DOUG LEONE IS THE managing partner of Sequoia Capital, where he has been a partner since 1993. Prior to joining Sequoia in 1988, he worked at Sun Microsystems, Hewlett-Packard, and Prime Computer in sales and sales management positions. Leone was responsible for investments including Guardent, ServiceNow, Aruba, Meraki, Rackspace, Netezza, Arbor/Hyperion, RingCentral and MedExpress. He received an MS in management from the Massachusetts Institute of Technology, an MS in industrial engineering from Columbia University and a BS in mechanical engineering from Cornell University. He is responsible for Sequoia Capital’s investments in Rackspace and Vina Technology.
1. “We want to be partners with entrepreneurs from day one … We know after many, many years that your DNA is set in the first sixty to ninety days.”
Leone makes a reference to genetics in his quote here. What is the DNA of a business? In my view, it consists of culture and values, plus a range of best practices. Best practices cannot be reduced to a formula since every business is different, but there are ways to learn from others. I learned most of what I know about optimal company culture and best practices during one magical period in my life when I would sit in on meetings as Craig McCaw met various captains of industry when they visited him. A parade of executives, including Charlie Ergen of Dish Network, Alan Mulally of Boeing, and Jeff Hawkins of Palm, came into my life during that time, and what I learned in those meetings was astounding. I tried to be a sponge for knowledge and best practices and to make the best parts of their DNA part of my DNA.
2. “In venture, big is completely the enemy of great. You want very small, tight teams, the same thing with running an engineering department.”
Leone believes that small teams of people making decisions make better decisions (i.e., too many cooks spoil the broth). Leone wants to find founders who understand the importance of a strong team and a teamwork mentality. As an example, he looks for founders who use the word “we” instead of “I.” He advises founders to “raise as little as you can to get you to something that you can show—plus maybe a quarter or two so you have a little bit of cushion—and then raise some more money. Raise as little—not as much—as you can because that’s the most expensive equity you’re going to sell.” He also says, “Be very generous with the early engineers that you hire. Those are the ones that you should invest in, because the first two or three engineers, if you get those wrong, you are done.”
3. “We’re happy to help recruit the first three, four, five engineers, but we firmly do believe that recruiting is a core competency that companies should learn.”
Team composition and chemistry determine the success of a business. Since great people attract other great people in a nonlinear way, getting a strong early start with recruiting is essential. Leone believes that if a company cannot recruit its own people after getting assistance from the venture capitalist, it is in trouble. If great people are not being attracted to the startup, something is wrong. By contrast, a startup that punches above its weight in attracting great employees is on the right track. If you think, “How did they hire someone of her or his caliber?” that’s a good indicator that the startup will be successful.
4. “There are three types of startups: (1) ones that are so young that it’s difficult to tell if the dogs are going to eat the dog food; (2) ones where there’s clear evidence of market pull; and (3) ones that are unfortunately stuck in a push market or have a very difficult product to sell. The trick is to say away from (3). You only go to (1) if you are a domain expert and you have an informed opinion on a product or market, but this is a rare trait. The real trick is to end up in (2).”
When he made this statement, Leone was giving advice to salespeople about factors to consider when deciding whether to join a startup. The best case for a salesperson without domain expertise exists when product–market fit has been found and there is existing sales traction (type 2). In other words, the dogs are eating the dog food and want more. Leone is also pointing out that if a business has not yet established product–market fit (i.e., it’s still difficult to tell if the dogs are going to eat the dog food), it’s best for an ordinary salesperson to leave the opportunity to others who have domain expertise, special skills, and aptitude (type 1). When offered a type 3 job, the salesperson should decline.
5. “Little companies have really two advantages: stealth and speed. The best thing for little companies to do is to stay away from the cocktail circuit.”
Startups need feedback when developing a product or service. Having said that, a startup need not spend a lot of time promoting its offerings until the time is right. There are so many things to do to prove the value hypothesis by discovering core product value that unessential activities like attending cocktail parties are an unwise use of time.
6. “Don’t confuse the cost to start a company with the cost of building a company.”
Creating a product or service and finding product–market fit are only small steps toward success. Unless a business finds sales, and its marketing and distribution approach a larger scale, a startup will not find success. There is a huge gap between finding product–market fit and scaling a company.
There are many attractive business opportunities that do not require and should not involve venture capital. Ben Horowitz writes,
Building modern companies is not low risk or low cost: Facebook, for example, faced plenty of competitive and market risks, and has raised hundreds of millions of dollars to build their business. But building the initial Facebook product cost well under $1 million and did not entail hiring a head of manufacturing or building a factory.
7. “Hire the guy who has something to prove.”
