing this strategy.

What's the answer?

One recent example: Tapulous

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