On Wednesday we uncovered a potentially worrying trend of VCs investing in very early stage companies by giving money to network rich, cash poor entrepreneurs — or “scouts.”
Ostensibly, the trend has a lot of advantages for the investors involved. Scouts get to become angel investors quicker than their liquidity schedules might allow, more startups get funding, and venture firms get a pulse on deal flow they might not have seen otherwise. The only problem? Entrepreneurs at the receiving end have told us these relationships frequently aren’t disclosed.
Since our original story ran, we have received a flood of emails telling us more about this trend. In many cases, the entrepreneur was surprised when they found out where the money was from after the deal was already done. There was another commonality among the tips: Most involved Sequoia Capital.
We reached out to Sequoia, and partners Mark Dempster, Roelof Botha, and Alfred Lin agreed to discuss the program openly for the first time. In the interests of transparency, we’re hoping other firms follow suit.
“We started [our scout program] about three years ago, and your story characterized it correctly,” Dempster says. “We’re lucky enough to be in the company of some pretty fabulous founders. They attract great entrepreneurs to them for advice and referrals and sometimes resources. They hadn’t achieved liquidity yet, and so they couldn’t invest. That was the backdrop.”
As we wrote on Wednesday, the program makes sense in a lot of ways. You have VCs who have a glut of money and are having a hard time investing at the earliest stages. And you have well-connected, would-be angels who have the access to those deals but lack the cash to make their own investments. It’s totally reasonable the the former would want to join forces with the latter. What is less reasonable is keeping the arrangement secret.
Sequoia was quick to draw a line between something being a “secret” and merely “not talked about.” “It wasn’t so much sneaky, as it was stealthy,” Botha says.
Indeed, Sequoia chooses to keep a lot of stuff close to the vest — more than most firms. It doesn’t disclose who their limited partners are or how many investments they have at any given time. And there was a limit to their openness, when we talked about the scout program: They wouldn’t give us the full list of names or even share how many there were or how much the firm invested in them.
This difference between “secret” and “stealth” may sound like splitting hairs — and it is a little. But to be fair to Sequoia, there are two legitimate distinctions. The biggest is that the decision to be stealth mostly came at the behest of the scouts three years ago during the very first meeting of the program, according to Sequoia and three of those scouts we spoke to.
“The people in the program agreed that they preferred to keep it stealth for as long as possible,” Dempster says. “It was their decision. They were at liberty to describe what the relationship is and where the money was coming from in their own way, but the scouts were never ever told to obscure the relationship with us. In no way would we want the scout to lie or hide the source of money. The wire transfer came from Sequoia Capital every time.”
Sequoia partner Alfred Lin was the CFO of Zappos then and was among the first scouts. “At the time I thought it was innovative and creative,” he says. He remembers that first meeting and the debate. “We didn’t want people banging on our doors,” he says of the reason he wanted the program to remain quiet. “We weren’t professional investors doing this full time; I had a job. Also, we didn’t know how this was going to work. It could have been a complete flop. I could have been crisper or clearer. But this was actually discussed, and we all agreed we didn’t have a ton of time to screen a bunch of investments, and we mostly didn’t want to get pinged all the time.”
Says Nick Mehta, another one of the first scouts, “They definitely left it open to us but told us to think about the impact on the entrepreneur. We were told we should tell the entrepreneur. But they told us to make sure the entrepreneur thinks about it before they broadcast that Sequoia is an investor because of the signaling effect if Sequoia didn’t invest later on.”
“We agreed not to advertise it but to always be truthful with entrepreneurs,” says another early scout, Sam Altman. “I always gave my companies the opportunity to take money from Sequoia or me personally. Only once did a company ever have any concerns.”
The structure isn’t exactly like a standard limited partner arrangement, because the bulk of the returns go to the scout, not the firm. Exactly what benefit Sequoia gets out of it remains unclear. I asked all three scouts if their deals would have likely pitched Sequoia eventually anyway, and most of them said yes. Sequoia doesn’t get any warrants or right of first refusal or equity in the company. “We’ve never asked for information on the company and we don’t want it,” Dempster says. “The value was having a blip on the radar screen.”
“When I was a scout, I didn’t pass information from the company to Sequoia,” Lin says. “I did give them the heads up when these guys might be raising a Series A but nothing more than that.”
Although the scouts were the ones who decided to keep things quiet, several of the people I spoke with were relieved it was finally out in the open. Constantly explaining such an odd arrangement could be annoying and confusing for first time entrepreneurs. Most hoped that other firms would follow suit and disclose these arrangements, particularly as some of the programs work differently.
But some wondered whether our forced openness around the issue has somehow killed the benefit of the program. Will companies run around saying they’re funded by a Sequoia scout to get credibility in the market, and start to incur the same signaling risk that the firm was trying to avoid in the first place? Will dodgier firms push the envelope on a relationship that’s based so heavily on trust?
And, more unknown, will this become as standard at firms as entrepreneurs in residence programs, killing what was a unique and proprietary thing for Sequoia?
“If every venture firm did it, it wouldn’t be that interesting anymore,” Mehta says. “I think there was value to being first.”