An Insider’s view on Sequoia and Others VC Firms

Secretive and Sequoia seem to go together like Kim and Kanye, but there is nothing mysterious about their success (Sequoia’s) and the success of other top venture capital firms along Sand Hill Road. Fidelity, Blackrock, Tiger Global, T. Rowe Price, and others have come to find out, but the secret is simple, probably known, and worth repeating.

In fact, it was stated by Yale University’s David F. Swensen (more on him later) in 2013:

“Top-tier managers benefit from extraordinary deal flow, a stronger negotiating position, and superior access to capital markets, and thus are well positioned to outperform their peers.”

Top venture capital firms like Sequoia have created a “franchise” by mastering different forms of capital: social, intellectual, and financial.

Social. Top venture capital have established an extensive social network which bring deals from past entrepreneurs and others. No surprise here right, but why the surprise when Sequoia uses “scouts” to find the next deal?And did Don Valentine “just take a risk” on Michael Moritz? Or was Valentine’s odds hedged by Moritz’s existing social capital of Oxford andWharton MBA alumni networks, relationships from running Technology Partners or connections built working the Silicon Valley beat for Time Magazine?

Intellectual. The top firms have “hard-won investment insight”. For Sequoia Capital, this could be encapsulated by Don Valentine’s large market concept: “If you don’t attack a big market, it’s highly unlikely you’re ever going to build a big company or “I like opportunities that are addressing markets so big that even the management team can’t get in its way”. This thinking may be the reason for Don Valentine’s backing and building companies such as Cisco Systems.

Financial. The firms along Sand Hill Road also have “access to capital markets” from established relationships with investment bankers. The top firms complete the venture capital cycle of investing in entrepreneurs and the exiting their portfolio companies with a public offering. Entrepreneurs seek out the top firms to insure success. Could this be reason why Page and Brin sought out Sequoia and Kleiner Perkins in 1999?

Top firms are successful because they are successful: they attract talented people who contribute to the firm’s success and then the process repeats. The virtuous circle makes it difficult, but not impossible for other firms to leap into the top tier.

The “insider”, David F. Swensen, is the Chief Investment Officer (CIO) of the Yale Endowment. He started as CIO in 1985 and pioneered the use alternative assets such as venture capital for institutional investors. David F. Swensen wrote Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment.

At the end of June 2014, the Yale Endowment had total assets of $23 billion and was a Limited Partner of Sequoia as of 2007.

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Breaking News: Twitter Just Sold

Seventy to Fifteen and Twitter is gone, sold. At least, that’s the news reported this week as Twitter’s stock prices falls and stories circulated that Twitter will be purchased. Old media (Time) says it is “Twitter’s Final Days”and the newer ones say “Why Twitter is Hard to Buy” (The Information). Twitter is not an attractive target and not for the reasons reported. Twitter even said so.

Golden Egg. Twitter has lots of past losses, which is common, especially in the technology sector. In fact, Twitter has losses of $2.6 billion. The losses allow Twitter to offset future taxable income. The past losses are there to offset future income, until things are evened out, like children on a seesaw; so losses are really an asset.

Don’t Kill the Goose. Remember, Uncle Sam is another partner any business and he gets his share, before other shareholders, in the form of income taxes. As an owner, you would do anything to reduce your taxable income. Knowing this, Congress wanted to discourage anyone from acquiring a company just for its tax losses. Thus utilizing the tax losses is limited. Twitter even said so in its 2014 Annual Report (Page 34).

Scrambled. Utilizing the tax losses is limited when there is change in ownership. Now if someone does not care about the tax losses then go ahead and buy Twitter. But some tax savvy private equity firm (Silver Lake Partners?) or a large company (Google?) with lots of taxable income may be concern with tax issues. And so acquiring Twitter becomes more difficult and more expensive.

Markets are made of people who are motivate by fear and greed, not necessarily the rational. Stock prices go up when there are more buyers than sellers and visa versa. Example: everyone get excited about Twitter, new book, etc, and at the IPO, the stock price goes to $26, eventually to a high of $70, and then poor user growth and the stock falls to $15.

It is up and down and boom and bust. During the recent boom, there has been more press about technology and more dealers in tech news. In the current period, there appears to be a lot of speculation in the financial markets and the financial press.

