In the last post, I discussed how commingled funds, whether they be managed by micro-VCs, leading angels, or traditional venture capital funds, can be an important component in an early stage investor’s overall strategy. This is especially for those who otherwise can’t assemble a diversified portfolio. In this post, I’m going to talk about 9 areas I think are most relevant to look at before investing in a startup fund. They are:
1) The Manager’s Background /Reputation
2) Prior and Current Investments
3) Focus: Sector, Geography, Stage
4) Philosophy: Size, Due Diligence, Participation
7) Decision Process
This isn’t just academic: Except for my individual angel investments, everything I’ve got, from index funds at Vanguard to the more exotic, is managed by external managers. I’ve invested in several angel funds before, and I’m looking at some different angel funds right now.
And never in history have entrepreneurs had more choices for seed-stage funding. Early-stage capital has exploded, with new funds entering the ecosystem and late-stage funds playing earlier in the funding cycle. Indeed – in the last few years we’ve seen strong seed-stage investment activity from funds like Felicis Ventures, FirstMark Capital,FlyBridge Capital Partners, Flywheel Ventures, Formative Ventures, Foundation Capital,Founders Collective, Founders Fund, Foundry Group, Floodgate Fund and fBFund. And those are just some great funds that start with the letter F.
Much is written about how to select an institutional investment manager. There’s an entire industry of investor manager consultants (Frank Russell Company, Cambridge Associates, etc.) dedicated to the task. I’ve been on both sides of the fence on this one, having managed institutional fixed income for years, and having been on the investment committees of a few large foundations that chose managers. While many of the principles carry through to selecting a commingled seed fund, the number one tool of all limited partners, i.e., starting searches by reviewing “top quartile” managers based on past investment returns, simply is unavailable in early stage managers. Why? There is a paucity of good data, and it’s a relatively new field.
So what to do? Well, here’s my checklist. Your mileage may vary.
I. Background of the Manager
Just as there are the big kahunas of traditional Venture Capital (the Sequoias, Kleiner Perkins, etc.) and the old pros starting feisty newer firms (Union Square Ventures, Andreesen Horowitz), there is a known pecking order in Angel World. There are big kahunas (Ron Conway of SV Angels) and feisty upstarts (Dave McClure of 500 Startups) in angel land as well. While having a big rep makes it easy to attract money for your fund as well as deal flow, in my mind that’s not the big thing. It’s experience, whether that experience comes only from investing in the sector for a long time, or even better, investing combined with a successful career as a founder/entrepreneur yourself. Just as focus, flexibility, drive, work ethic and humility are important in a founder, they are just as important in a manager. And that background goes a long way towards understanding how that manager will be able to source quality deal flow, which is the life blood for an early stage manager.
Example: NextView Ventures, Boston MA
NextView is less than a year old, which might lead people to the wrong conclusion that the managers are just starting out. Each of three partners, Lee Hower, David Beisel and Rob Go has a great background as entrepreneurs (LinkedIn, PayPal, Ebay, BzzAgent, Sombasa, About); and as VCs (Spark Capital, VenRock, Masthead, Point Judith). While they have bi-coastal connections and are beginning to gain a larger reputation (e.g., via Lee’s recent article in Fortune, Rob’s highly-regarded blog), they also are totally hooked into the regional scene (David founded and runs theWebInno events in Boston) As in virtually any endeavor, the team is paramount. Make sure your team is marked by having not just experience, but success.
II. Prior and Current Investments
There is no better indication of what types of investments someone will make going forward than by dissecting past investments. Study the portfolio: are these the types of investments you would want to have made yourself if you had had access to them?
Example: Felicis Ventures, Palo Alto, CA. Who wouldn’t want to invest with someone who has found places in such hot companies as Groupon, LinkedIn, Twitter, etc. Scouring some of the other names in their portfolio, you can see that the manager, ex-Googler Aydin Senkut, also backs Tasty Labs (Joshua Schachter’s (of Del.icio.us fame) latest company), Room 77 (which wowed everyone at the Launch Conference), or RovioMobile (Angry Birds). These are overallocated, highly-sought companies that you can’t simply invest in by handing over a check; instead, you have to be hand-picked in advance. If, on the other hand, you see companies you don’t know, and worse, know and dislike, ask the manager why they invested in them, and see if you like their logic.
