San Francisco-based fund-of-fund Cendana Capital has just filed paperwork with the SEC to announce the final close of its $88 million fund. This fund will invest solely in institutional seed funds or micro-venture funds, as they’re sometimes called.
If you’ve been following the venture world closely, you know that’s a bit contrarian for two reasons. The first is that Cendana is a relatively new firm and increasingly limited partners — or the guys who invest in VCs — are declining in the US, sending more and more VCs to other countries to ask for money.
The second is that it’s not such a great time to be putting money behind seed funds.
As the cost of starting Web companies has plummeted in recent years, firms have flooded into an opening for more angel and seed funding, causing an absolute glut of startups that raised just enough money to test an idea. But since the number of traditional venture firms is — if anything — winnowing, there are not close to enough Series A deals to go around for all those seed companies. Hence, the much written about Series A crunch.
Data has shown that some $1 billion of investor money will evaporate, as small companies quietly go under over the next year or so, which everyone likes to describe as a healthy macro trend for the ecosystem. But it’s less welcome for seed funds who actually backed the companies going under.
Making matters worse for this sliver of the industry: We reported numbers last week that showed that these micro VCs have a harder time finding follow on funding for their startups, when compared to larger venture firms.
All the data and common sense would suggest that the microVC world is likely to experience their own shakeout in coming years — just about the time Cendana has formed the only pure play fund of funds we’ve ever heard of to invest in them.
Of course the key in the venture world is always who you are investing in, not what category they are in that matters. Again, this is a lopsided industry where 5 percent of the deals make up 95 percent of the returns. Being in any category doesn’t mean anything. Being in a specific company — or in the case of an LP, a specific fund — is all that matters.
As we wrote last week, there’s a massive gulf of quality when it comes to micro VCs — perhaps a greater gulf than anywhere else in the venture world. The good ones are near impossible to get into because they are so small. The mediocre ones may be walking dead.
Cendana has done a decent job of getting into many of the top ones including Lerer Ventures, SoftTech VC, Forerunner Ventures, Founder Collective, and Freestyle Capital. That gives the firm early bets in companies like Fab, Fitbit, Poshmark, Warby Parker, Bonobos, and many other up and comers. “There are only 15 good seed firms in the US and perhaps 10 more worldwide,” says Cendana founder Michael Kim. “I’ll be the first to admit, I’m not in all of them. I can’t get into Michael Dearing’s fund or Mike Maples’. Those are closed and they are disciplined about their fund size. But that kind of scarcity helps my cause. I can say, ‘Look at my portfolio. These are the ones you can’t get in.’”
Beyond their reputations, Kim digs deep to try to figure out which of these firms is actually adding value to portfolio companies and which isn’t. He shies away from spray-and-pray firms and favors those who make a smaller number of bets, lead rounds, and reserve capital for follow on fundings in the companies they deeply believe in.
I can attest to his rigor: I first connected with Kim, because he was considering an investment in New York seed king pins Lerer Ventures, who invested in PandoDaily. He was reaching out to several of their portfolio companies to hear how valuable they’d actually been, and asking a lot of hard questions. (So, by the transitive property, Kim has a small stake in PandoDaily too.)
The beauty of investing in this stage is the earlier you go the less you pay for ownership. And if his firms continue to invest as the company’s age, the underlying stakes can become very valuable.
At the same time, as long as these firms back talented entrepreneurs, there’s a nice hedge of an acquisition given the rabid war for talent in the tech world. That’s the advantage to being overweighted in Silicon Valley where tight social connections mean these deals are more common.
The key, of course, is backing the right horses, who can in turn, back the right horses. Otherwise, in a world where Series A deals are harder and harder to come by, Kim’s strategy can unravel rapidly. So far, he’s invested in ten funds with some 175 underlying portfolio companies. Only five have completely gone under, he says. “The mortality rate is surprisingly rare,” he says. (Words he might regret as the year goes on.)
In all, Kim has met with more than 200 seed funds, most of them under $100 million in size. He’s traveled to China, India, Brazil, Turkey, London, Russia and all over the US to find them. And a big takeaway has been how important the ecosystem around the firm is. He would up only investing in firms in Silicon Valley, two in New York and one in Boston. And the Boston one — Founder Collective — does 90 percent of its deals outside Boston. Even ecosystems like Southern California, Seattle, and Austin didn’t feel mature enough to Kim.
What he looks at specifically within those ecosystems is how high quality the entrepreneurs and co-investors are and how much follow on capital there is to avoid things like the Series A Crunch. And in everywhere except Silicon Valley, he found deficiencies on those areas. New York got a break, for Kim, because so many Valley firms are also investing there at later stages. “New York is getting there,” he says. “It’s better than any other place other than Silicon Valley right now, at least for seed funds.”
Kim has been around the startup ecosystem since the late 1990s. He moved to the Valley to work in Morgan Stanley’s M&A group during the first Web bubble, was a partner at Rustic Canyon Ventures and served on the board of San Francisco’s $15 billion pension fund. In 2009, he decided to start his own fund-of-funds.
Fund-of-funds are sort of a middle man between wealthy families and endowments and VCs and private equity funds. They were very hot in the late 1990s as it became harder and harder for these groups to get into venture funds. Fund-of-funds sold themselves as a way to broadly invest in venture capital and get into better firms. As with everything else in the late 1990s, a lot of them didn’t fare so well once the bubble burst.
Kim started raising money and investing as he went, and after 18 months he’s closed $88 million in capital, which he’s committed to ten funds. Because he came from the venture world, he has a slightly different mentality than a lot of other LPs. For one thing, he’s not afraid to be the first money into a new fund. VCs are rewarded for that; LPs — many of whom are essentially working for large civil servant pension funds — are rewarded for putting money into the same old names everyone knows and already likes. The most annoying question VCs get from LPs is “Sounds great, but who else is in?”
Like the funds he backs, Kim says he’ll continue to think micro in fund size in the future. “Venture capital isn’t an asset class,” he says. “There are only a handful of firms that matter and if you’re not in those, you just shouldn’t be in it at all.”
[Image courtesy JD Hancock]