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Yelp’s Recent 8-K: No Five Stars Here

Yelp recently released earning news, oh boy! The headline read: “Net revenue was $153.7 million in the fourth quarter of 2015….” You need to look further for the really BIG news… Yelp’s CFO, Rob Krolik decided he needed …some time off to spend more time with family” and quit, or did something else happen?

Yelp reported to the SEC that on:

“February 4, 2016, Rob Krolik and the Company’s Board of Directors (the “Board”) mutually agreed that Mr. Krolik will step down…”

So it is not like Mr. Krolik did a great job and the Board begged him to stay; both the Board and Mr. Krolik thought it might be a good idea. A brief review of Mr. Krolik’s tenure as CFO tells a lot about where Yelp may be going.

Pluses. Mr. Krolik was there for the 2012 Yelp IPO which raised $122.6 million. And he was there again in 2013, when Yelp’s stock was trading high, for a secondary offering which raised $291.7 million. Both financings helped raise capital so Yelp could operate. And in the last two years, Yelp’s operating activities have been cash flow positive.

Big Minus. Yelp did miss out on raising cheap capital with convertible notes; but not like Tesla, LinkedIn, and now Pandora. In fact Twitter did aconvertible note offering in 2014; three months after hiring its CFO, Anthony Noto away from Goldman Sachs. Twitter raised approximately $1.3 billion in a private placement of convertible notes. Generally, convertible notes pay a low interest rate, but give holder’s an equity upside.

Extra Gold Stars. Don’t worry about Mr. Krolik, he will be fine; he will earn his regular salary of $325,000 and vest stock until December 2016 or until his successor is found. But wait there’s more, about $450,000 more. Per the SEC filing, Yelp will recommend to the Board that Mr. Krolik receive additional stock. If the Board agrees, Mr. Krolik could be paid restricted stock units of 30,000, which vest quarterly as long as he remains an employee.

So one could say that the Board eased out the old CFO and decided to give him extra money. But why? Does Yelp have an aspiration for greater things, so it needs a heavier CFO? Answer: It difficult to know when reading between the headlines. The question was asked and answered on Quora, by Venice Patrie CPA, Senior Internal Auditor at Yelp:

Yelp is looking to scale. Rob is an awesome mentor and CFO and has done a great job here. He’s been great to work for but is more experienced in a smaller channel.

Here is the screenshot of the now deleted answer:

Yelp seems stuck in Web 2.0 and its mobile mojo has yet to catch on. Now with Mr. Krolik gone, and a new roll of the dice may be something more is in store, such as an acquisition or going private?

Was this review….? Useful, Funny, or Cool.

Marissa Mayer’s New Money Pit

Four billion dollars is nearly the amount reported as goodwill write offs in Yahoo’s recent Form 8-K. Does this mean Yahoo paid too much for Tumblr?

What it could mean is that Marissa Mayer has treated Yahoo as some Palo Alto fixer-upper, spending lots in capital improvements, but not getting too much in return. And that is really bad news for activist investors such as Starboard Value LP, who care a lot about the cash, the dead presidents.

Snap. Goodwill represents the excess of the purchase price over the fair value of the net assets acquired, per the bean counters. Translation: WhenYahoo paid cash of approximately $1 billion for Tumblr, the net assets were $250 million and the extra amount of $750 million was the goodwill.

Each year, companies must confirm the fair value of the goodwill, and if it’s not correct, then part of the goodwill is written off. The write offs are losses, shown on the income statement; so much for the Benjamins.

Crackle. As reported, Yahoo wrote off $230 million of the $750 million Tumblr goodwill. What happened? Back in 2013 Yahoo said the Tumblr acquisition was…

“….expected to bring a significant community of users to the Yahoo! network by deploying Yahoo!’s personalization technology and search infrastructure to deliver relevant content to the Tumblr user base”.

That apparently did not happen and part of the goodwill had to disappear. Did Yahoo pay too much or did Yahoo not try hard enough to drive traffic to Tumblr? Goodbye cheddar, lettuce, and clams.

Pop? When does Ms. Mayer’s cash drain end? Very soon, at least according to Starboard Value’s letter to the Board of Directors of January 6, 2016. No one needs the post office to telegraph the message of the January 6th letter: Make some changes or We (Starboard) will change the Board of Directors.

