Lessons From Sequoia’s $21 Million Investment Mistake

Content marketing article published on Lynk Global

The rule of thumb for all venture capitalists is to not invest in a direct competitor to any existing portfolio companies. Reasons? Conflict of interest, or it simply is unethical. But in a shocking realisation, Sequoia Capital, one of Silicon Valley’s most respected venture capital firms, recently found themselves having made exactly that investment mistake.

Earlier this month, Sequoia announced it had parted ways with San Francisco-based payments infrastructure platform Finix as the investment was in conflict with the venture capital firm’s existing portfolio company Stripe. Sequoia subsequently handed back its board seat, information rights and equity. What’s more, Sequoia had to give up its full investment in the firm, essentially donating US$21 million to Finix.

Pat Grady, the Sequoia partner behind the deal, said in a statement : “While we’d previously concluded that Finix was not a direct competitor to any existing portfolio companies, after making the investment we came across a variety of small data points that collectively painted a different picture of the market. This decision had nothing to do with Finix, and everything to do with Sequoia’s desire to honour our commitments. It is incredibly difficult to part ways with Richie, Sean, and their team at Finix. They are exceptional people and leaders, and their future is bright”.

In the venture capital world, it’s uncommon for a VC to unwind an announced deal and let the portfolio company keep the capital. But after realising Finix and Stripe are chasing after the same customers in some ways, Sequoia made the unprecedented move in its 48-year history to eliminate the investment.

What’s done is done. But what are the lessons venture capital firms can learn from this US$21 million mistake and prevent any such embarrassment in the future?

HOW IT HAPPENED?

While Sequoia completed a due diligence process and decided that the products and business models of Finix and Stripe were not directly competitive, analysts said Stripe’s recent partnership with the Canadian point-of-sale and e-commerce software provider LightSpeed may be linked to the conflict of interest as Finix is also a partner of the Montreal-based company.

Sequoia might have spoken to experienced payments professionals to understand the nuanced distinctions between the two payment platforms’ business models, one extra step venture capital firms could do to lower the risk is speak to the ordinary merchants. As it turned out, merchants and software companies viewed Finix and Stripe as rivals because they were essentially offering solutions to the same problem. But it was already too late when Sequoia began understanding how other stakeholders saw the two companies.

While venture capital firms usually are the experts in the sectors and products that they invest in, they can prevent making mistakes related to conflicts of interest if they opt for a thorough due diligence process such as channel check. Channel check is the practice of directly investigating the operations and performance of a company as part of investment analysis. It involves conversations with suppliers, customers and employees of a firm. Through speaking to employees of a company and its customers, investors will be able to get a sense of its sales volume, pricing and customer behaviour. Meanwhile, the real picture of what goes on behind the scenes can only be understood by talking to people in the supply chain or distribution channels.

While conducting due diligence, for example for a B2B marketing software tool, asking buyers in relevant enterprise market segments the following questions could make the process more effective:

• What tools do their customers use and how’s their experience?

• How do they decide which products or services to buy?

• What value are they looking for?

• Where does their budget for this type of tool come from and how much is the budget?

One key lesson to be learnt here is that you simply can’t be the smartest guy in the room if you don’t understand the perspectives of all relevant parties – whether or not they are experts. An effective channel check should represent a wide mix of existing and potential customers of the target companies.

However, startups could sometimes be similar and it’s not uncommon for investors to come across potential investments that they want to pursue but are direct competitors with their existing portfolio companies. On the market, there are tools and services such as Lynk Answers knowledge platform among others that allow investors to speak to people from the industry or end market with the right experience and expertise who are independent of their target companies for a thorough due diligence process.