Welcome back to our final post in the Smaller, Earlier VCs Should Invest Differently series. If you’re just joining us now, you can learn about portfolio variance here or dilution here. This week I’m wrapping up by demonstrating the huge effect seemingly small changes in valuations have at earlier-stages — and why a micro-VC should be the exact opposite of “valuation insensitive.”
This is part three of a four-part blog series that I began two weeks ago. The first post outlines why micro-VCs investing in early-stage startups should notfollow the best practices of their larger, more traditional VC peers. Last week in the second post, I discussed a little-discussed metric — portfolio variance — and how that significantly impacts a smaller, earlier fund’s risk. The big takeaway? A larger portfolio size of 70 companies both increases the median fund return and decreases portfolio variance (i.e. risk) to match that of a 20-company-portfolio Series A fund. This week I’m bringing up a metric that is touted as a chief concern for investing in smaller, earlier VCs but I find it completely over-hyped: dilution. Turns out, it really doesn’t matter that much…
Last week I began a blog series on how the growing array of micro-VCs investing in early-stage rounds should think differently. You should read that now before diving into this post, but TL;DR is that these VCs (including us at M25) should not utilize some of the best practices in portfolio theory that have worked well for the larger, traditional VC. These strategies, transferred to our stage and AUM, don’t take account of the vast differences in risk and reward. Today, I’ll first dig into a little-talked-about metric: portfolio variance.
Like any industry, VC can be resistant to change and disruption, and we’ve now begun to see a myriad array of new strategies in this growing asset class: accelerators & their follow-on funds, geo- or thesis- focused strategies, “index” portfolios and miniature versions of traditional firms abound. If you read much about this space, you’ve probably already read a bit about “the rise of micro-VC.” Most of these smaller firms focus on earlier-stages than their larger counterparts, as they generally need to make smaller investments.
Data science is here, and it’s growing fast. No one’s questioning that. Which is core to our thesis behind one of our most recent investments, Astronomer. But it wasn’t too long ago that explaining the value of data science to folks wasn’t that easy.
I’m about as Midwest as you can get. I was born in small-town Indiana to a fourth-generation Hoosier farmer and my early childhood was spent playing “farm” with miniature International Harvesters. We traveled across miles of flourishing, flat cornfields to visit my grandparents and cousins on my mother’s side just outside Peoria, IL. When I was in high school my family moved to a Big Ten collegetown. We vacationed at a sandy, spring-fed lake in Michigan. For college I went to Chicago and majored in economics at one of the finest “freshwater” economics institutions.
We’re frequently asked by entrepreneurs about what things we do to bring value to the table beyond our capital. The vast majority of the time this is refreshing and well-received, as we want to work with founders who are smart and strategic enough to be selective and intentional about who they partner with.
From our count, M25 is one of the most active seed investors in the Midwest with 23 new portfolio companies in 2016. That may sound like a lot, but it’s a small percentage of the myriad of companies M25 has reviewed. How do potential companies stand out? Victor Gutwein, M25’s managing director, outlines the top four components to their proprietary scorecard.
There is no consensus about what constitutes good due diligence when in the convoluted sphere of early-stage startup evaluation. When a co-investor asks “Have you done due diligence already?” or when a tag-along angel investor claims “Well if they’ve [Respectable VC Firm] done their due diligence then that’s good enough for me”, they often have only a limited understanding of what effort was actually undertaken. In addition, there are often unspoken and competing ideas around the due diligence process’s actual purpose. Therefore, in the spirit of better communication to entrepreneurs who pitch us at M25 Group, LPs that invest in us and co-investors who trust us when joining a round alongside us, I’m going to outline our view on the due diligence process, what our due diligence process looks like and what each piece of the due diligence process actually entails.
Let’s start off with full disclosure — I’ve invested in what M25 is doing in more ways than one, and inevitably have some inherent biases. I’m wearing multiple hats as author of this blog. I’m on the board of M25, I’m an investor in both funds M25 has launched, and I’m the father of the Managing Director of M25. That being said, I’m prepared to tell you by the end of this writing why I believe M25 is the “best thing since sliced bread”.