February 24, 2014

This post is a bit of inside baseball, but bear with me.

Like everyone else, I was very impressed by Facebook’s $16B+ acquisition of WhatApp. Apart from the founders and employees of the company, Sequoia Capital was the big winner, and that was recognized by everyone.

As a VC, I was extremely impressed with Sequoia’s investment, just based on the information provided publicly.

Umm… thanks Rob, thanks for stating the obvious. Of course if you invest in a company that exits for $16B and return billions of dollars to investors, that’s very impressive.

But for those outside the VC business, there are a few nuances here that aren’t obvious, but really goes to further illustrate why the team at Sequoia delivers such extraordinary performance over time with a pretty big fund.

The most impressive fact is that Sequoia is the only institutional investor in the company. This is very unusual for most large scale VC-backed companies. Sequoia led an $8M series A round in 2011, 2 years into the life of the company, and put in another $50M over time.

Here’s why this is contrary to how most VC’s act:

  • Most VC’s buy their ownership in a company relatively early.  They would like to increase it over time in their winners, but they also like getting external validation that they have made a good investment by getting another firm to mark-up their investment.  Basically, this means that another VC invests at a higher valuation, making the early VC seem really smart and able to show unrealized gains.  This tends to make LPs happy and make the lead partner look good among his or her colleagues.
  • Most VC’s like having some leverage on their dollars.  They like to share risk with other investors in case things go sideways. It’s comforting to be able to maintain ownership by putting in $X, while someone else provides capital to the company by putting in $5X.  It’s also nice to have some other deep pockets beside you in case things go wrong, or markets turn sour.

But this is actually not what you want to do.  As an investor, you want to put as much money into your winners as possible. External impression or leverage be damned.  When a company is ultimately successful, every VC thinks to themselves “man, we should have just invested more earlier”.  But few firms actually do this.  It’s hard, and takes a LOT of guts.  Some folks on Twitter commented that Sequoia is a big fund, thus, this is easier for them.  Sequoia is pretty big, but there are other VC funds that are of similar size, and I don’t see this behavior most of the time.  Also, $60M in capital is not chump change.  This financing probably came out the Sequoia US Venture fund and Growth fund, which are separate entities, but I believe represent a pool of capital somewhere in the neighborhood of $1.2B. So $58M is still nearly 5% of their total fund in one company.  If a fund was $300M, that would be $13-$15M into a single company with no other coinvestors.  You don’t see that very often at all.

I’ve also seen multiple tweets comment that this was an obvious decision because of the traction that WhatsApp had.  Again, I think this is easy to say in retrospect, but not so in reality for a few reasons.

  • First, messaging apps don’t monetize very well. There are tons of investors who would dismiss the category entirely because it’s hard to build a big business. It’s kind of like chat and instant messenger.  Big user bases, but tiny revenues.  The userbase is also largely international, as is most of the revenue, another ding on the company’s ability to monetize. Companies like Skype have eventually monetized, but through premium services associated with long distance calls, which doesn’t quite seem like a great direction for the company and is ultimately a commodity game.
  • Second, not all companies with “user traction” are valuable. We tend to remember the winners. But the battlefield is littered with the decaying carcasses of the losers.  Some companies are the early entrants and seem like great winners, but no one snatches them up and they fail to build a real business and durable service (MySpace). Others grow really quickly out of the gates and fade just as quickly (I could name a bunch of examples, but I don’t want to hurt people’s feelings).  Also, because of the first point, getting a really big exit is probably dependent on acquisition, and once you get beyond a certain scale, your list of acquirers is pretty darn slim.
  • Third, investing in traction is obvious, but at what price is not so obvious. Sequoia essentially paid a very high price for Whatsapp equity with little or no external market validators.  How high? Last Friday, it was reported that the valuation for WhatsApp at the series A was $80M, and the subsequent $50 was invested at a value of $1.5B in mid 2013.  This was higher than even my own back of the envelope math (I had previously estimated that the last round was done at ~$800M).  If this is true, and we believe that the company was on a path towards $20M in revenue last year, that’s a 75X+ revenue multiple.  Insanely high, even in the frothy environment we find ourselves in at the present time.
  • Fourth, regardless of what Sequoia wanted to do, the ultimate decision around a financing is up to the entrepreneurs.  Techcrunch’s friday report mentioned that the last round’s financing was done with 3X participation.  This means that in a downside scenario, Sequoia would get paid out 3x $50M first, before anyone else, including founders and employees.  This isn’t a crazy term given the valuation, but given the traction, there would likely be other potential buyers at that price, and maybe without that kind of preference.  But the founders chose to let Sequoia speak for the entire round, even though one could come up with a dozen reasons why it might be beneficial for the founders to diversify their investor base.  To name just a few: 1) expand the rolodex of connections 2) expand the capital sources in case things go sideways and more money is needed 3) bring another set of intellectual capital to the table with different experiences, especially with social/consumer internet experience from some of the recent winners (Facebook, Twitter, etc). 4) create an auction for the financing and drive up the price even higher, etc. etc.  But ultimately, the founders did not take this path, and chose Sequoia for the entire round.  This indicates that the relationship between the founders and the investors was very strong and that there really wasn’t anything lacking that would lead the founders to seek out other capital partners.  Again, pretty unusual for a company at that stage.

There are a lot of other things to admire about Whatsapp and Sequoia. But hopefully this gives a bit of color on one element that I find really impressive and isn’t that obvious unless you are in the VC industry yourself.  I can almost guarantee that if any other fund was an investor in this company, the cap table would look very different by the time they exited.  Well done.

Note: I am basing my observations and analysis entirely off of public information, and have had no substantive conversations with anyone at Sequoia or Whatsapp about the company and this investment.

  • Neill Kramer

    And when you add the fact that the founders were a lot older than normal (they couldn’t even get hired at Facebook as employees!) it is a remarkable vote of confidence from Sequoia. It gives me hope that VCs are not lemmings after all.

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