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, HP and Prime in sales and sales management positions.
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 60 to 90 days.”
Doug Leone would prefer to be the “first outside dollar” in a new business. He believes it is easier to train people about the right approach than to change what has already been established. The cynic might say he is saying this because valuations are lower for the “first dollar in” venture capitalist. The non-cynic would reply that the probability of success goes up when a business gets a great start, since investing early helps retire risk and uncertainty.
Doug Leone makes a reference to genetics in the quote. What is the DNA of a business? In my view it is culture and values, plus a range of best practices. Best practices can’t be reduced to a formula since every business is different, but there are ways to learn from others. Many posts on this blog have been about best practices and company culture. I learned most of what I know about optimal company culture and best practices mostly during one magical period in my life when I would sit in on meetings as Craig McCaw met various captains of industry as they came to visit him. A parade of executives like Charlie Ergen, Alan Mulally and Jeff Hawkins passed through my life during that period, and what I learned in those meetings was magical. I tried to be a sponge for knowledge and best practices, and to make the best parts of their DNA part of my DNA.
It is important to break at least a few rules in creating a startup, since you can’t outperform a market by simply copying others. BUT, not taking the time to learn from others about best practices is a huge mistake. A group called the Startup Genome team created this “avoid-to-achieve-success” list, which is instructive rather than complete:
- Spending too much on customer acquisition before product/market fit and a repeatable scalable business model
- Overcompensating missing product/market fit with marketing and press
- Building a product without problem/solution fit
- Investing into scalability of the product before product/market fit
- Adding “nice to have” features
- Raising too little money to get thru the valley of death
- Raising too much money. It isn’t necessarily bad, but usually makes entrepreneurs undisciplined and gives them the freedom to prematurely scale other dimensions. I.e. over-hiring and over-building. Raising too much is also more risky for investors than if they give startups how much they actually needed, and waited to see how they progressed.
- Focusing too much on profit maximization too early
- Over-planning, executing without regular feedback loop
- Not adapting business model to a changing market
- Failing to focus on the business model and finding out that you can’t get costs lower than revenue at scale.
2. “[In venture] big is completely the enemy of great. You want very small, tight teams, same thing with running an engineering department.”
Doug Leone believes that small teams of people making decisions make better decisions (too many cooks spoils the broth). The Startup Genome team also makes a few points on small team failures:
- Hiring too many people too early
- Hiring specialists before they are critical: CFO’s, Customer Service Reps, Database specialists, etc.
- Hiring managers (VPs, product managers, etc.) instead of doers
- Having more than 1 level of hierarchy
3. “We’re happy to help recruit the first 3, 4, 5 engineers but we firmly do believe that recruiting is a core competency that companies should learn.”
A repeated theme of successful VCs in this series of blog posts has been that the composition and chemistry of the team will determine the success of the business. Since great people attract other great people in a nonlinear way, getting a strong early start with recruiting is essential. Doug Leone is also saying that if the company can’t recruit its own people after getting an assist from the venture capitalist, they are in trouble. If great people aren’t being attracted to the startup something is wrong.
Because hiring the right people is so important Sequoia has in house recruiters to help companies. If a startup if not able to attract great employees that is a “tell” for an investor that something is wrong with the business or its culture. By contrast, a startup that punches above its weight in attracting great employees is a sign that the business is on the right track. If you think to yourself: “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 start-ups: 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. 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/market, but this is a rare trait. The real trick is to end-up in #2.”
When he said this, Doug Leone was giving advice to salespeople about joining a startup. In the best case for the salesperson, product/market fit has been found and there is at least some sales traction. In other words, dogs are eating the startup’s dog food and want more. Doug Leone is pointing out that if the business has not yet established product/market fit (ie., it’s still difficult to tell if the dogs are going to eat the dog food) it is best for the salesperson to leave the opportunity to others who have special skills and aptitudes. A different breed of employee is required when it is unclear whether the dogs will eat the dog food (type 1).
5. “Little companies have really two advantages: stealth and speed. You [Arrington] come from the world of speed and no stealth. The best thing for little companies do is to stay away from the cocktail circuit.”
As my blog post on LinkedIn’s Reid Hoffman pointed out, startups need feedback when developing a product or service. Having said that, a startup need not spend a lot of time promoting the offerings until the time is right. There is a big difference between developing a product and finding product/market fit, and promoting a product in ways that do not relate to product/market fit. Attending parties is not what creates great companies. Typically you are not interacting with customers at a party. Having said that, as I wrote in my post on Nassim Taleb: “Living in a city, going to parties, taking classes, acquiring entrepreneurial skills, having cash in your bank account, avoiding debt are all examples of activities which increase optionality.” A balance is required in all things, and the level and intensity of party attendance and socializing is a part of that.
