Navigating The World Of Early-Stage Co-Investing For Micro VCs

At the peak of the Indian startup funding boom in 2021, with a record $42 Bn raised, it was not only the growth-stage startups scoring large cheques and valuations from larger VCs. High value seed rounds also became routine affairs thanks to the boom in the micro VC space and the rising trend of co-investments.

Given that in 2022, most investors across stages are becoming cautious in dealmaking, co-investments have allowed VCs to hedge risks and still see a big upside.

This is largely because the capital needs for some early-stage startups have not changed, particularly when it comes to startups in the consumer tech space or B2C models.

In 2021, seed-stage funding crossed the $1 Bn mark for the first time in a calendar year. Compared to 2020, the capital inflow in seed stage surged 180% in 2021. Moreover, the average ticket size for seed deals has risen consistently in the past three years, growing from $1.3 Mn in 2019 to $2.3 Mn in 2021.

While seed stage funding has shown resilience amid the so-called funding winter, given the high capital requirements for some new startups, micro VC funds are increasingly looking at co-investments as a strategy to differentiate themselves from large VC funds that also have an early focus.

Micro VC funds typically write small cheques at a pre-seed or seed stage, focussing on a particular niche or sector to narrow down their thesis. But given their relatively low corpus, they need to engage with other similar micro VC funds, angel networks and also their own limited partners or LPs to boost their ability to back startups that have high working capital needs.

This is particularly true for startups in the consumer tech space — D2C brands, quick commerce and other emerging sectors in fintech. Examples include Zepto’s $60 Mn ‘early-stage’ round in November 2021, ecommerce platform 10club’s $40Mn seed round in May last year and Lenskart subsidiary Neso Brands’ $100 Mn seed round earlier this year.

While these large rounds are not typically on the micro VC radar and indeed not led by smaller funds, the fact is that many seed stage startups are arming themselves with enough capital to build a runway for several years. There have been some ripple effects from this surge even on the relatively smaller ticket sizes of micro VC investments.

The enthusiasm around the micro VC model has spurred Inc42’s next big initiative — CapitalX — where we would enable investment analysts, entrepreneurs, and angel investors, to learn the art and the science of building and managing a micro VC fund from the very people who have successfully navigated this journey.

Why VC Co-Investments Have Surged

There are generally three options for micro VCs when co-investing. The relatively common option is where multiple small funds or angel networks invest in a startup, while increasingly we are seeing limited partners in micro VC funds also join the round in their individual capacity.

While micro VC funds frequently collaborate with funds of their ilk to find co-investment opportunities, these connections can also come from the startup or the founder.

No matter which co-investment route is taken, the benefits are more or less similar. The primary reason why micro VC fund managers have adopted the co-investment model is because it allows them to bridge the funding gap as well as minimise their risk.

One of the critical aspects of managing a micro VC fund is defining the ticket size and the number of companies you are looking to invest in a year. This is the trickiest balance to achieve, and also why we are seeing more and more co-investment deals.

Co-investment essentially allows the fund to focus beyond its own limitations of ticket size and portfolio management. Often, a micro VC fund may co-invest in a startup as a secondary investor, which means lower pressure on portfolio management, but the upside remains the same.

For instance, with a small ticket size of around $300K per deal and five investments per year, the value created by a micro VC fund is not that great. At the same time, the micro VC fund cannot go too big either since this runs contrary to the micro VC concept altogether.

So to maintain this tricky balance, co-investing has become the go-to option for such emerging funds.

Funds tend to offer co-investments for several reasons, including when the investment is too large to fit in the fund or for maintaining control of an investment as well as building relationships with their LPs, who will be counted upon for future fundraising.

Managers at micro VC funds also recognise that many LPs are seeking co-investment opportunities through their engagement with the fund. The more sophisticated LPs might also have a family office and their own individual investments, which could be further useful for micro VC funds in co-investments.

How LPs Fit Into The Co-Investment Puzzle

“Co-investments provide a way for us to expand and deepen our relationships with our LPs. Most of the time, they are also looking to expand their portfolio and as long as compliance is met, such co-investments can unlock a lot of value for the fund too,” according to Ideaspring Capital founder Naganand Doraswamy.

