Sequoia formalizes its scout program, raising new fund to continue it

By Sarah Lacy , written on February 19, 2013

From The News Desk

Sequoia Capital is formalizing the Scout program that we first wrote about last year. It has filed paperwork with the SEC to raise the first separate financial entity to support the program.

The program allows entrepreneurs in the Sequoia network to act as angels to newer entrepreneurs the same way any entrepreneur would. The only thing different is they are actually using Sequoia's cash to fund these deals, not their own.

Last year, we dinged both Sequoia and Andreessen Horowitz for what we called the "sneaky" nature of these funds, which many in the industry knew about but had never been widely reported or confirmed before. We'd heard in some cases that entrepreneurs didn't even realize mega-VC firms were the source of capital, not the scouts themselves. Sequoia countered that the transfer always said the money was coming from Sequoia, these companies just didn't identify to the market and other investors as Sequoia companies.

While they weren't thrilled about it at the time, the outing of the program has likely allowed Sequoia to support it more formally with a bespoke fund.

That said, the firm is still being pretty tight lipped about the program. After all, a lot of the benefits of it are that the "scouts" that invest on behalf of Sequoia aren't necessarily disclosed to the world as acting on Sequoia's behalf. That mitigates the so-called "signaling risk" that startups worry about when raising seed money from large VCs. VCs with seed funds will invest in a wide variety of companies, but only go on to invest in a few Series A deals.

VCs who operate seed funds -- like Menlo Ventures, Accel, Greylock, and Andreessen Horowitz -- explain that this is simply the nature of the asset class and everyone gets that. Series A investments require more money, a board seat, and more involvement, and they simply can't invest in every company they seed. Instagram is usually invoked as an example of a company that didn't get a series A from its seed investors Andreessen Horowitz because of a portfolio conflict, and continued to do just fine.

But all those caveats aside, many VCs have told us that when a firm seeds a company and doesn't invest in the Series A, it makes them think twice about funding that company. As Josh Kopelman said at last month's PandoMonthly, "Do I think I know more than the guys who already invested in them?"

The scout fund was also characterized as a way to help out entrepreneurs in Sequoia's network who were getting a lot of in bound deal flow from peers and had the relevant experience to serve as angels, but not the liquid capital.

From our earlier story:

We started [our scout program] about three years ago, and your story characterized it correctly,” [Sequoia's Mark] 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,” [Sequoia partner Roelof] Botha says. (Ben Horowitz was slightly more colorful in his defense of the program...)

Sequoia -- and likely Andreessen Horowitz -- still are keeping mum on a lot of details. It isn't disclosing the size of this new fund, but it's likely sub-$100 million. They also aren't disclosing the number of scouts. A Sequoia spokesperson did confirm that the program has helped more than 100 companies get off the ground since its inception -- the bulk of which have gone on to get funding from other venture firms.

We've been in touch with Sequoia to confirm the fund, and hope to have more details on the program's success to date in a later post.

This may surprise some people, given how critical I was on the stealthy nature of these programs a year ago, but I'm glad to see Sequoia doubling down on the program -- and being more open about its existence. Since we first covered the issue, concerns about potential negative signaling risks have only mounted in the market. As Series A deals have become more competitive, many entrepreneurs are paralyzed between wanting to take money from an institutional firm with deeper pockets that might give them an edge in getting a Series A and fear that, if they take money from a VC and aren't one of the lucky few to get a Series A, they'll be dead in the water.

As long as we're admitting these things exist and entrepreneurs know where the money is coming from, it seems like a good alternative to the other options out there.

[Image courtesy clotho98]