The VC’s Customer

Tabby Kinder recently wrote an article for the Financial Times discussing Sequoia Capital’s decision to “walk away” from its investment in Citizen, the crime-tracking app that lets its users live-stream crimes in progress. The article does a good job of explaining that Sequoia led the Citizen Series A financing over 6 years ago, but declined to invest in a recent “cram-down” financing, which apparently resulted in the shares of existing investors (including Sequoia) becoming diluted to the point the investors were “effectively wiped out”. Part of Sequoia’s walk away from the investment included the resignation of Mike Vernal, a Sequioa partner, from the Citizen board.

Dan Primack, the influential journalist from Axios who focuses on the technology industry reposted Kinder’s article on Twitter and added the following statement: “Regular reminder that, ultimately, VC funds work [sic] for their limited partners, not for their portfolio companies”.

In response to Primack’s post, prominent and highly successful VC Fred Wilson of Union Square Ventures posted a few comments on his blog and provided a link to an article he wrote nearly twenty years ago titled “The VC’s Customer”. He stated in his new post that he would not change a word from the old post. I thinks Wilson’s original post is a very good one, but wanted to add a few of my own words on this topic.

First, founders of startups know, or should know, that an initial investment from a VC firm is not a promise from that firm to make further investments into the startup. Certainly the startup hopes the VC firm will make further investment, either to support accelerating growth, or support the business if it is struggling. (Though it is worth nothing that if the startup is doing really well and demand from new investors is high, often the founders hope its existing investors don’t invest their contractually allocated amount in a next financing, as the founders want to add to their index of name-brand VCs on the cap table). And, an obligation (whether legal or moral) to invest further into a company is not, in my view, appropriate. VCs provide funding based on promises made by founders and management of startups (promises that include financial projections). In my experience, a VC will support a company that is missing its targets for another round, or perhaps two, of financing, but not forever. Nor should it. The job of the VC is to return capital and profits to its limited partners, which it does by investing in and helping grow successful companies. Given Sequoia first invested in Citizen six years ago, and its partner held a spot on the board until recently, I strongly suspect that Sequoia participated in multiple rounds of financing of Citizen, and gave a lot of support to the business. At some point, Sequoia is entitled to shifts its capital and resources to other opportunities.

Second, it’s important to remember that VCs invest out of “closed-end” funds, which have a finite period to invest in companies, called the “investment period”. This period is usually around four years. VCs try to avoid investing in the same company from multiple funds, for reasons Mark Suster stated in a 2010 blog post. Given Sequoia first invested in Citizen 6 years ago, it is almost certain the fund that made that early investment (or investments) is no longer making investments. So, any investment by Sequoia in Citizen today would be from a new fund. As Kinder’s FT article notes, this new round of Citizen funding “wiped out” the investments made in earlier rounds of financing. Consider the reaction of an earlier fund Sequoia limited partner if it learned that a subsequent Sequoia fund (where it may not be an investor) participated in a financing that wiped out the position of the earlier fund. It is hard to imagine a scenario where Sequoia would make that later investment without doing serious damage to its franchise.

Third, Citizen should (and likely does) welcome the departure of Mike Vernal from its board. In fact, the new financing likely required it. This is unrelated to Vernal’s skills as a board member. Rather, one of the distinct advantages, in my view, of closely held private companies vs publicly listed companies is that the majority of members of the board either own directly (founders) or indirectly( VC partners) a large percentage of the shares of the company. They have a strong financial incentive to contribute time and energy to the business. Indeed, the personal financial and professional success of a VC is tied to the success or his or her portfolio companies. This stands in contrast to “independent” public company directors, whose compensation from the public company is often a minimal amount of their personal financial assets.

Finally, VCs do indeed work for their limited partners. They are in business to earn returns for their limited partners. But, they only way they can earn those returns is to help their portfolio companies increase in value. So, at most time, the same activities by a VC constitute working for their limited partners and working for their portfolio companies. This diverges only when the VC must make the difficult decision to not make further investment in a portfolio company when investment is needed. When the VC makes this decision, it is typically in a scenario where the prior investment in the portfolio company is at risk of impairment, or total loss. It is not a decision made lightly.

I am not an apologist for VCs. I am an angel investor, but also have been a startup company lawyer for over 25 years, mainly representing companies, not VCs. Not all VCs are good actors, nor all all founders. Most VCs and founders are good people trying their best to help companies on highly improbably, but deeply rewarding and important, journies. Life is full of nuance. Twitter generally is not. It is the space of grossly over-simplified “hot takes” and Primack’s tweet qualifies. It can be a great platform for connecting with and learning from experts, but too often the appropriate desire to build one’s profile on Twitter leads to attention-grabbing tweets that create often enduring misperceptions of how the world actually works.