Because co-investments can be attractive opportunities, VC funds will typically take the offer to LPs, rather than broadly seeking co-investors, which can result in longer gestation periods.

One of the advantages of co-investing is that the investment risk is shared among all parties, which helps build two-way loyalty and trust between the LPs and the fund.

Simply put, a VC’s customer is an LP and their product is the fund. So while creating a fund thesis or when managing the portfolio it’s critical to consider how the fund might help solve problems for LPs. Engaging with LPs through quarterly or monthly reports also helps funds assess how LP needs are changing and this further feeds into the evolving thesis for a fund.

Co-investing also requires a highly hands-on approach, such that fund managers and LPs get the chance to work closely with startup founders. LPs can gain a better understanding of the fund’s investment strategy, while funds can help their portfolio gain access to go-to-market strategies, alliances and customers through their LP base.

Building strong co-investment relationships can be tricky for new funds that do not have a proven track record for exits. So often, co-investing requires a deep relationship with LPs in the case of a maiden fund for a micro VC.

On the LP side, the benefits of co-investing also include the first-mover advantage for hot sectors. It allows them to identify technology trends before other casual LPs might or building a moat to differentiate their portfolio from other investors.

Another reason why LPs are increasingly entering co-investment deals with VCs or micro VCs is that some funds have a blind-pool where they are typically required to participate in each investment. But co-investments allows a greater autonomy for LPs and helps them manage their overall portfolio diversification needs as well.

This is particularly vital for inexperienced LPs entering the investor pool. The co-investment opportunity allows them to conduct very specific due diligence into the business model and the sector, which can enhance their knowledge on a particular industry and allow them to take better calls in the future at a lower risk.

The Rules Of Co-Investing

What makes or breaks a co-investment deal? There are several factors at play here, ranging from the track record and experience of both the fund as well as co-investor whether it is another micro VC fund, an angel investor or indeed an LP that is joining the round.

Corporate venture funds or big tech companies are also an avenue for co-investments, particularly from a strategic point of view.

“Understanding the motivation of the LP or co-investor behind the investment is paramount. This is only possible through continuous engagement with the LP base and informing them about deal flow and pipeline,” says deeptech fund Speciale Invest’s Arjun Rao.

LPs that offer superior access to the potential investee and also active involvement in the development of the startup are more likely to gain co-investment opportunities with funds.

“Our LPs, particularly business owners, write back to us, saying such and such deal has a bigger success potential, because they either understand the space well or they have potential customers that can leverage the tech,” Rao says, adding that this two-way channel is hugely beneficial for smaller funds that are looking to offer more than just capital to their portfolio.

The biggest challenge in co-investing is in the pre-deal due diligence. Both sets of investors are expected to do their due diligence individually on the potential deal. Herd mentality can be detrimental and creates undue expectations, even if the lead investor is someone with a great track record.

For LPs, the potential upside in early investments is large, but they need to be wary of joining a round just because a micro VC or larger fund might be investing. For a fund, the investment might be a small part of their corpus, whereas the exposure of angels or LPs is higher in a co-investment since they typically have a smaller corpus to invest.

For an angel investor, $200K could mean a significant portion of their corpus, but the same amount for a $20 Mn or $200 Mn fund is a drop in the bucket. In such a case, LPs need to be wary of a potential lack of dedicated focus by the VC co-investor on this startup.

Further, large VCs who take small bets can be very fickle with investing in follow-on rounds if the company has not met its revenue or growth targets, in which case, the company’s chances to raise from other investors reduces significantly, thereby potentially devaluing the LP’s investment.

As Ideaspring’s Doraswamy adds, “While relationships are built on trust, the due diligence is paramount. One cannot take up any deal just because of the say-so of an LP or even the other way around. Just because a VC has conviction, it does not mean that LPs don’t have to do their own due diligence.”

From the VC point of view, the biggest trap could be the bias that they have for specific niches and sectors. This is often part of their thesis building, but for the sake of co-investments some of these preconceived notions need to be set aside. FOMO over a deal is never a good reason to invest, and that’s true as much for regular deals as it is for co-investment opportunities.

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