Starboard Value is not too happy where Yahoo’s cash has been going and said as much in its January 6th letter:

“In addition, the Company has spent over $2.3 billion on acquisitions. Unfortunately, most of these investments have been misguided, poorly overseen, and, ultimately, shut down.”

Starboard Value believes that if management can not properly manage Yahoo’s cash, then the cash be should be return to shareholders as a special dividend or share buyback. Is not a company more than just pieces of paper (stock), but an actually business responsible to an investor: an angel, a venture capitalist, or public shareholder?

Remember Marissa, the dough.

More Ugly News for Good Technology Employees

The latest from Good Technology (Good) is rather ugly. The old news reported in a NYT article had Good employees losing money on their stock when the company was acquired by BlackBerry on October 30, 2015. It turns out, Good really needed the cash a quick exit could bring.

That news comes from a filing made by Blackberry on January 13, 2016 to the Canadian Securities Administrators. The filing details a $20 million bridge loan from Blackberry, $80 million of senior notes from Oppenheimer & Co., and the true amount distributed to shareholders.

The Ugly. In September 2014, Good received $80 million from Oppenheimer & Co. in exchange for senior notes and warrants. The senior notes had stiff terms: annual interest of 5.00% and more. If the an IPO did not occur before March 1, 2016, then the amount due was not $80 million, but $88 million.

In addition, if there was change in control, then the amount due would be more, which appears did happen. If there was a change in control after October 1, 2015, and there was, the amount due on the senior notes was around $88 million.

The Bad. As reported, Blackberry paid $425 million for Good, but only $328 million of cash was available to all shareholders after paying $89 million to debt holders and $8 million of related expenses.

Preferred shareholders probably received the liquidation amount of nearly $267 million reported in the January 13, 2016 filing. That would then leave around $61 million for the common shareholders and some preferred shareholders who had a participating liquidation preference.

The Good? As of September 30, 2015, Good Technology had a negative book value of $212 million. Translation: After paying off the creditors, there was ZERO money for any shareholders. Running on low cash, Blackberry provided a $20 million bridge loan on September 8, 2015, so Good could keep operating.

The final chapter to the Good saga could be summed up by Sequoia Capital’s Don Valentine who said, “All companies that go out of business do so for the same reason — they run out of money.”A moral for other startup employees? Tell me and others what you think.

Tumblr’s (not so famous) startup lessons

Tumblr co-founder, David Karp is free of Yahoo in 2017.

David Karp made approximately $209 million when Yahoo paid $1.1 billion for Tumblr in 2013. David Karp’s Yahoo odyssey provides valuable lessons for startup founders and employees.

Here are the most important:

Two sided coin. Every transaction is an exchange: trading equity for venture capital means getting a venture capitalist in return. And at some future time, the venture capitalist will need to leave and exit the investment.

Just like startups, venture capital firms also have customers in the form of limited partners, who contribute money to an investment partnership. At some point, the venture capitalists must return the limited partners’ original investment and hopefully more.

Tumblr began in 2007 with little to no revenue and a lot of expenses. So David Karp sought venture capital from Union Square Ventures and Spark Capital and also in 2007, Tumblr became a portfolio company. Considering a portfolio company’s average life is five to seven years, this appears why Tumblr was sold to Yahoo in 2013.

Lesson: Venture capitalists need an exit.

Know the exit strategies. Venture capitalists need a liquidity event, something which will turn their investment into cash. Most founders and employees dream of the Initial Public Offering as their liquidity event.

An acquisition is another likely possibility. Why? Mature tech companies need to expand and have lots of cash. In the case of Yahoo, it stop being a technology company long ago and became a bank, holding lots of cash. Instead of innovating, Yahoo used its cash to buy parts of Alibaba and Yahoo Japan, and all of Tumblr when prodded by Wall Street for a turn around.

Lesson: An exit could an be IPO, but an acquisition is also possible.

Take the money and…. run? Startup employees can trade services for company stock, but private company stock is illiquid; it can not be easily converted into cash. As part of the acquisition, David Karp agreed to be an employee and until 2017, his total compensation is $110 million in cash and Yahoo stock, which is public stock and liquid.

Equity compensation allows employees to contribute and benefit from the startup’s growth. Upon an exit, the stock can be worth a lot and in bankruptcy, the stock is worthless; anything is possible with startups.

Lesson: Cash is always king.