Micro VCs are notorious for building large and friendly syndicates.  One or two players decide (sometimes rather quickly) to make a seed-stage investment in a new startup, and as a round comes together they invite in a number of their Micro VC and angel cohorts.  What’s the reasoning for all of this chummy behavior?  While traditional VCs sometimes have a love/hate relationship with their syndicate partners (often depending on how well their mutual portfolio companies are performing), it seems as though in the Micro VC arena all of the players speak and act like best friends.  Can this friendship last forever?

Just like traditional VCs, Micro VCs syndicate to pool their risk and their (tangible and intangible) resources in maximizing the upside of the investment while hedging the downside.   Therefore, the most obvious reason for Micro VCs to syndicate more prevalently is due to capital constraints.  When a Micro VC is working from a relatively smaller pool of capital (usually less than $25M per partner), it would prefer to spread risk out further.  Plus, unlike traditional VCs which have capacity to invest over the life-cycle of the startup, Micro VCs can usually only afford to play for a round or two.  Or not even a full round in many cases.  By definition MicroVCs need each other.

However, the friendly nature of syndicates is not just dictated by capital constraint, but deal sourcing and velocity as well.  Perhaps implicit in Micro VC model is the aim to potentially maximize the number of good deals to deploy capital, as opposed to maximizing the amount of capital deployed into a number of potentially good deals.  Given the number of deals that they do each year, Micro VCs more actively turn to their peers for deal sourcing.  This situation is further exaggerated by the smaller funds they manage which result in less management fees.  Without additional cash flow coming into the firm, Micro VCs lack the ability to hire associates or other support to provide leverage on deal sourcing, so they instinctively turn to their fellow firms.

This reliance on outsider syndicates for deal flow does present risks for Micro VCs.  Outsourced deal sourcing shouldn’t be confused as outsourced deal diligence – a potential fatal flaw which does certainly happen.  Playing nicely in syndicates is not reliable due diligence, period.  This group-think effect also fosters a negative situation for entrepreneurs as well.  With Micro VCs building syndicates in familiar packs, a cursory investment decision by one group-member can spread quickly.  Somebody passes in a clique, and soon an entrepreneur is receiving an automatic “no” from the rest of the network of informal ties.

The third reason Micro VCs travel in overly-friendly packs is that the Micro VC space is relatively immature, so the supply of good investment opportunities is still outweighed by the demand.  Almost all of the firms or quasi-firms are just a couple years old.  As the Micro VC space matures and there are additional entrants in the market, potential competition for getting into deals and more capital in each will increase.  This evolution will drive up the “price” of getting into good deals and the chumminess will be dampened.  

Moreover, as some Micro VCs experience success and decide to change strategies by “growing up” into traditional VCs, their capital constraint goes away.  So players who were friendly originally may be less so down the road.  Yet just as traditional VCs are face their peer firms as coopetition, this situation will endure in the Micro VC segment as well.  As the space matures some of the over-enthusiastic pupply-love will be lost.  And if Mirco VCs lose their defining characteristics and become the pigs at the end of Animal Farm, they’ll lose the overtly syndicate friendliness.

But as long as these Micro VC players remain capital constrained and seek a higher deal velocity, they’ll remain good friends forever.  A critical mass of high quality friendly syndicates creates an activation energy for an ecosystem.  Having more smart people giving their time and their resources into a startup market creates a ripple effect of new companies, better performing companies, and ambitious entrepreneurs.  Afterall, it’s good to have friends.

This is a dynamic I'm in the midst of and watching very closely. I wrote about this in detail in my latest letter.ly mailing (sign up here!), but I predict "spray and pray" angels who put in $10-50k will get investing fatigue, Micro-VCs will beat out VCs for the new Series A ($750k-2M on $3-5M pre), and the first VC only rounds will look a bit like Series B rounds ($3-6M on $8-12M pre).

