Micro-funds introduce smart funding to seed ventures

Near-zero yields of the past few years have been driving the traditional venture capital (VC) funds to change course and streamline, transforming the venture capital model as we have come to know it in more than one way.

Some traditional VC funds consolidate into massive investment entities to invest in mega-projects such as the next generations of web, applications and mobile security solutions. Others merge, disappear or continue managing their current portfolio without further investing at all or while investing in start-up companies in later stages. Ventures’ prices at these stages may be higher but they offer lower risk, leaving the VC fund room to make profit.

The vacuum which the traditional funds leave behind them has been filling up in the past few years with micro-funds and professional “angels” that invest in ventures in seed and early stages. These ventures are mostly involved in the areas of consumer, end-user and software for the Internet and mobile worlds. Examples include Lool Ventures and The Time, both of which have completed a capital-raising round.

Prominent angels and micro-funds in this space include Zohar Gilon, Rhodium, Partam, Tal Bar – Noah, The Time of Ilan Shiloach and Nir Tarlovsky and YL ventures of Yoav Leitersdorf.

And yes, there are also the traditional funds which partially adopt the new micro-fund model. Examples include Index Ventures, an international fund, Genesis Partners with it “The Junction” and Jerusalem Venture Partners and their “Media Quarter” Project.

Micro-funds invest in ventures with relatively low value, in the range of $1 million-$2m. up to $14m.- $16m. Until recently, ventures of this size had no professional and methodical funding solution available to them on the market and were forced to rely on related parties or unprofessional angels. Short of the right connections or capital-raising expertise, some tried to make it without funding altogether. The micro-funds are now moving in to fill the space with smart funding.

High risk was the main reason the VC industry shied away from small start-ups in these fields. Additional reasons include the strong involvement and the prohibitive management costs required in this early stage.

Micro-funds and professional angels, however, can afford to invest in early-stage start-ups because their investments are small and more widely dispersed across a broader range of ventures.

Companies’ prices are considerably lower at this early stage and the micro-funds enter them with positions of five percent to 15%, unlike the VC funds which enter as controlling shareholders or large minority shareholders to justify the management fee they collect from their investors and to obtain a return on their investment.

THE ENTRANCE of micro-funds and angels into the market has far-reaching implications for the entrepreneurs, the investors and the public at large.

Firstly, the board of directors of the start-up company is run in a more democratic manner from the outset since it includes a significant number of professional investors. The investors appoint a consensual “the-bestamong- us” chairperson to represent them and take the company forward in collaboration with its founding team.

This is very different from the hierarchic, “monarchic” management style which characterizes investors with controlling shareholder or large minority position.

The democratic management model offers several important benefits: It preserves the entrepreneur’s independence and authority to take the best decisions from the start-up’s perspective, and allows investors to determine the quality of management by the actual performance.

The distribution of the burden between five to 10 professional investors makes it easier for everyone in terms of the time they need to dedicate and also in terms of funding the venture through to maturity if necessary.

Smaller burden translates into saving the precious time consumed by additional capital-raising rounds, and into the ability to ensure continuous development without getting stuck because of insufficient funding.

Since the micro-funds and the angels see the companies through to the exit, either by selling it to a traditional fund, corporate M&A or through an IPO, the professional board accumulates knowledge and experience with the company throughout its early years.

Consequently, it is more capable of assessing the pace at which the company progresses, the quality of its management and its suitability for the next stage of funding.

Another advantage is that failing ventures, which previously obtained funding based on connections alone, are no longer nurtured at all. In other words, having an angel or micro-fund look after the venture provides it with a “quality stamp” for the more traditional funds that move in at a later stage.

Needless to say, the traditional venture funds benefit from a deal flow of better quality as a result of the close, professional attention the start-up has been receiving.

Theoretically, the broad investment distribution of the micro-funds, which manage up to $20m.-$50m., could result in a portfolio identical to that of an ETF or mutual fund, which can be issued in stock exchanges around the world. Hopefully, as this area develops, we will see micro-funds issuing an entire portfolio, obtaining yields as well as exercising flexibility, in the negotiable capital market.

If this happens, the non-professional public will become exposed for the first time to investments across the fund’s portfolio. It will stand to gain from the entire profit potential without having to try and understand the nature of each company.

This is very different from the current situation, in which “laypersons” can invest only in ventures the professional investors have opted out of, namely the companies that have the lowest prospects of success, and without tools to assess their potential gain. However, once the micro-funds are issued on the stock exchange, their results will become visible to the public and ranked by fund indices.

In conclusion, the micro-funds provide smart funding to start-up companies, enabling them to work methodically and professionally with the capital market throughout their evolution: starting a venture with a truly promising potential; monitoring and analyzing its performance to increase the investment in the more successful ventures of the portfolio, thus creating a high-quality, managed deal flow all the way to the traditional VC funds, and hopefully in the future to the public too, to enable everyone to benefit from the fund’s full gain potential.

The writer is CEO of Darya Venture Capital.