Scouts

The Wall Street Journal recently had a great piece on Sequoia Capital’s Scouts program. Basically, it’s a program whereby Sequoia gives its scouts around $100K a year to invest in promising startups. The scouts consist of entrepreneurs that Sequoia has backed in the past, academics, former Sequoia partners, and anyone else that Sequoia believes may have the ability to identify and access great startups.

Most of the gains from successful investments are shared by the scout making the investment and Sequoia’s LP’s. Sequoia’s GP’s and other scouts only get a small fraction. The fact that the returns from the investment go to the scout rather than Sequoia’s GP’s ensures that the scout has sufficient financial motivation to perform well. The scout essentially gets free money from Sequoia with no downside in the case of a poor investment, but significant upside in the case of a good investment. In this way, the scout effectively becomes the GP of an angel fund where Sequoia is the main LP.

There are no formal strings attached to Sequoia’s capital. Since the investment is made by the scout’s investment vehicle, the startup is free to take capital from whichever source it chooses in the future. However, Sequoia hopes that the scout will repay Sequoia’s goodwill by giving Sequoia priority access to the company’s future larger rounds. Companies like Stripe and Thumbtack, which Sequoia invested in after its scouts Sam Altman and Jason Calacanis referred the companies to them, suggest that the program is working. Companies like Uber, Optimizely, and Zenefits also received original investments through the scout program but Sequoia didn’t participate in their follow-on rounds.

The economics of the scout program also make a lot of sense. The article shares the names of 105 scouts. Some likely no longer serve as scouts, and there are likely others beyond the names on the list. However, assuming that there are ~100 scouts and that each is given $100K a year to invest, that’s a total of $10M per year. In exchange, Sequoia gets the opportunity to find out about great performing startups before other investors, as well as a scout who can vouch for the entrepreneur to take Sequoia’s money over that of other investors. Let’s try to place a value on this.

Sequoia led Stripe’s $18M Series A and Thumbtack’s $12.5M Series B rounds respectively. I don’t know how much Sequoia invested and at what terms, but assuming that each round was for 20% of the company and that Sequoia invested $10M in each round, that’s 11% and 16% of the companies. Stripe and Thumbtack are said to be valued at around $5B and $1.3B right now. Assuming 20% further dilution in each round, Sequoia’s 11% original stake in Stripe is now 4.5% after 4 rounds. Its 16% original stake in Thumbtack is now 8% after 3 rounds. That’s a total paper value of 4.5%*$5B + 8%*$1.3B = $225M + $104M = $329M. These calculations ignore the returns from the follow-on rounds in which Sequoia likely participated to at least retain its pro-rata.

Let’s be very conservative and say that these are the only two return-producing companies that Sequoia invested in as a result of its Scout program over the last 5 years. The actual number is likely much larger. The total cost of the Scout program over 5 years is $50M, and the total investment amount we assumed is an additional $20M. So for a total investment of $70M, Sequoia is sitting on a paper value of $329M. That’s a minimum 4.7X return. This calculation also ignores the paper value of the investments made by the scouts which, although they only produce a small return for Sequoia’s GP’s, are likely shared with its LP’s on the same terms as the core fund.

The scout program makes both logical and economic sense. In startup ecosystems where capital is plenty, having a strong and wide network that gives you priority access to startups is an important competitive advantage.