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 the business finds sales, marketing and distribution approaches that scale, a startup will not find success. There is a huge gap between finding product market fit and scaling a company. Bill Gurley of Benchmark Capital points out: “If you want to get to 50 to 100 employees (unless you’ve discovered the next Google AdWords) you’re going to need outside funding, but that doesn’t mean VC investment is the path for everyone.”
There are many attractive business opportunities that do not require and should not raise venture capital. Ben Horowitz of a16z 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 $1M 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.”
Especially since he came from humble beginnings economically, Doug Leone is a big fan of hiring people who are hungry for success. His partner Michael Mortiz explains: “Every time we invest in a little company, it’s a battle against the odds. We’re always outgunned by companies that are far larger than us, who have threatened us and the founders with extinction.”
The best VCs 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. I’ve have found in my own life that many people who come from comfortable financial backgrounds are also driven to find success. Bill Gates and Craig McCaw are just two examples. Of course, some people from affluent backgrounds are also growing organic vegetables in a commune (not that there is anything wrong with that if it makes them happy).
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. The founders will need shares to compensate key people and to keep themselves 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 a relevant old saying in the venture capital business: “There are three phenomena that can wreck even the best of investments: Dilution, Dilution, Dilution.”
A16z points out that there are many tradeoffs involved: “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 Angels who add both money & other contributions, or Angels with only money to contribute, choose the former. Especially circa 2015, raising money is not a problem if you have a great team and an offering under development with significant optionality. Founders increasingly realize that they need more than money from an investor. 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 Angels 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 10 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.”
Pension funds and universities have ~ 8% return assumptions, and hope for some sort of justification that they will deliver magical returns via the venture capital asset class. In other words, they invest in the way that Doug Leone describes, since it enables the investment committee of the pension or endowment to defer the pain of reducing the return assumption – and that makes the underfunding problem the job of someone else in the future. No one associated with an endowment or pension likes to cut spending or raise contributions, so they pretend that certain returns are possible. This results in more money coming into the VC asset class than would otherwise be the case.
What this also causes is for money to chase performance in the venture capital asset class, and for this to be true: “Venture Capital has long been a trailing indicator to the NASDAQ. Venture capital is a cyclical business.” (quote from Bill Gurley)
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 40, 50 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 optionality. It is magnitude of success and not frequency of success that matters in the end. The greatest venture capitalists, just like Babe Ruth, strike out a lot, but hit massive “tape measure home runs”. It is worth emphasizing that Doug Leone talked about “uncertainty” rather than risk. Uncertainty is actually the investor’s friend since it is the primary cause of mispriced assets. I discuss the difference between risk and uncertainty in my post on Vinod Khosla of Khosla Ventures. Without mispriced assets (i.e., the mistakes of other people), you can’t outperform the market, and it is when there is uncertainty that assets most often get attractively mispriced.
12. “If you’re in Cleveland, we cannot help you.”
Doug Leone said this in 2011. Unfortunately, physical location matters even with the Internet as a powerful tool to distribute expertise. My late friend Keith Grinstein used to say that “you can’t milk a cow over the phone.” Physical location still matters, which is why there are cities that benefit from agglomeration effects. Smart cities embrace this fact and create their own positive feedback loops.
If the venture capital firm is too far away from the startup, it is hard for the venture capitalist to provide much more than money. Without more than money, Doug Leone does not feel the company has the same probability of success. Since Doug Leone has helped established Sequoia branches overseas, he must believe that the Sequoia VCs in overseas city X can help startups in city X. Doug Leone obviously feels other cities can have agglomeration effects while investing in, or Sequoia would not have such big investments in China and India.
Don Valentine (the Founder of Sequoia), who I will write about soon, said once about his firm: “In 30 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 here (in Silicon Valley), that we’re not comfortable we can (be successful) 3,000 miles away, never mind 8,000 miles away.” If a city is a just a couple of hours away from a venture capitalist, I would argue that the rule doesn’t apply. Lots of venture capitalists from San Francisco have been successful investing in Seattle and vice versa, especially if they have strong venture partners in the other city. A firm like Benchmark Capital benefits immensely from having a partner like Rich Barton in Seattle.