At Bee Partners, we’re sometimes asked, “Why should I invest with you when I can instead invest with a Series A fund manager?” It’s a reasonable question. After all, with high loss ratios in the Seed phase, and with valuations loftier than ever, how do investors get paid for the additional risk?
We’re dedicated to constructing a portfolio that may generate outsized returns for our investors. Every week, we review our new opportunities and evaluate follow-on financings in the context of our remaining reserve capital. We consider specific metrics and look both holistically as a portfolio manager as well as individually on the merits of each investment. As stewards of others’ capital, we aim to reward our LPs with higher ROI than other fund managers who accept less risk. But how do we quantify this higher potential ROI?
The Capital Efficiency Score
To answer that, we’ve built a model to help benchmark ourselves relative to our more institutional brethren at the Series A, and we believe others in the ecosystem may benefit from this model, including LPs evaluating prospective Seed managers. We call it the Capital Efficiency Score. For Seed managers to deliver returns that exceed other return profiles, we need to demonstrate that every dollar invested through the Seed manager is worth more than an equivalent dollar invested at the Series A. Put another way, our Capital Efficiency Score must exceed 1 to compensate our LPs for the additional risk and time of investing at the Seed versus investing at the A.
The ratio consists of four key metrics: the fund sizes, the survivorship rate of the Seed manager’s portfolio from Seed to A, the weighted average ownership percentage of the Seed manager, and the weighted average ownership percentage of the Series A manager.
The Capital Efficiency Score essentially describes that for every dollar invested through a Seed manager, there is an equivalent dollar invested at the Series A, while normalizing for both ownership differences and survivorship.
The equation looks like this:
In the first normalization, we consider only the amount of capital put at risk by the Series A investor to achieve an ownership percentage equal to that of the Seed manager. Note that we’re using Seed and Series A here to delineate between two managers. The comparison really holds for any two manager types that differ only in their entry points.
In the second normalization, we consider what amount of capital would be necessary for that Seed manager to have a fund that is entirely composed of Series A risk. It has become increasingly common for Seed managers to tout their survivorship rate to the Series A (we do) as a proxy for return potential. After all, LPs and VCs alike understand that raising an A is no small feat, and typically requires a startup to achieve product-market fit and articulate a story of greatness to unlock that round. Raising an A serves as a significant measure, then, and is a leading indicator of a portfolio’s potential. We recommend that fund managers use a dollar-weighted survival rate for this formula, versus the percentage of companies achieving a Series A.
The equation adjusts the Seed fund by its survival rate and the Series A fund by its ownership to create an apples-to-apples comparison. Anything less than 1, and the Seed is less attractive relative to the Series A … Time to dust off those resumes and find non-VC-related jobs. Greater than 1? Get out there and raise another fund, as we are delivering initial alpha at the Seed to our LPs, relative to the downstream investor.
So let’s compare some funds: In our model, we assume a $125 million Series A fund with ownership of 20 percent. We’ve modeled out three Seed funds, each with their relative fund size, ownership, and survivorship:
Spray VC follows a broad mandate, deploying capital across many companies, with an ownership and survivorship expected from such an approach. Pre VC has far more ownership due to its concentrated approach, and enjoys a survivorship rate higher due to its deeper diligence at decision-making time. And Accelerated VC has a high survivorship due to investing late, but can’t achieve nearly as much ownership due to competition from other investors. All else equal, it’s clear that Pre VC is the optimal choice here for LPs, but there’s still work to be done to exceed a CES of 1. For fun, take the model for a spin yourself and see how dependent the CES is on fund size.
Even when considering the differentiating features that VCs oftentimes tout, the CES can pick those up. For those with sensitivity to valuation, one would expect ownership to be higher. With superior founder selection, the survivorship rate may benefit. For operationally-focused managers, perhaps that skill set should contribute to both.
And, the CES is timeless. In times when the pendulum sways towards founders, we expect terms and structure to be largely equivalent between the Seed and A, so this formula is directionally accurate as it ignores nuances that may arise from preference stack overhang, voting rights, etc. In times when the pendulum sways towards the investor, investor ownership will increase across the board, and survival rate becomes more important. We believe the elegance of the CES arises from distilling this all into these four critical variables: fund size, ownership, capital deployed, and survivorship rate.
However, this model is not without its limitations. First and foremost, it ignores completely that venture returns follow a power law curve. Put another way, a Seed manager should demonstrate both a CES well above 1 as well as a strategy that filters for exceptional potential. Nor does it take into consideration the longer liquidity cycle of pre-Seed and Seed investing. One could layer on a time-weighted discount rate to the Seed fund normalization as a further adjustment. And finally, it ignores the quality of the Series A firm. It is true that exceptional returns have historically congregated in a small handful of firms. Nevertheless, given the proliferation of firms resulting from younger partners splitting from larger parents, we believe that this reality looks back at a time where brand equity played a larger role in sourcing deal flow than it does today. Irrespective of quality, it’s still danged tough to raise a Series A.
In our first fund at Bee Partners, we enjoyed a CES of 1.66. Not bad, although our small fund size coupled with a 70 percent-plus survivorship rate really moved that upwards. We anticipate the Bee I CES to shift slightly as our ownership continues to get diluted. Most Seed funds have neither the strategy nor the capacity to participate in follow-on rounds beyond the Series A.
In Bee Partners II, which saw both the fund size and the average ownership quadruple relative to the first fund, we’re not yet fully invested, so our survivorship rate currently stands at 56 percent on a dollars-invested basis. That puts Bee II’s current CES at 0.96, and we expect 2018 to be a banner year for the fund in terms of matriculations from the Seed to the Series A.
Looking ahead, we have a lofty goal of achieving a CES of 2.0 at Bee Partners—for every dollar we deploy, we want it to be the equivalent of $2 at the Series A. Doing so requires valuation discipline, remarkable founder identification and selection, and such value-add that we can maintain pro-rata through the Series A. We’re up for the challenge.
So LPs, tell us what you think: Is this a viable rubric for manager evaluation and selection? What else would you like to see here?
Our thanks to Samir Kaji at First Republic, Winter Mead at Sapphire Ventures, Marc Phillips at Arafura Ventures, and Nader Ghaffari at VentureScanner for reviewing early drafts.