The Seed Rounds They Are a-Changin’: Three Shifts We’ve Made to Homebrew Investment Model

“Write your principles in pen but your strategy in pencil.” Now that we’re 18 months in to our first Homebrew fund, and 2014 is coming to an end, thought it could be interesting to share three places we used the pencil eraser thus far. 17 core investments have been made, I’d say our investment model was, and continues to be, consistent with the type of firm we want to build but if you’re not constantly evaluating how to get better and serve entrepreneurs, you won’t last very long in the early stage venture business.

1) We Still Believe Boards Are Very Important, But Don’t Always Need to Take The Board Seat Ourselves

From the very beginning Satya and I have stressed the importance of adding an outside investor to your Board as early as seed stage. This notion is more common now than it was when we started the fund early in 2013, there’s still occasional question about whether this slows down a company’s operations or gives investors too much control. My answer is, if it does, you’ve selected the wrong investors, which is a bigger problem. Our emphasis isn’t on slide decks and governance, but instead on helping founders build leadership, steady cadence and periodic strategic discussion into their thinking, which we believes contributes to startups being more prepared for a successful A Round. Whether it’s correlation or causation, our first five investments have all raised additional money after our seeds, so we continue to emphasize boards as part of our model.

BUT we went to market asserting that Homebrew should take the seed investor Board seat. That was shortsighted and to be honest, I don’t even recall why we started with this assumption. It’s true that there are only a select number of institutional investors who are willing to take Board seats (largely due to higher volume investing models than Homebrew employs), but when we co-invest with a likeminded fund, we’re often thrilled to see a partner from that fund assume the Director role. We’ve been lucky enough to have this occur with Dave Samuel of Freestyle Capital and Michael Dearing from Harrison Metal. Out of 17 core investments, Satya or I serve on 12 Boards at the behest of the founders, while in five other cases, we’re either Observers or work with the companies outside of a formal Board role.

2) We Still Believe In Concentrating Our Capital In 8-10 Companies Per Year, But Changed Way We Think About Ownership Percentages

Homebrew I is a $35 million fund where we use roughly 1/3rd to make initial investments and then the remaining 2/3rds to follow-on in those investments. Our brand promise is to go to bed and wake up thinking not just about where the next dozen investments come from, but how to be of proactive and reactive use to our current founders. To invest at an appropriate rate for a fund our size and stage, but also deliver against that commitment, we believe we should be making 8-10 investments per year.

This resulted in an original model where we assumed owning 10% of a company post-seed investment. No more, no less. This would make room for a meaningful number of other investors in the syndicate but also the concentration we needed. Of course the real world doesn’t work like a spreadsheet and in 2013 we found ourselves with great opportunities where we’d need to take under 10% to make a round work, or the chance to own more than 10%. So we rethought our approach and decided that it wasn’t 10% that we were literally angling for but rather an ownership percentage in each company that could be meaningful in a successful outcome. So we backed off the 10% hard target and instead think about how to return 1x the fund in each investment. For example, if we thought a company ultimately had the potential to be worth $350 million we’d want to own 10% but at $500 million, 7% would suffice.

The result in our overall model? Not substantial on average because across the 17 investments we own roughly 10.5% post-seed, but it’s allowed us to look at each company differently. In some cases we own 10%, in others upper teens, and in some, single digits. (I should of course note that we’re not overly scientific in our “outcome” math – what we generally do is look at comps for the vertical – SaaS, ecommerce, etc – and just talk through some scenarios among ourselves).

3) We’ll Selectively Enter Post-Seed, If It’s Still the First Institutional Round

The majority of founders we speak with are raising a $1-2.5 million institutional seed round. Commonly this is the first money into the company or the first institutional raise after < $500,000 previously from angels. However there are two exceptions with great relevancy for Homebrew. The first is when a company has been around for a bit and is further along in their growth than a typical seed company. The second is when an experienced founder has an opportunity to go “straight to A round” with a multistage venture fund. In both cases their first institutional round looks more like $5-$15+ million with a single larger VC playing a lead role.

What’s a seed fund to do? I know some which skip these types of rounds out of fundamental concerns for valuations but Satya and I felt that wasn’t playing to our strengths. We’ve been lucky enough to work alongside many of the entrepreneurs who fell into the “Straight to A” situation and because of our Bottom Up Economy thematic approach, were meeting interesting fundable businesses with substantial revenue already coming in. So we decided to keep a high bar here, but enter with conviction where there was opportunity. Three of our 17 core investments were first institutional rounds priced more like A’s than seeds. In all cases there was some combination of (a) area we’d been investigating already, (b) lead VC with mission alignment, (c) ability to get enough ownership to meet our #2 condition above while staying within our per company investment threshold (ie we’re not writing multi-million dollar checks into these first investments and (d) founders we’ve known for a long time. If we can’t see at least three of these four attributes in place, we won’t even consider the deal no matter how sexy.

Closing: Discipline vs Iteration

First time fund managers can sometimes get caught changing too slowly out of fear they need to explain strategy deviances to their LPs. Our assertion has always been there’s a big difference in-between ‘smart iteration’ and ‘lack of discipline.’ In Homebrew’s case we believe we’ve stayed 100% true to our principles (entrepreneurs are our customers and who we serve; we want to focus on helping them years 0-3 of their companies; we want to invest in hypergrowth companies not be a hypergrowth fund), while testing hypotheses at an appropriate rate matching sense of urgency with not overreacting to limited market data. We’re still very early in the fund’s maturation but it’s been a very exciting and rewarding first 18 months.