Critics of Micro VCs have been quick to point out one primary difference vs. the traditional VC model as a significant flaw: the rapid capital deployment velocity. In other words, if Micro VCs are investing in an accelerated pace where they make at least a handful of investments each year per investor, then perhaps they aren’t doing the sufficient amount of diligence to truly vet these opportunities. Is the Micro VC approach merely just “spray and pray”?
The key issue to examine with respect to diligence speed is the distinction between diligence process time and the time expended during the diligence process.
During the seed stage where Micro VCs invest, there are three primary diligence factors:
- Team and individuals – The information discovery here involves conversations with former coworkers, cofounders, partners, investors, and customers. These people can validate and reference the abilities and integrity of the team involved in a venture.
- Market size validation – Part of this inquiry involves research and part relies on gut instinct based on being a domain expert in a space. By focusing on one domain, an investor can make instinctual decisions based on accumulated knowledge in addition to analytical decisions based on recently gathered information.
- Customer hypothesis gathering – Depending on the startup’s offering, these efforts involve calling potential customers which are end-users of a product, or understanding any early key usage metrics the startup may have already developed. On pre-launch consumer services, again the diligence partially rests on an investor’s instinctual pattern-recognition based on experience and understanding following a specific market. (Afterall, Henry Ford said, “If I had asked people what they wanted, they would have said faster horses.”)
#2 & #3 above can be diligenced systematically, but only to a modest extent at the earliest stage of a company. If the initial gut-checks aren’t there, then an investor isn’t going to spend time on diligence. At the end of the day, it’s all about #1: the team and ability to execute. The diligence on the team can be completed fairly rapidly, and is often already partially completed if an investor has a solid previous relationship with the entrepreneur founder or was referenced to him from an extremely trusted source.
In comparison, for a typical Series A investment, an investor needs to diligence all of the above plus also:
- Validate venture-scale opportunity. This effort is the least talked about, often the most difficult to discern, and truly a top priority. Although similar to #2 above where an investor is determining if there is a real market to go after, the distinction here is that given the post-money of a Series A is higher than a Series Seed round, the expectations of what will constitute a viable return potential for a new investor increases in step. A Series A investor must determine if both the exit opportunity and the company’s capital requirements match the size of their fund, which becomes more challenging as those figures go up in absolute terms. In other words, for traditional Series A venture investments, the exit outcome usually requires forecasts to in be the multi-hundreds of millions and the capital expectations are often $10M+ for a larger fund. These (relative) constraints are less inhibiting for Micro VC because of ability for these firms to win at smaller scale outcomes (even though they are also shooting for and enjoy the success of big wins). For new investors, thinking though the math for each opportunity takes time, especially as the absolute dollar figures involved go up the relative probability for a larger outcome decreases.
- Call initial customers/ reactions. Once there are meaningful customers/users and metrics to diligence, an investor should call these parties to fully understand the opportunity and service. While not difficult, these calls add an additional layer of process.
- Justify the investment internally. Given the capital constraints of smaller fund-sizes (and in turn fee structure) that Micro VCs face, by definition these firms have fewer people (if even more than one at all). Less people in a firm translate directly into less internal communication time. At one extreme, if a Micro VC is truly a sole super-angel, then he makes an investment decision and acts immediately. Even in a small partnership focused on a specific space and sector, education and buy-in for a particular investment opportunity can happen rather quickly. The relationship between number of investment professionals and time spent on internal justification isn’t a linear one, but rather a geometric one based on the number of communication links between people nodes. The larger the firm, there is real potential for this step in the process is just that… process. The cycles of internal deliberation and justification aren’t really diligence, but do take up significant time under that label. And often there is risk that the bulk of the “diligence” period is internal justification politics rather than legitimate inquiry and investigation. This extra layer of process can be further exaggerated if a firm operates with a leveraged resource model (analysts + associates + principals + jr. partners); or a multi-stage, a multi-sector, or a multi-country investment strategy. In those cases, a certain subgroup operates with a fundamental knowledgebase given their specialization and there needs to be further internal education about a specific set of assumptions on any given opportunity. In contrast, MircoVCs are either sole super-angels or small partnerships where this step is non-existent or minimized.
While Micro VCs posses the ability to employ an efficient yet thorough diligence process, it certainly does not mean that all quick diligence periods are thorough and exhaustive ones. It should be cautioned that even though a Micro VC has the capability to be both quick and yet exhaustive in diligencing an opportunity, it is incumbent on them to act as such.
But given the dynamics at play, a real careful and systematic diligence process appropriate for the seed stage need not (and should not) take as long as a full scale Series A investment. Quicker diligence is not lesser diligence at the seed stage for Micro VCs.