We want people who come from humble backgrounds and have a need to win.
Leone is a big fan of hiring people hungry for success. The best venture capitalists prefer missionaries to mercenaries, and people who have something to prove tend to be missionaries. I certainly have met people who were driven by the fact that they started with literally nothing before building a business. On the other hand, I have found in my own life that many people who come from more than comfortable financial backgrounds are also driven to find success. Bill Gates and Craig McCaw are just two examples.
8. “Be incredibly, ruthlessly selfish with your equity.”
Entrepreneurs who are not careful about dilution often learn a hard lesson about selling equity too cheaply. Founders need shares to compensate key people and to remain motivated to stay “all in.” Bill Gurley has said that he’s “seen companies take one or two angel rounds and wind up giving away half their company.” There is an old saying in the venture capital business: “There are three phenomena that can wreck even the best of investments: dilution, dilution, dilution.”
There are many tradeoffs involved, as the venture capital firm Andreessen Horowitz points out in advice it gives to founders:
The easiest way to think about valuation is the tradeoff it provides relative to dilution: As valuation goes up, dilution goes down. This is obviously a good thing for founders and other existing investors. However, for some startups there’s an added wrinkle; they may face an additional tradeoff, of valuation versus “structure.” Which reminds us of the old adage that “you set the price, I’ll set the terms.”
9. “What differentiated knowledge does the angel bring? Don’t just do an angel round with people whose money is thrown your way.”
Given a choice between angel investors who add both money and other contributions, or angels with only money to contribute, founders should choose the former. Raising money is not a problem if you have a great team and an attractive offering under development with significant convexity. However, founders are increasingly realizing they need more than money from their investors. For this reason, you see more and more venture capitalists blogging and using social media to convey to founders that they have more to contribute to a business than money.
When is raising money from angel investors a good idea? Ben Horowitz writes, “If you are a small team building a product with the hope of ‘seeing if it takes’ (with the implication being that you’ll try something else if it doesn’t), then you don’t need a board or a lot of money, and an angel round is likely the best option.”
10. “There are venture firms that have never generated a positive return or have not even returned capital in ten years that are raising money successfully. And that surprises the heck out of me. People talk about the top quartile—it’s not about the top quartile, it’s barely about the top decile, or even a smaller subset than that.”
Many pension funds and universities have financial return assumptions of about 8 percent for their investments. No one associated with an endowment or pension fund likes to deliver a message that requires his or her organization to cut spending or raise contributions. To achieve the desired financial return, fund managers may convince themselves that they can achieve high returns via the venture capital asset class even though this means investing in firms that have been in the bottom quartiles of performance. Such decisions can result in far more money coming into the venture capital asset class than would otherwise be the case when times are good.
11. “Just keep in mind that we are in a venture capital business. It’s called venture capital because nothing is certain. But if you look at our portfolio, it doesn’t include Twitter. It doesn’t include Pinterest. We have made many, many errors over the last forty, fifty years. But I’ll also tell you we’ve got many, many right.”
Venture capital is a business in which you are guaranteed to make mistakes since it is all about buying mispriced convexity. Just like Babe Ruth, the greatest venture capitalists strike out a lot, but they sometimes hit massive grand slams. It is worth emphasizing that Leone is talking about uncertainty rather than risk. Uncertainty is actually the investor’s friend since it is the primary cause of mispriced assets. Without mispriced assets (i.e., the mistakes of other people), you cannot outperform the market, and it is when there is uncertainty that assets are most often attractively mispriced.
12. “If you’re in Cleveland, we cannot help you.”
Physical location still matters, which is why there are cities that benefit from agglomeration effects. If the venture capital firm is too far away from the startup, it is hard for the venture capitalists to provide much more than money. Without more than money, Leone feels that companies do not have the same probability of success as those with investors who provide more than financial backing. Since Leone has helped established Sequoia branches overseas, he must believe that the Sequoia venture capitalists in overseas cities can help startups in those cities. Don Valentine (a Sequoia founder) agrees with Leone:
In thirty years we haven’t convinced ourselves to set up a presence in Boston. It’s a very difficult business to be good at consistently over a long period of time, and it requires a lot of thoughtful and integrated decision-making. We make enough mistakes on investments we make in Silicon Valley that we’re not comfortable we can be successful three thousand miles away, never mind eight thousand miles away.
If a city is just a couple of hours away from a venture capitalist, I would argue that the rule does not apply. For example, many venture capitalists from San Francisco successfully invest in Seattle and vice versa. This does not mean that others cities cannot have their own local sources of venture capital and find success. There are people who are trying to make that happen. Whether this can be done successfully at scale raises a different and complex set of issues that would be worthy of another book.