Lots of people continue to make over-strict comparisons between Japan's debt-engorged situation and that of the U.S. There is a new Credit Suisse report out arguing that such comparisons are way overdone. Here are the main bullets:

• The US has had far more proactive fiscal/monetary policy (Japanese monetary conditions were tight until 1995 unlike the US today, Japan fiscal easing was small);
• Japan had falling wages since 1997 and negative inflation expectations since 1993 (US wage growth and inflation expectations are >2%). Falling wages create sustained deflation;
• Asset deflation was more acute in Japan, with house prices declining by almost 80% in the big cities;
• The US moved to recapitalise banks quickly and have already written down 85% of their estimated losses (Japan needed 13 years to do that);
• Japan was very slow to de-regulate (and hence the price of labour fell as oppose to the quantity) with companies having little incentive to maximise RoE, the return on capital is a third of the US;
• Deflation became economically and politically acceptable because Japanese households have net financial assets of 41% of GDP so they benefit from deflation.

I don't disagree, but keep in mind that it's early. Japan has had more time to sink deeply into its mess than the U.S. has.

I'd like to think that the various US government bailouts have helped us avoid a decade of deflation, but I strongly believe there has been a structural shift in employment that will leave a lot of blue collar / lower middle class people out of work for a long time.

A huge challenge for user-generated websites is overcoming the chicken-and-egg problem: attracting users and contributors when you are starting with zero content. One way to approach this challenge is to use what Geoffrey Moore calls the bowling pin strategy: find a niche where the chicken-and-egg problem is more easily overcome and then find ways to hop from that niche to other niches and eventually to the broader market.

Facebook executed the bowling pin strategy brilliantly by starting at Harvard and then spreading out to other colleges and eventually the general public.  If Facebook started out with, say, 1000 users spread randomly across the world, it wouldn’t have been very useful to anyone.  But having the first 1000 users at Harvard made it extremely useful to Harvard students.  Those students in turn had friends at other colleges, allowing Facebook to hop from one school to another.

Yelp also used a bowling pin strategy by focusing first on getting critical mass in one location – San Francisco – and then expanding out from there.  They also focused on activities that (at the time) social networking users favored: dining out, clubbing and shopping. Contrast this to their direct competitors that were started around the same time, were equally well funded, yet have been far less successful.

How do you identify a good initial niche?  First, it has to be a true community – people who have shared interests and frequently interact with one another.  They should also have a particularly strong need for your product to be willing to put up with an initial lack of content. Stack Overflow chose programmers as their first niche, presumably because that’s a community where the Stack Overflow founders were influential and where the competing websites weren’t satisfying demand. Quora chose technology investors and entrepreneurs, presumably also because that’s where the founders were influential and well connected. Both of these niches tend to be very active online and are likely to have have many other interests, hence the spillover potential into other niches is high. (Stack Overflow’s cooking site is growing nicely – many of the initial users are programmers who crossed over).

Location based services like Foursquare started out focused primarily on dense cities like New York City where users are more likely to serendipitously bump into friends or use tips to discover new things. Facebook has such massive scale that it is able to roll out its LBS product (Places) to 500M users at once and not bother with a niche strategy.  Presumably certain groups are more likely to use Facebook check-ins than others, but with Facebook’s scale they can let the users figure this out instead of having to plan it deliberately. That said, history suggests that big companies who rely on this “carpet bombing strategy” are often upended by focused startups who take over one niche at a time.

Focus is a really important for early stage startups, as it forces you to stay close to your customers while achieving product / market fit. It also allows you to concentrate any word-of-mouth effects you may have, helping you build your brand + critical mass. Great post by Chris (as usual).

Hot topic the last few days are VCs railing against the proposed new tax legislation on carried interest. The proposal is to tax the money VCs make on their investments as regular income instead of as capital gains (which is the tax you pay if you were to make money buying stocks on the stock market). The argument for the tax is that it is income, and special capital gains treatment should be reserved for cases when you are investing your own money (a big risk), not somebody elses (and getting paid to do so).

