investing

Announcing Bee Partners III: $43M to invest and a new partner

It is with profound gratitude and a sense of great purpose that Garrett, Tim, Kira and I officially announce today the closing of our $43M fund, Bee Partners III. 

You may have already learned this news from our own personal conversations these last few months or today from VC Journal and Crunchbase News. And as many of you know, we have been investing Bee Partners III since early 2018, with 10 positions already and one more pending. These companies represent a remarkable future, one in which we as humans co-evolve with machines, and the world is most definitely a better place. Much more to come about them in future posts. 

We also are announcing another important development: We’ve promoted Tim Smith to Partner!  We are delighted to have him assume the title of a role he has largely filled for the last two and a half years by both building the proprietary systems that help support our Founders and supporting them from the depth of his own experience as a longtime Silicon Valley Founder, advisor and angel investor. 

Now, empowered with an optimal fund size for pre-Seed investing and our incredible team, here’s what we stand for at Bee Partners: 

We will never leave pre-Seed.

We have no plans or desire to stray downstream and we absolutely remain committed to inception-stage investing. Founders ride a violent rollercoaster of entrepreneurship and we're committed to helping them straighten the path when it is most difficult. Being this early, vital support to a Founder and their nascent idea is critical to our success. That’s proven out in events like TubeMogul’s 2014 IPO, the $275M sale of BuildingConnected last year, and the valuation of another nine companies at more than $100M. Our investment model works, and we aim to keep continuously improving and learning through the work we do with our Founders. 

Machines will win, and how they win is up to our brilliant Founders.

We are in a window of profound change. The steps innovators and backers take, the designs we create, the outcomes we envision and build toward in the next few decades will be as important as those machines and processes that laid the foundation for the factory systems in the late 1800s and the Internet frameworks in the 1990s. But, to be clear, we as investors will not be the ones to deliver the solutions here. It will be Founders who are deeply immersed in the respective technical domains who will show us the best, most innovative ways forward. It falls to us as investors to identify the optimal traits of Founders and then trust the Founders to build the machines that will win. 

We welcome the crazy, the outlandish, the passionate.

Yep. Remarkable change comes from those who passionately apply their energy and precious time to deeply-felt problems. Share your dreams with us and if we invest, we commit to being your partner for life. Full stop. You’ll get an answer from us, we’ll tell it like it is. And yes, we’re wrong sometimes, but that goes back to our willingness to learn.   

On behalf of the team here at Bee Partners, thank you all for your support through these many years and the successes you’ve brought us all. We welcome your insights, feedback, dealflow and introductions. We look forward to partnering with you, investing alongside you, collaborating with you on your own journey, and welcoming you into our community. Most of all, we look forward to sharing a bright and hopeful future, one we’re honored to take part in creating. 

A New Scoring Methodology to Compare Seed and Series A Managers

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:

CES+wrong+equation.jpg

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. 

Examples

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:

CES blog examples.png

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. 

CES Considerations

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.

Navel-Gazing

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.