An interesting flip side is to ask about a manager’s “anti-portfolio”, i.e., the good companies that they passed on. There are plenty of good reasons to pass on a company, such as they don’t fit within your stated investment thesis or mandate, you didn’t buy the premise and didn’t see the pivot coming, etc. Fred Wilson of Union Square Ventures, perhaps the hottest VC firm today, wrote about why he passed on AirBnB; one of the longest-lived VC firms, Bessemer Ventures, talks about decades of greatest misses here. To me, though, I’m less interested in why they missed—just that they were able to be in a big time game and at least have a chance to see the winners. If the biggest success someone has had access to was some mere 4x small win, don’t linger—you can find better.
III. Focus: Sector, Geography, Stage
I’m not going to argue that anyone should be looking at, or limited to, any single sector. As an angel, I dabble in several: it’s my money, it’s my responsibility. But for outside managers, I want there to be a focus. Most early stage funds focus on some aspect of tech, for the same reasons most angels do—it’s capital efficient. But there is plenty of room for you, should you so desire, to think about hiring a manager to give you diversification on either a sector basis (e.g., healthtech), geography (especially important if, like me, you’re living outside of major entrepreneurial regions), and stage (which is why large pension plans typically dedicate slices of their PE allocation to both growth funds and LBO funds, representing different market characteristics and risk.) There has to be a hook that will allow the manager to specialize in something so that they know everything going on in that space. A micro-VC can have multiple foci, but only if they have multiple principals. As far as stage goes—do they strive to be the first institutional money in, investing in lower valuations, managing relatively small amounts of money, and then handing off to later stage investors? (First Round Capital, profiled here.) Do they wait to invest at the A round, looking to invest $millions per company, through to B and beyond? (Most traditional big VC funds.) Or do they try to do the whole gamut, including tiny investments to $50 million slugs (Andreesen Horowitz; Yuri Milner of DST). Again, no necessarily right way, but there are some wrong ways. See if you buy their approach and reasoning.
Example: IA Ventures, New York, NY Roger Ehrenberg, founder of IA Ventures, is an “Investor without Borders,” as likely to be looking for deals in Israel as he is in the U.S. But while he has no geographic bounds, his firm focuses like a laser on “Big Data”; he’s earned a reputation as one of the must-see guys for companies in that arena. Just like it’s best to be own a small market, it far better to be the big fish in a carefully selected small pool than to be roaming all over the tech market.
IV. Philosophy: Size, Numbers, Due Diligence, Participation
At the core, you can divide angel funds, micro-VCs and VCs in a graph with two axes: the first is size of fund, and the second is number of investments. Let’s start with numbers: the larger the fund, the more the pressure seems to be to hang on for home runs. That’s a function of VC math, and the reason why many proclaim the “VC model is broken”: the more money the VC draws in, the larger their 2% carry, and they can live fat off the land, eschewing singles and doubles and holding out for home runs. Personally, I buy Basil Peters’ “Early Exits” strategy for most angel investments—there’s nothing wrong with a few doubles, and I probably would never consider a fund with more than $100mm dollars in it. Small is good. However, being small doesn’t necessarily mean you can’t be swinging for the fences—Mike Maples Jr. of Floodgate bluntly states that Floodgate is going after “thunder lizards”, companies that will blast through their markets like Godzilla. Higher risk, higher return. Something for everyone, so know your manager.
While size generally is a good indicator of philosophy, most telling is “numbers”—how many investments does a fund anticipate making? With that information, you can figure out two important ratios: average $s invested per company (which can tell you how many rounds are going to be invested along the way), and average # of companies per partner, which tells you how much attention each investment is going to receive.
The latter is the biggest style item, as it goes to the heart of a manager’s philosophy. There is a strong case to be made for index-style investing, which in startup land is often derided as “spray and pray”. While normally index investing is meant to give rock-bottom costs on efficient markets such as large cap domestic equities where it is really difficult to justify active management, in inefficient markets like startups, the argument is two-fold: when one is investing so early, especially when before product-market fit is found, it’s a numbers game: it can be hard to judge between the top 20% of companies you see, and the hope of landing that 100x or even 1000x return company can justify a portfolio with literally hundreds of companies. (Revisit Sim Simeonov’s analysis on diversification.)
