This one weird trick to get $21M for free

How a competitive conflict cost Sequoia $21M

Image result for tug of war

Pictured: A VC firm (the rope) when a competitive conflict exists between portfolio companies.

Conflict Policies

“You must know I miss you. But what can I say? Rules must be obeyed” — ABBA

Imagine you are a VC. Your job incentivizes you to generate good returns for your LPs so that you can eventually take home some carried interest. You decide you are really interested in the no-code space so you decide to invest a no-code infrastructure company. In exchange for your money, connections, and advice the company gives you equity, information rights and possibly a board seat. You now have a vested interest in helping this company grow.

A year later you hear about an amazing team that is going out to start a no-code infrastructure company. As a VC you know that you are more likely to hit upon the winner in the space if you invest in multiple companies, so you decide to invest in this new company as well.

Now you are in a position where your returns could be helped by you sharing confidential information across the companies, favoring one for introductions, or otherwise sabotaging the weaker one to help the other (competing) portfolio company.

This is why even having two portfolio companies in the same market can make founders nervous and weaken a VC firm’s claim to be the best partner to help them grow their respective business.

Is it possible to mitigate conflicts of interests with different partners, information firewalls, and policies? Sure. It’s really hard to do though, especially given the dynamics of venture where only one company will usually define the returns of the fund.

In a world where reputation drives your ability to get into deals, being known for using your position on the cap table to favor competing companies within the portfolio can kill your deal flow and reputation.

A famous case of conflict policies preventing investments was A16Z not investing more in Instagram because they had pivoted into a space that where the firm had already invested in a competing company (picplz).

That one weird trick to make $21M

Amid all of the market turmoil today, a piece from Connie Loizos about Sequoia Capital “separating itself” from a startup they invested in earlier this year (and was announced last month) due to a “conflict of interest”. This involved letting the startup (Finix) keep $21M from Sequoia and surrendering their entire position including the board seat and equity ownership.

Surrendering an investment after it has been announced due to a competitive conflict is extremely unusual and leads to a lot of questions around what actually happened.

So What Happened?

I don’t know the details and don’t want to speculate on what actually happened.

The suggested narrative from Sequoia is that ways Stripe & Finix are competitive slowly emerged and Sequoia was uncomfortable with the position they found themselves in.

Sequoia didn’t want to further a conflict with their companies and build a reputation of harboring conflicts so they exited as soon as they can while taking care to not damage Finix (and consequently their own reputation). This would have been harder to unwind later down the road. $21M ends up being a painful price to pay but worth it to not create conflict (especially with the company that will single handedly return the entirety of prior funds).

This could have happened because of a competitive deal environment without enough time for extended due diligence, a change in roadmaps, or planning that emerged from board meetings. Many of you may be wondering why it wasn’t obvious, but I imagine a large part of the pitch/meetings/partner meeting was around focused on how Finix is differentiated from Stripe. At some point after the investment, it may have become clearer that the distinction is blurry.

Other possibilities raised on VC Twitter:

  • Stripe had a “no competitive investments” clause in their deal (or were promised it) and flagged this deal. Sequoia wanted to preserve their relationship with one their largest positions and walked this deal with Finix back without harming Finix (and their own reputation) too much.

  • There has been some talk about this being related to customers (example: a partner deal that was announced in February) choosing between Finix and Stripe. When it became clear that they are competing for a similar enough customer base, they decided to unwind their new investment.

  • Something else? It’s hard to tell what happened here given everything happened behind closed doors and in consultation with the two companies. It seems everyone here operated in good faith.

The minor details

This brings up more questions. Some of the obscure details I’d be interested in knowing:

  • Does Finix need to pay taxes on this gift of $21M of its own stock — it used some of that for it’s new raise? Can it recognize that stock as revenue? Did this transaction single handedly make Finix profitable? Was it transferred directly to the firms involved in the new raise?

  • How will Sequoia message this to LPs (if at all any differently from how they are messaging this to the public?)

  • Will Sequoia cover this expense from their own fees or somehow offset the impact on LPs? They won’t have to given their reputation and how well their fund is likely doing but I wouldn’t be shocked either way.

  • Do LPs even care about $21M? Is this above the bar to care about (especially considering how well the rest of their portfolio is doing)?

  • Who gets to decide what’s competitive? Could you have a third party rating agency for judging competitive-ness? Entrepreneurs have a broad definition of “competitive” when it comes to their own companies, so it’s unlikely that you can rely solely on what your existing portfolio companies say.

  • How much of other investor’s decision to invest was based on Sequoia investing (and securing a path to future fundraising). If they knew Sequoia was going to unwind their investment (but leave the cash), would they still have invested?

  • What about the founders? Would you rather have twenty-one million dilution free dollars or Sequoia backing you?

Should firms have this policy?

Founders now have to come to expect VCs to not invest in competitive businesses, and it’s reasonable to have. And in theory, if you had conviction that the companies you invested will win the markets they compete in, would you really have to intentionally hunt out competitors?

No conflict, no interest — supposedly from John Doerr of KPCB

There’s a quote that’s reputed to be from John Doerr (but unverified) that seems to suggest that firms shouldn’t have competitive conflict policies but from what I can tell, it’s not actually suggesting that. It seems to be more in reference to how having “skin the game” does not disqualify you from having opinions

Then again, KPCB is an investor in both Zenefits and Gusto. So maybe it is?

Of course, if you want to learn from the experts of funding multiple competing portfolio companies you might want to take notes from the Vision Fund.

Next time on the newsletter: I’ve been working on a post about why every VC seems to know each other and be friends.