As the venture capital landscape largely concentrates on both ends of the fund size spectrum – enormous funds (A16Z, NEA, Sequoia) and micro VCs (generally defined as funds smaller than $50M), there has been a lot of discussion around the chasing of unicorns ($1B+ companies) to drive returns. Jason Lemkin wrote a great post on why $150M+ funds need unicorns just to survive, and he hits the nail on the head.

The bigger funds need unicorns – multiple – in order to drive the 20%+ IRR and 3x+ net return LPs are looking for from venture. As a result, there is continuing competition to fund unicorns – those that can return $5B (Zenefits, which just raised $500M at a $4.5B valuation, or around 100x ARR), $10B (AirBnB, Snapchat), or $50B+ (Uber) at IPO. It is a virtuous cycle – fund multiple unicorns, and you’ll likely get increased access to fund the next batch that comes through. Add in public-market investors dipping into late-stage venture as companies wait longer and longer to go public, and you’ve got a very company-friendly landscape in which to raise late-stage capital, driving valuations up.

But what’s happening at the earliest stages, where funds are writing $500K to $2M, not $50M-$200M checks? Do micro-VCs need to swing for the fences and chase unicorns just like the bigger funds? If so, we are operating in a dangerous landscape – the vast majority of exits, even successful ones, occur below $100M – and while pushing companies to grow faster is an ever-present part of VC, expecting all companies to have the potential for unicorn returns is dangerous. These companies need to walk before they run, and certainly run before they can gallop (or do unicorns fly?).

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Our thesis when raising institutional capital in 2012 was that, at the level we play at, $100-$300M exits can drive excellent venture returns (that is, 4-5x gross proceeds on our fund). Lower valuations (which we think are inherent to the Midwest, mainly due to the size of the funds and less competition for deals) and capital-efficient startups (mandatory given the Series A crunch impact our friend Blair Garrou of Mercury Fund describes in his recent VentureBeat piece) lead to much lower hurdles for the same IRR and net returns, both compared to coastal funds of similar sizes and to the bigger funds.

Of course, an investment thesis and actual investment outcomes are often not the same thing at the end of the day. So, how has our fund and our investment thesis played out in practice? We’ve made 25 investments, all at the Seed or Series A stage. The largest investment round we made our initial investment in was $3M, and the typical seed round was closer to $500K than $2M. We’ve invested initially at valuations ranging from $500K (literally an idea on a napkin) to $7M (generating $1M+ in revenue), with an average seed-stage valuation of around $2M. Yes.. $2M. As a general rule, we’ve invested at valuations of around 30-50% of the benchmark valuations for Silicon Valley SaaS startups as laid out here. What does that mean for our returns?

  • Let’s assume our investors are looking for 4x gross returns (before fees/carry), or around $80M on a $20M fund.
  • We have made 25 investments in this fund, at an average valuation of $2M.
  • Our average check size has been around $400K, giving us 1/6 of the typical company (This is almost exactly our average company ownership, after multiple rounds of follow-on funding, though the actual ownerships range from 1% to 30%).
  • To return $80M gross returns on an average ownership of 1/6, total gross proceeds across all portfolio exits need to be $480M ($80M x 6).

As Jason pointed out in his post, it’s obvious why VCs are often ownership-driven. If the biggest “winner” in the fund is one where we’ve been able to get in early with a $250-$500K check and quickly follow-on with another $1M+, owning 20-25% at exit, the gross exit hurdle to return the $80M from just that one company becomes $300-$400M, not $500M. And that’s the goal for us; identify the likely winners early and quickly follow on with additional capital. We think we’ve been able to do that successfully to date.

You can see that the micro VC model is not predicated on unicorns. In fact, efficient $100-$500M returns like Pardot likely provide better cash on cash returns than $1B+ exits on Series D and later rounds of capital. That’s not to say seed stage is a walk in the park.  We are not betting on 12 months of promising unit economics, the scalability of working customer acquisition channels, or the ability to monetize vast market share. Rather, we are quite simply betting on a founding team that has the hunger, knowledge, and competitive edge to take an idea and turn it into a company that turns an industry on its head (or threatens to before it is bought by a large player). Sometimes, that hunger, knowledge, and edge is enough to build a $100M business from scratch but not a “unicorn”, and we’re more than happy with outcome.

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