Examples: SV Angel/Yuri Milner’s Start Fund; Dave McClure’s 500 Startups. While the Ron Conway of SV Angel and Dave McClure of 500 Startups could not be more different, their investing styles are essentially alike: Invest broadly in areas you know, and then work your butt off for your companies, realizing that there is only so much of you to go around. The Start Fund, which invests $150k in every Y-Combinator company at to-be-determined market rates, is the closest approximation right now we can find to a broad, high quality index fund. The first batch through was 40 companies at a time, and the next batch this summer is around 60. It’s provocative, but I think effectively investing across the board at an incubator as selective as Y-Combinator has many things going for it. SV Angels also has managed other funds, but I’m not yet familiar with them other than this video. 500 Startups focuses on data, design, and distribution, in a quasi-accelerator fashion making use of terrific external mentors, as there is only so much McClure to spread around. When I asked him what his due diligence was, he glibly joked “writing the check”—in other words, he makes very quick decisions from the gut informed by his background at some seminal startups as well as manager of the Facebook Fund.
Who’s best to do this type of investing? Someone with massive dealflow and a lot of experience. I myself am waiting for the day that Naval and Nivi bring out their “Best of AngelList” Fund. Since they spend time interacting and interviewing all of the people who get to post to AngelList, I imagine they know a thing or two about spotting winners, and their deal flow would be global and second to none.
On the other side of the coin, there is the hand-crafted style of investment manager who makes few bets, but lavish portfolio companies with their time and attention. The idea here is that better coaching and selectivity leads to fewer write-offs leads to better ROIs. Jeff Bussgang’s terrific book “Mastering the VC Game” makes the good point—calculate the number of companies being handled by each partner. How many boards can a person sit on effectively? Not many. But that’s the point—500 Startups and SV Angel don’t want board seats—they want quality, but they want breadth.
Example: Manu Kumar’s K9 Ventures, Palo Alto, CA K9 only invests in local companies where they can add value. How hands on? He actually funds companies at concept stage—for those of you who remember CardMunch, Manu was so integrally involved that he’s a co-founder of the company. That’s the furthest thing from “spray and pray”—more like “invest in and dig in”. In that way, he’s more like a typical VC.
There’s more early stage funds around then I can count. How can a firm differentiate themselves…not to their LPs, although that’s important, but to the startup companies they need to court? Reputation is important, as is focus, but what can give it an edge?
Example: Borealis Ventures, Hanover NH Borealis is a small shop out in the boonies. While its three partners have the classic background I mentioned earlier (including stints as early employees at Yahoo, SoftDesk, etc.), Borealis’s unique edge is its intimate connection with Dartmouth College. Those ties, from involvement with the Dartmouth Entrepreneurial Network of alums to faculty/founders and the Tech Transfer Office, got it in to megahits like life science companies Adimab and Glycofi. While there are hundreds of VCs circling Stanford, Borealis is the only game in town in Hanover, and that town houses Dartmouth College, its Business School, its Med School, its Engineering School, and a surprising amount of entrepreneurial mojo.
Example: Project 11, Cambridge MA. OK, I know this firm is just getting started—I blogged about it as The Future of Seed Capital. Most of their investments stem from having a personal relationship. Their edge: their access (and role within) the TechStars Network. Katie is the director of TechStars Boston and sits in on the selection process in TechStars NY. Accordingly, she sees not just thousands of applications, but also is tight with the entrepreneurial plans of the TechStars Boston mentors—that’s leverage and reach! Additionally, Katie and her Project 11 partner Reed Sturtevant (they worked together before at Microsoft and at Eons) put on working sessions all over various incubators, and are co-located in the space at Dogpatch Labs Cambridge. Accordingly, they see hot companies like GreenGoose (originally out of Betaspring in Providence, RI), peerTransfer (MassChallenge, Boston, MA) in a far more intimate way than just attending a demo day, increasing the certainty of attracting winners and avoiding flashy but flawed startups. That kind of intimate contact with promising, vetted companies at the pre-seed stage? That’s a real edge.
If “a man is known by a company he keeps”, it also holds true for VC firms of any stage. The best sign of respect for someone’s judgment is co-investing alongside. That’s the basis of Chris Farmer’s work on “Investor Rank”, which is akin to Google Page Rank. It’s a simple matter to cross-reference deals on CrunchBase to see who else is finding and valuing the same startups as the fund on which you’re doing your due diligence, and who’s in how early.