Here's more detail, for those of you who aren't familiar. University endowments, giant pension funds, and the like invest their money in a bunch of different ways to both maximize their returns and diversify their risk. One of these "asset classes" is venture capital. They pay VC firms a fee of 2% of the total money invested to take their money and invest it into promising startups. To encourage VCs to pick the most promising startups, they also give VCs 20% of the profits from the startups that are successful. This is called the "carry". 

From the NY Times article:

"Under current rules, carried interest is taxed federally at a rate of 15 percent because it is treated as a capital gain. That contrasts with the tax rate on ordinary income, which can be as high as 35 percent. The plan approved by the House, which overcame strong lobbying pressure from Wall Street, amounted to a compromise that would tax 75 percent of carried interest as ordinary income and 25 percent as capital gains. It is expected to raise more than $17 billion in tax revenue over the next decade."

The argument against the tax increase is that VCs will immediately pass along the higher tax cost to the LPs in an effort to maintain their profit margins. In the face of reduced revenues, LPs will divert money going to VCs into other asset classes that have higher returns. This (they claim) will result in fewer dollars available to invest into startups, which will result in the creation of fewer jobs. Therefore, the new tax hurts the economy.

I don't buy it, and here's why. First of all, the best startups will always be able to find VC money because VC money isn't disappearing, just shrinking (maybe). And it's the best startups that result in creating the majority of jobs. It's also the best startups that create the 100x returns that VC funds are structured to require. The top funds result in the majority of VC returns, with the rest (over the last decade) barely breaking even or worse. So LPs will be even more competitive to try and get their money into the top funds, and it's the poor performing funds that will suffer. So yes, fewer jobs will be created, in that sucky VC firms will die and the bad investments they would have made will never exist. In my opinion, the projected $17 Billion in tax revenue seems more than enough to make up for it.

My argument breaks down if LPs shift so much money away from VC that it affects the top VC firms. I don't think that will happen, as LPs need to diversify their portfolios and high risk / high reward asset classes like VC are important pieces of that portfolio. The poor returns of VC funds over the last decade will be a good test of this theory – who cares what the tax rate is if your ROI was 0%!

This is definitely a complex issue, and I want to hear your thoughts on the matter, so please reply! 

Now this is a graph that makes me happy

This one is about the "Starving Startup" and how, with all the talk of "Lean" vs. "Fat" startups, too many entrepreneurs are taking too little money. Click the link above to sign up for future posts.

These are the high level results of a survey sent to entrepreneurs living in NYC, Boston, and Palo Alto.

Public Funding

Ø  Just 13% of respondents sought public financing; 42% sought private financing

Ø  The median public raise was $2 Million, while the median private raise was $275,000.

Ø  69% of companies that applied for public funding received some

Ø  Only 30% of companies raised as much private financing as they had hoped

Office Space

Ø  42% of respondents with commercial office space in New York did not pay rent last month versus 24% and 22% of respondents from Boston and Palo Alto respectively

Ø  When factoring in this free rent, the median rent per employee, per month was $200 in New York, $350 in Palo Alto, $500 in Boston

Ø  When calculating the cost of office space only for those companies that paid for their office space, the median rent per employee, per month was $733 in New York, $475 in Palo Alto and $500 in Boston.

Geography

Ø  Just 18% of respondents moved to a location to launch their business (15%) or to move their business to a new location (3%). 

Ø  Exactly 70% of respondents were either born in the city where their business is based (17%), came for education (23%), or came for a prior job (30%).

Ø  37% of respondents from Palo Alto moved there to launch their business (32%) or to move their business to a new location (5%).

 Key Recommendations

 Ø  Student Loan Forgiveness for Entrepreneurs

Ø  Create “Immigrant Friendly” Cities

Ø  Recruit and Support Firms with “Entrepreneurial Prominence”

Ø  Raise Awareness of Public Funding Availability through Social Media

Ø  Use City-Funded Offices to Help Entrepreneurs Identify and Apply for Public Funding

Ø  Tax Incentives for Established Companies that House New Ventures