VII. Decision Process
OK—I’ve been noticeably absent on talking about sidecar funds of angel groups. Why? Lots of reasons, but a major one is that angel groups act so slowly, and therefore second-time entrepreneurs often pass them by in favor of their existing connections. How slow? Well, it might take a few months to get from a selection meeting onto the next opening in a monthly meeting, and then again another 2 months to get due diligence together and actually execute. Who would you rather call on, someone who can give you a quick answer, or someone who takes 4 months from start to finish? There are reasons beyond financial in order to invest in some angel groups’ funds—see my last post on that. But if more than one person is needed to pull the trigger (which generally I prefer), I want to know how the decision is made.
Example: CommonAngels III.
I’m in this fund for a few reasons, but mostly because of my experience sitting in on the group’s meetings. The membership is deeply talented and experienced in tech, and that network constitutes this fund’s advantage providing significant deal flow, vetting capability, and value add. Large buy decisions for this fund occur in those deals for which there is substantial amount of investment and/or involvement by member angels. In addition, CA’s two professional managers of the fund run an active seed program, making seed investments in those deals which will close too quickly for the usual consideration by membership. The quickness with which they can execute these seed investments also gets the fund and the group in the door for further follow-ons.
This goes without saying—you don’t want to entrust your funds to people who are cavalier about paperwork, reporting, etc. You should get examples of the fund’s communications back to the LPs. Should you wish to back a new firm who otherwise passes the above tests with flying colors from their past lives, first make sure that they have this in place. Some entitities entrust their back-office matters to Village Ventures, which oversees the activities of many venture funds. That’s fine as well—but find out in advance how you’re going to receive tax accounting, statements, etc., from all of your big winnings. Remember, these are long term commitments—avoid long term headaches.
I’m not talking about the personal rapport between you and someone within the Fund’s management. I have no idea who manages my small cap index fund at Vanguard, for example. But I’m talking about the rapport between the partners, and between the partners and their companies. Again, this is going to be a long-term arrangement between you and the firm, and you don’t want the partners of that firm to be undergoing a company divorce.
Example: The Foundry Group, Boulder, CO Consider what Brad Feld of the Foundry Group said in his post about Deeply Held Beliefs: We will never add anyone to the team. I have three partners (Seth Levine, Jason Mendelson, and Ryan McIntyre). We’ve worked together for a decade. We’ve committed to each other to work together as partners “until we are done investing as VCs.” We work extraordinarily well together and have no interest in ever introducing someone new into the mix.
I believe the best funds are those where everyone works together in the same office, and everyone is on the same page on any investment. Those of you who have worked in a distributed workplace where there are clashes of personalities with geographical lines know what I mean.
I especially like those teams who have worked together before in good times and bad, and who are equal partners. If you can visit the fund in person and see the interaction of people, all the better. My time at Year One Labs in Montreal is one reason why I hope to be involved backing their next vintage fund.
As for checking up on the relationships between Fund and their portfolio companies, that’s easy to do nowadays. Peruse their list of companies, figure out a connection to one of them via LinkedIn, and make a few calls. Maybe peruse The Funded, although I wouldn’t take any single comment as truth. But it doesn’t take long to get a sense of the general drift.
OK, that’s my checklist of points to investigate. Below I’ve started a further list of some of the well-known firms I didn’t squeeze into the article above. A crowd-sourcing request—if you know of big names I’m leaving off (though let’s stick it to folks managing fund sizes below $250mm, please let me know in the comments area, and I’ll add them in.
Some other well-known names not mentioned above:
Who do you like that I’ve missed?
- New VC Firm Level Equity Seeks Tech Investments (xconomy.com)
- Everything You Wanted to Know about Commingled Angel Funds…but were afraid to ask (tydanco.com)
- Google To Launch Venture Capital Fund (blogs.sitepoint.com)
- How Can Venture Capital Funds Differentiate Themselves [VC Wish List Part 2] (vccafe.com)
Filed under: Angel, startup, Uncategorized, VC Tagged: | 500 Startups, AngelList, Aydin Senkut, Borealis Partners, Brad Feld, CommonAngels, dave mcclure, David Beisel, Felicis, First Round Capital, Floodgate, Foundry Group, Fred Wilson, IA Ventures, K9 Ventures, Katie Rae, Lee Hower, manu kumar, Mike Maples, NextView Ventures, Phil Ferneau, project 11, Reed Sturtevant, Rob Go, Roger Ehrenberg, Ron Conway, Start Fund, SV Angel, Union Square Venture, VenRock, venture capital, Yuri Milner